How Will the New Financial Reform Bill Impact Commercial Lending?

Last week the Senate passed the conference version of the financial reform bill, formally call the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Act’s sponsors say it is intended to “create a sound financial foundation to create jobs, protect consumers, rein in Wall Street, end too big to fail and prevent another financial crisis.” Quite an ambitious goal, but like anything coming from Congress, it represents compromises and bargains. President Obama is expected to sign the Bill this week. While this is a major accomplishment for the Obama administration, whether it will accomplish many of its ambitious goals will only be determined over time.

The causes of the financial and banking crisis that ushered in the current recession are still being (and may forever be) argued, but there is no argument that among the key contributors were a housing bubble fed by irresponsible borrowing and lending; a lack of transparency in financial derivative products and transactions; and a deep belief that some financial institutions were too big to fail – a belief that their failure would cause a systemic collapse of the interconnected financial system far more serious than the massive subsidies that were infused to forestall the collapse. In the crisis atmosphere of early fall 2008, lawmakers, generally on both sides of the aisle, approved emergency actions they believed necessary to forestall an immediate disaster. Having had nearly two years to consider the causes of that crisis and vulnerabilities in the financial system, Congress passed the 2,300 page Dodd-Frank Act, which is a collection of disparate measures intended to address various of the favorite financial bogies, reflecting more of the give and take of the political process more than any coherent economic theory or well-grounded view of financial and regulatory reform.

While the details of this 2,300 page Act are complex and varied, the thrust, at least initially was simple:

First, to reduce the risk to the entire financial system created by huge institutions trading in obscure and opaque instruments with counter-parties who may not be able to perform – It was this financial daisy chain that both generated huge profits for financial firms and created the risk of an AIG failure, for example, bringing down the entire system.

Second, to enhance protection of consumers, either from lending practices such as extending loans to unqualified borrowers (so-called NINJA loans of the 2007 era), from unfair lending practices such as yield spread premiums or from the need to bail out the financial entities who faced overwhelming losses through those obscure trades above.

Highlights of the Act include the establishment of a mechanism that is intended to end the view of any financial institution as too big to fail, along with a requirement that certain large institutions create “funeral plans” explaining how they could be unwound in an orderly manner were they to fail; the requirement that many derivatives, including many asset-backed securities be traded and cleared on markets where counter-party risk is mitigated through the requirements of certain margin or collateral requirements; requiring banks, bank holding companies and subsidiaries to separate their proprietary derivatives trading (other than traditional hedging activities) and hedge fund/private equity fund sponsorships or investments from their banking activities. This last is the “Volcker Rule” which will bar both banks and other financial institutions regulated by the Fed from such high risk positions, unless they are undertaken by a separately capitalized entity, which itself meets the capitalization and margin requirements to be established for such trades. The Act further creates a consumer protection agency and forbids mortgage lenders from unfair lending practices and making loans unless they have gone through a process to ensure that the borrower can make the payments. The Act brings in new requirements and oversight of credit rating agencies, appointing the SEC to annually examine rating agencies and make key findings public; requiring education and qualifying exams for ratings analysts; and empowering the SEC to deregister a rating agency for providing bad ratings over a three year period.

What does this all mean for commercial real estate? Probably not much, directly at least, but the attempt to bring some more transparency and regulation to derivatives and exotic financial instruments may limit the availability of some real estate related loan securitizations, and until the markets more fully understand the implications of the Act the uncertainty will likely be something of a damper. It will take years for the regulatory agencies and the affected industries to establish and work under the market mechanisms and regulatory structure called for by the Dodd-Frank Act. Only over that time will we begin to learn whether it has reduced systemic risk, increased consumer protection, or had any unintended side impact.

-Ed Finn

Ed Finn is General Counsel and Chief Operating Officer at NAI Global.