By Chuck Jaffe
Dow Jones Columnist
If you want to figure out where the next big financial crisis is coming, watch the proceedings in Washington over the next two weeks. Whatever pieces of the proposed financial reform legislation get watered down or eliminated during current negotiations will create the holes that future bad actors slip through.
No investor should be naive enough to assume that legislation, no matter how comprehensive, will make problems disappear. But the singular hope for investors should be that legislation protects against known and foreseeable threats, and deters the bad guys from making their play.
Looking at both the House and Senate versions of financial overhaul, it's clear that the politicians actually recognize some of the biggest problems, but it's equally clear that they're not willing to take the hard steps needed to go all the way to eradicating trouble.
Functionally, any change should leave the people on Main Street feeling a bit more like equals to the people on Wall Street, rather than feeling like the little guy playing in a rigged game with the rules set - and bent - by the big players.
Wall Street's lobbyists are working hard to weaken the new legislation, and insiders say they are having some success. That is where the loopholes come in; the weaknesses in the final version that comes out of Congress create a roadmap to trouble.
Congress Won't Limit Banks' Size
For example, if Congress wants to avoid the next bailout, it should take steps to avoid that now, by deciding that a bank which is "too big to fail" is actually "too big for the good of the country." Quite simply, Congress needs to limit how big commercial and investment banks grow; if it put in limits-say, that assets should not exceed 3% of the U.S. gross domestic product-there would be fewer than a dozen institutions that would fall on the wrong side of the line. Meanwhile, bank failures and closings have actually made the biggest institutions larger, which increases the potential for trouble if and when there's another crisis.
There is no way that Congress will actually limit bank size, so investors should hope it gives government the ability to increase capital requirements (which would reduce the risk of bank failures) and approves the "Volcker rule"-named for its chief proponent in former Fed chairman Paul Volcker-which would stop banks from trading for their own account. That way, if a bank wants to make a leveraged bet on stocks or derivatives-and that's where the big-money banks make the bulk of their profits-they don't get federal deposit insurance and they can't come running for a bailout.
Congress could also step in on the trading front, trying to curb rapid trading and put in minimum holding periods for securities. While day-traders add liquidity to the market and help keep things flowing, computer trading programs making round trips in 10 seconds bring no real economic benefit to the party, and create some real dangers. A mild limit would help, but since Congress is unlikely to act, this is another area where no curbs lead to bad news in the future.
The biggest issue directly tied to the consumer involves fiduciary standards. Under one proposal, all stripes of financial adviser would be required to put client interests first; currently, many types of advisers-notably most brokers-need only live up to a "suitability standard."
The Senate still wants to study the issue, which is basically like seeing a shark in the fish tank and letting it swim around to see if it eats anything. The problem has been around for decades, and studying it more now will simply lead to more troubles before the issue is put right. Hopefully, the House version carries the day in the current negotiations.
Also, regulating derivatives would be a step in the right direction, especially if it creates transparency and puts derivatives on exchanges. While average investors do not understand how derivatives work, the simple knowledge that the securities are easily priced and that the net asset value of a mutual fund holding derivatives is based on an actual price instead of a manager's best guess would be a big step.
We'll All Pay, In The End
Expect a lot of attention to be paid to consumer issues, specifically around credit cards and debt collection. What recent credit-card reforms have shown, however, is that the credit industry is adept at finding new ways to maintain its revenues and profits. No reform in the credit-card world comes without some sort of payback on the part of the public.
In the end, expect the politicos to touch on a lot of major issues, and solve practically none of them. They'll be compromised steps in the right direction.
Consumers, of course, are expecting too much, hoping that financial reforms will somehow fix the economy. That's not happening here, but a small step forward would at least represent progress. That said, if the House and Senate leave the most critical and largest changes on the floor, it will be the American people who pay for that mistake in the end.
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