Congress Has Some Interesting Plans for Financial Regulation

Jim Hamilton reported yesterday on Congress’s plan to reform financial market regulation, as delivered by Barney Frank, Chair of the House Financial Services Committee. The two-pronged approach will (1) address the creation of a systemic risk regulator and (2) strengthen investor confidence by increasing investor protection. Two particular components of the plan stood out to me.

First, to prevent loan securitization from shifting the risk of default completely off the shoulders of loan originators and securitizers, Congress would place a limit on how much of a loan may be securitized.

In order to restore the discipline of the lender-borrower relationship that was substantially weakened by securitization, the legislation will make it illegal for anybody to securitize 100 percent of anything. The exact percentage of retention is open for debate, said the oversight chair, but whatever percentage Congress decides to allow must follow the principle that the first dollar of loss is borne by the securitizer. This principle is correct, he reasoned, because securitizers are the ones who have to do some checking. But some liability will also be put on the originators.

This type of limitation would force the entities that purchase loans from originators in order to securitize and sell off the loans in parts to retain some portion of the purchased loans, which causes the securitizers to suffer some losses if those loans go bad. This retention of risk should cause the investment banks, hedge funds, and other securitizers to be more wary of the quality of the loans they purchase from originators, which in turn will cause originators to use tighter, more responsible lending standards.

Second, Congress intends to revisit the notion that “sophisticated” investors do not need the protection of the federal securities laws. This notion is the basis of numerous exemptions in the various securities laws that have allowed private investment funds to avoid most federal regulation by restricting access to investors with large amounts of money/financial sophistication. However, thanks to massive frauds pulled on these “sophisticated” investors by the likes of Madoff Investments and Stanford Financial, this notion has been seriously challenged.

If the exemptions for sophisticated investors are removed and all investors are treated the same, that could spell the end of hedge funds and possibly private equity funds as we know them. Hedge funds could be forced to disclose their trading strategies and take on less risk, which would basically turn them into mutual funds. Private equity and venture capital funds could be forced to give up their long lockup periods on investor funds, which could make their long-term investment strategies far less stable. Even if the only reform is that the standard of what makes someone a sophisticated investor is raised, that could cause a permanent contraction of the private investment fund market as the pool of potential investors shrinks.