By Yanking the Teeth Out of Dodd-Frank Act Ratings Rules, SEC Blunts Hope for Real Financial Reforms

[Editor's Note: Retired hedge-fund manager Shah Gilani is one of the industry's foremost experts on the global financial crisis - and all the worldwide ripple effects that this financial scandal has caused.]

Make no mistake: The Dodd-Frank Wall Street Reform and Consumer Protection Act is a slippery political football.

But this early attempt at reform is actually just the kickoff for a political skirmish that will pit legislators, lobbyists and other hired guns against one another on the post-financial-crisis gridiron.

These ongoing reform efforts will turn into a long affair whose outcome is far from certain.

But investors can bet on this: The millions of dollars in lobbying money that's thrown at legislators every year in an attempt to influence the regulatory rulebook will certainly influence that outcome.

An Unwelcome Exemption

The Dodd-Frank Act was intentionally drawn up as a loose set of rules, due to the understanding that lobbying money would be a factor: Congressional representatives, having received money for their re-election campaigns, would undoubtedly feel obligated to influence the referees charged with safeguarding the financial system that reforms are supposed to fix.

Already, gamers of the new Dodd-Frank Act notched up a significant victory.

Last week, Wall Street's fantasy punter, the U.S. Securities and Exchange Commission (SEC), essentially exempted companies from a key portion of the Dodd-Frank reform act by indefinitely extending the timeframe under which the issuers of asset-backed securities (ABS) can omit credit ratings from marketing materials.

Even though companies issuing bonds in the $1.4 trillion market for asset-backed mortgages, autos loans and credit cards are required by law to include ratings in the offering documents.

Here's why that's doubly screwy: Credit-rating agencies - running scared and fearing the risk because by law they are now liable for the quality of their ratings - are now refusing to allow issuers to use their ratings in public documents.

So, rather than calling a foul on the raters, the SEC advanced the interests of securities peddlers and gave the rating agencies a free pass.

Regulatory backsliding on the hard-fought Dodd-Frank reforms is a clear-and-present danger to investors in every market. Backed by all those lobbying dollars, special-interest groups may eventually take the sharp reforms contained in the Dodd-Frank Act - and whittle them down into the blunt instruments that Wall Street prefers regulators to wield.

As a consequence of the rating agencies' explicit complicity in the subterfuge that made invisible all the risks and dangers of the massive subprime-securitization and collateralized-debt-obligation marketplace, these credit raters can no longer hide behind the free-speech protections of the First Amendment that they formerly used for cover.

It used to be that after issuing "opinions" about securities they rated as "investment grade" - that subsequently morphed into toxic trash - the agencies didn't feel they should be accountable for their "opinions."

But ever since U.S. President Barack Obama signed the Dodd-Frank bill into law in July, ratings outfits are considered to be "experts." As "experts," these firms have discovered that they have a much greater fiduciary responsibility than they did in the past when they generously issued top ratings on companies and the securities of issuers who paid them handsomely to grade their paper.

The new definition by which rating agencies are judged to be liable for their work caused them to back away from rating any ABS paper just prior to the bill's enactment.

The finance arm of Ford Motor Co. (NYSE: F) - known as Ford Motor Credit Co. - skidded right into the rating-agency stonewall in July when the firm wanted to use ratings in an offering prospectus for a $1.39 billion auto-loan-backed bond issue. The rating agencies refused to let Ford Motor Credit include those ratings, so Ford had to seek a special dispensation from the SEC to leave the ratings out of its offering circular.

To everyone's relief, the SEC granted the exemption.

But when the securities-regulator made that exemption indefinite last week, relief wasn't the emotion most investors were probably experiencing.

So much for holding rating agencies to a higher standard and facilitating transparency.

A Look Ahead

It seems the SEC would rather see investors do their own due diligence on securities being offered in the when-issued, primary and secondary markets.

In other words, investors can no longer expect to see reforms that force the rating agencies to live up to an absolute standard that facilitates a fair-and-transparent assessment of some of the most complex securities that trade in the global financial markets today. Instead, regulatory bodies such as the SEC are going to punt this critical capital markets function to us, the very people whose taxes pay their salaries - in theory, to protect our interests as investors.

To expect the typical Main Street retail investor to be able to assess the credit quality of an asset-backed security is so ludicrous that it is laughable. After all, these are the same securities that were too complicated for many of the investment banks to analyze - certainly very few thought that these were so risky that they could collapse, and nearly bring down the global financial system as a result.

That pass-the-buck attitude is deeply troubling. But it's far from the only topic of reform to be concerned about. T he Dodd-Frank bill is more than 2,300 pages in length, and contains 240 rulemaking provisions. It also mandates that 67 studies be conducted and 22 reports issued on the impact of proposals in the bill and the potential outcomes of still to-be-fashioned rules and regulations.

That's why I am able to say with such certainty that the Dodd-Frank Act is only the warm-up to a lengthy saga whose outcome is far from certain. And that's why I know that special interests will be waging a full-court press, using campaign contributions as a key weapon.

After years on Wall Street, I know the drill all too well.

But don't just take my word for it. In a Sept. 21 speech that was part of a distinguished speaker series sponsored by Loyola Marymount University's Center for Accounting Ethics, Governance and the Public Interest, SEC Commissioner Luis A. Aguilar stated that "now that the Dodd-Frank Act is law, the focus will move from Congress to the regulators, including the SEC, to fill in the details and to write the rules that will make financial reform a reality. This point has not been lost on all the financial industry participants impacted by the legislation. The focus of these groups has quickly shifted away from Capitol Hill and settled squarely on the primary regulators."

But what caught my attention and should unsettle the American public is what Commissioner Aguilar said next, in a comment on special-interest agendas: "Already my office, as well as many others throughout the [SEC], is fielding meeting requests from lobbying groups, industry groups and trade associations on a wide variety of issues raised in the legislation."

As part of my role here at Money Morning, I intend to make it my job to keep you informed about how financial reforms are going to be reformed by the same bankers and financial engineers who brought us the biggest credit crisis in modern history - spawning the Great Recession as a result.

The suffering from that downturn continues. And this lack of resolve over needed reforms isn't likely to help.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, and carefully demonstrates how to profit from every one.

But he doesn't stop there. He's also the consummate risk manager. As the article above demonstrates, Gilani also makes sure to highlight the market pitfalls that can ruin years of careful investing and saving.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here.]

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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