As Senate takes up financial reform bill, a look inside the sausage

If one’s grasp of history can deter a repeat of it, then a nutshell review of the 2007-09 financial crisis is now needed as Congress nears passage of a massive Wall Street reform bill.

The crisis grew out of a ramp up of federal support for mortgages to home buyers who were either unworthy to take on big debt or unaware of their loan’s details. These shaky purchases helped create a housing bubble, while the iffy mortgages were snatched up blindly by Wall Street investors. The risks were magnified by shoddy practices in credit-rating firms, the derivatives industry, and banks. When the bubble burst, Washington didn’t have enough tools to prevent the fallout.

Now, more than a year later, a 2,319-page bill known as the Dodd-Frank Wall Street Reform and Consumer Protection Act aims to prevent a repeat of this worst economic disaster since the Depression. And just in case the remedies don’t work, the bill makes it easier for government to clean up future financial messes.

If passed, as expected, it faces a long highway of implementation with potential offramps for its most difficult provisions.

Congress, for instance, leaves dozens of the toughest decisions up to regulators, such as levels of compensation for bank officials, the types of proprietary investments that banks can pursue, the determination of when a firm is too big to fail, or the amount of money that big firms must keep in reserve.

Granting such wide discretion to regulators may give them flexibility in responding to a crisis, but it also leaves them open to influence by lobbyists, as is often the case, or allows future presidents to weaken regulations.

The bill has no provision to guide regulators if American firms decide to take their business to other countries with fewer regulations. Without a global agreement on how to manage such companies across borders, the US stands to lose jobs and income.

The bill doesn’t do much to improve how credit-rating agencies assess risky mortgages. It lacks needed reform of the two largest firms that bundle mortgages into securities, Fannie Mae and Freddie Mac, both of which were guilty of lowering mortgage standards and which the government was forced to take over.

A new Consumer Financial Protection Agency would be charged to set standards on mortgages, as well as credit cards and payday loans (although auto dealers are exempt – a sign of the power of lobbies). But its authority isn’t clear as it sits inside the Federal Reserve, whose main focus is inflation and banking stability.

Perhaps the strongest reform lies in the Financial Stability Oversight Council. This body would try to bridge the interests of many regulatory agencies and see the financial landscape as a whole, preventing bubbles in any part of the economy. But its exact scope is left up to the appointed officials.

Second in importance to the council is a requirement for transparency in the multibillion-dollar derivatives industry. This type of financial instrument, now conducted largely in secret between private parties, would be put on public exchanges. Bringing this shadowy practice into the light should help identify systemic risks in the economy.

Congress was under political pressure to rein in Wall Street’s worst practices before this fall’s election. And President Obama claims the reforms “can help prevent another financial crisis like the one that we’re still recovering from.”

But so much has been left hanging that voters will have to decide if lawmakers made the right choices. Taking the biggest risks out of financial markets cannot be easily done if so much about this law still remains at risk.