HR4173

No, it is not a new Flu strain. It is a monster of a package of laws passed by the US House of Representatives on Friday. And it is otherwise a referred to as the Wall Street Reform and Consumer Protection Act. It is a catalogue of initiatives aiming at making the financial sector more accountable, more transparent, and less leveraged. I have on earlier occasions voiced my doubt that anything significant would happen to one of the most profitable financial products namely the OTC products. Such products are also covered in the HR4173.

Among many other things the law package also deals with boring stuff such as accounting practices and what must be counted on the balance sheet of a financial institution. The package also suggests a new role for the FDIC in the dissolution of systemic important institutions and new standards for consumer protection.

Trying to make sense of it leaves the impression that there are ample possibilities of creating loopholes. Not surprising given that the banking lobby has spent more than $300m in 2009 to influence lawmakers.

Take one example, swaps, which have always been OTC products, with no marketplace, little standardisation and non-existing transparency. No more has this been the case than for the Credit Default Swaps. A CDS is a contract between two parties that a third party will not default on its debt. One of the two parties issues the CDS and the other party is said to buy protection. The outstanding volume of CDS's on a given company has nothing to do with the actual volume of debt.

One of the biggest issuers of such protection was AIG and it is still anybody's guess how much money the US Treasury had to give to AIG in order for the company actually to be able to pay to all those who had bet that e.g. Lehman would fail. It would seem highly appropriate to make sure that such products were subject to standardisation and transparency. Notionally, the HR4173 does that in the sense that swaps (if the package is passed by the US Senate) must be traded via a recognised exchange. Unless the company buying it belongs to certain sectors, which are specifically exempt (hedge funds, airlines??) or alternative settlement facilities exist. In that case, no transparency is required.

The HR 4173 will probably not survive in its existing form when it moves on to the senate. What is important is that the areas of reform are now laid out and the Europeans can get going on their own projects. Sadly I have to use this word in plural, as the only sensible solution would be to have a solution for the entire European Economic Area. What we have seen so far from the European governments has largely been pathetic (a 50% surcharge on bank bonuses) and will prove ineffectual in the medium term. While we are waiting for the Americans, probably the European initiatives will be limited to small issues primarily aimed at pandering to public opinion.

For one, I do not understand why the EU has not seized the initiative and introduced a pan-European legislation. The experiences of the futures markets in the '90s proved that standardised contracts traded on a controlled exchange could attract large volumes of trading.

For the investors, the HR4173 contains provisions likely to be passed in one form or the other, and in the longer term the most important is the requirement to carry more instruments on the balance sheets. It means one thing, namely lower gearing. It will undermine the profitability and reduce the size of the banking sector relative to the economy. While many of the provisions in HR4173 will appear pointless, this one makes sense. Investors beware.