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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 is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. pk | December 1, 2010

    Mr. Galani, Why are you shocked about Regulatory Capture? It's inherent, and as you seem to understand, has always been that way, and always will be that way.

    That why it amazes me you always seem to be calling for more regulation, as if it is possible to regulate these industries without creating more and more distortions. The SEC made the credit agency oligopoly mess in the first place, and encouraged shopping for ratings, rather than letting the agency market develop as protection for investors, not for debt issuers. Clamping down harder is going to change that?

    It's the regulations that make the big boys bigger, along with their friends at the Treasury and the Fed. You don't like that? Me neither. So how about we remove all the backstops. Wall Street can't get special deals as long as Washington is handing them out. Any regulation is a special deal to someone.

  2. Thomas Coleman | December 1, 2010

    You castigate the rating agencies for not standing behind their opinions to the extent of being sued when a rating turns out badly (which essentially could mean betting the company on every deal).

    Would the same logic apply to the pundits at Money Morning when they issue a buy / hold / sell recommendation?

  3. Dan Morton | December 1, 2010

    Are not all SEC Commissioners, like those at other Federal Agencies, required under the so-called "Sunshine Act" to make public the full agenda and results of discussions they hold with ALL outsiders, such as the lobby's mentioned above? If so, where have they made this information publicly available?

  4. Werner Strohmeier | December 1, 2010

    Thank you Mr. Gilani to give us this insight and drrawing our attention to the flaws built in by political authorities.
    I am non US resident and non-US citizen, but this report just is another alert for me not to touch the US market, since I have to consider it as too rigged, or simply applying an old theory : "Dont't touch what you cant analyze thoroughly". It may not be better in my country, but I am at least nearer the local facts which can be very helpful in making and investment or disinvestment decision.

  5. Shah Gilani | December 1, 2010

    Dear Readers:

    Thank you very much for pointing out our obligation to be held to high standards here at at Money Morning. You are correct in stating that we should always attempt to maintain such standards. And I assure you that we make every effort to do so.

    However, I think that we need to point out that there's a difference between us and a rating agency.

    Rating agencies are paid by securities issuers to assess the credit quality of debt instruments those issuers want private and public investors to purchase. The agencies use material facts and figures provided by issuers to determine the strength of the collateral backing the issue, and specifically in the case of asset-backed-securities, the creditworthiness and standards used to judge the ability of debtors whose interest and principal payments owed against the underlying subject collateral are passed through to investors.

    The "pundits" at Money Morning are not paid by the issuers of securities we recommend to recommend them. While we diligently analyze the securities positions we recommend, we do not have access to non-public information regarding our recommendations, as the rating agencies are privy to when they are hired by issuers. We expect to be held to a high standard and strive to exceed all our expectations. Equity instruments are not debt instruments and subject to far more variables than fixed-income pools whose principal variable (especially if they are determined to be "AAA" or "investment grade") is the general level of interest rates.

    Thank you again for taking the time to comment. We welcome all feedback.


    Shah Gilani, Contributing Editor, Money Morning

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