The Senate reconvened reconciliation hearings at noon today with a deal brokered yesterday to place the new financial watchdog agency within the auspices of the Federal Reserve, rather than establishing an independent agency. This compromise by Congressional Democrats – which is engendering strong opposition from some important constituencies – could indicate a growing desperation to get something (anything, anything at all) in front of the President before his appearance at the G-20 this weekend. As someone who spends a good piece of my week (and some weekends) reading and writing documents that are intended to build a legal framework around unforeseeable real-word events, I can appreciate the utter impossibility of crafting legislation that will simply get it right the first time. I’ve learned this too many times: As complexities increase, the better can become the enemy of the good.
However, the most comprehensive financial reform in seventy years is too important a matter to be figured out post-closing. And the open items list, as could be expected, contains some of the most controversial elements to be hammered through. Closer to an agreement, but still on the agenda: the Volker Rule. Volker himself on Monday told Reuters that he didn’t want his rule so loaded with exemptions that it looks like "swiss cheese". While banks certainly did not do themselves any favors with their own assets during the bubble, proprietary trading cannot really be identified as a major cause of the 2008 collapse. It bears considering that perhaps it was trading on behalf of clients – specifically, the collection of assets on behalf of buyers when the music stopped – that caused (by far) the biggest losses. However, the Volker Rule, and the cult of personality growing around the former Chairman of the Federal Reserve himself, has breached the event horizon. With a memorable, marketable nickname, some machination of the Volker Rule will be part of the final legislation (with a directive to the agencies to fill in the blanks).
Perhaps most critically, risk retention is still undecided at even the most fundamental level. In terms of underpinning, the "skin in the game" provisions rely on the basic premise that no rational person would make an interest-only negative-amortizing adjustable-rate subprime mortgage loan if that person were required to retain 5% of such interest-only negative-amortizing adjustable-rate subprime mortgage loan. (NOTE: For more on this, see the Vanity Fair article excerpting Michael Lewis’s book, The Big Short). May even be true. I doubt it seriously, but maybe.
However, this is too important an issue to "kick the can down the road". A possible compromise being discussed includes a sliding scale, permitting less retention for safer loans and more retention for risky loans. What that could mean, how it would be instituted, why it’s necessary (or even helpful), who would make such a determination, why the person making the determination could do it better than the market, the return of the housing market, the impact on the return of a healthy residential securitization market, the potential for market participants to opt for a covered-bond structure (stay tuned for more on this), and the rule’s interplay with existing regulations (think FAS) – all of that could end up on the post-closing letter. Senator Chris Dodd, for his part, seems to understand the enormous impact a poorly-thought-through risk retention policy could have, insisting that some low-risk loans be exempted. He also seems to have flatly rejected proposals that could result in risk retention in the commercial sphere- with potentially catastrophic consequences for the existing CMBS model.
According to the Washington Post this morning, Dodd, the primary author of the Senate’s Fin Reg bill, announced to his colleagues one evening last week his fear "that we’ve all died and this is our purgatory".