How financial reform will really work

(Money Magazine) -- Almost two years after the near collapse of the U.S. financial system, a sweeping reform package has finally been signed into law. Now the real work begins.

Government officials are starting to staff a brand-new half-a-billion-dollar federal agency. Regulators are gearing up to conduct 67 studies and write 243 new rules. Wall Street lobbyists and consumer advocates are lining up to influence those watchdogs as the law is put into practice. And financial services companies are adjusting to -- or looking to work around -- the new rules.

But even amid the uncertainty, some things are clear. "Borrowers and investors are likely to benefit from a higher level of regulation, but at the end of the day we could all be paying more for credit," says Kathleen Engel, a professor at Suffolk University and a member of the Federal Reserve's consumer advisory board.

Read on to see how six major consumer and investor provisions could play out, and what the changes could mean for your finances in the years ahead.

A big new federal agency will police credit products

Protection Rating: 4 shields

The Law: The centerpiece of financial reform is the new Consumer Financial Protection Bureau (CFPB), which will write and enforce consumer protection rules for most loans, including credit cards, private student loans, and mortgages. The agency will be housed within the Federal Reserve, but its director will be a presidential appointee. The bureau will consolidate consumer protection staffs from half a dozen existing regulators, and it should be up and running within a year.

The Flaws: The bureau has no authority over auto dealers, a giant loophole since three-quarters of new cars are financed or leased through a dealer, according to J.D. Power and Associates. And while the agency's rules apply to all banks and lenders, existing regulators will enforce those rules for institutions with less than $10 billion in assets.

What's more, the Financial Stability Oversight Council, a new council of nine financial regulators, including the Treasury secretary and Fed chairman, can override any agency rule if two-thirds of members feel it threatens the stability of the financial system. "Two-thirds is a pretty high bar, but it could be used as a delaying tactic," says Kathleen Day, spokeswoman for the Center for Responsible Lending.

Best-Case Scenario: With a single agency dedicated to nothing other than making sure consumers are getting clear and accurate loan information, you should come across fewer fee traps and overly complicated credit offers. "Consumers won't have to wait for Congress to pass a law to be protected," says Engel.

The CFPB will operate a toll-free hotline for borrowers to report problems with a loan, and it will have the power to crack down on deceptive practices and hidden fees.

State regulators will also have the right to enforce new federal rules, adding another layer of protection. Though auto dealers are exempt from bureau oversight, the new law gives the Federal Trade Commission, which already oversees dealers, beefed-up authority to look into car-financing complaints.

Feared Rollback: The next fight could be the Senate confirmation of the agency's first director, since that leader will go a long way toward establishing just how tough the CFPB will be. The leading candidate is Elizabeth Warren, the Harvard University law professor who proposed the agency in 2007, but her outspoken criticism of the financial services industry has made her a contentious pick.

Regardless of who leads the CFPB, industry pushback won't end there, says Engel, as banks and other lenders will weigh in on disclosure proposals and seek exemptions from agency rules. "The battle will shift to influencing the work that this bureau does," says Engel.

Bottom Line: The CFPB is a major victory for borrowers. "This is the biggest thing in consumer protection since deposit insurance," says Ed Mierzwinski, consumer program director for the U.S. Public Interest Research Group.

New guidelines will ensure that loans are affordable

Protection Rating: 3 shields

The Law: The reforms crack down on one of the root causes of the economic crisis: mortgages that many borrowers could neither understand nor afford. It establishes a simple standard for all home loans, requiring lenders to make sure borrowers can repay their mortgage by checking their income, assets, employment status, and credit history. Though most lenders do that today, the rule officially ends the era of no-doc and stated-income loans.

The law also bans the prepayment penalties that locked borrowers into unaffordable loans. Lenders must spell out the maximum you could pay on a variable-rate mortgage. And the reforms ban the financial incentives that led some mortgage brokers and lenders to steer borrowers into high-rate loans when a lower-cost option was available.

The Flaws: Not all the loans that got homeowners into trouble are dead and buried. Interest-only and negative-amortization mortgages are still available. "Once real estate recovers, these loans could make a comeback," says Keith Gumbinger, mortgage analyst at HSH.

Best-Case Scenario: Tighter lending standards and better upfront information about costs should reduce the risk that borrowers will end up with a loan they can't pay back -- which in turn could leave lenders in better financial shape.

Feared Rollback: Lenders will eventually pass on the higher cost of doing business by hiking fees, says Gumbinger. "We're not seeing it yet," he adds, "because interest rates are so low and the mortgage market is still weak."

Beyond that, no one knows what the next problem loan will be, but many expect lenders to devise one by the time housing heats up again. "People in the banking industry are extremely creative," says Steven Krystofiak, president of Mortgage Brokers for Responsible Lending, "and they'll find the loopholes."

Unintended Consequence: Stricter documentation requirements are already delaying mortgage approvals, even for buyers with good credit and deep pockets. And the rules will make it even tougher for those with poor credit and low incomes to borrow, which could have a dampening effect on the struggling housing market, says Phillip Swagel, a Georgetown University business school professor who was chief economist at the Treasury Department from 2006 to 2009. "Stricter underwriting is a good thing, but this is a very fragile industry."

Bottom Line: The changes are long-overdue improvements -- too bad they weren't in place a decade ago.

A discount for stores may trickle down to shoppers

Protection Rating: 2 shields

The Law: Every time you pay with plastic, retailers fork over about 2% of the bill to banks and card networks. Merchants have long hated these so-called interchange fees, especially on increasingly popular debit cards. Because shoppers tend to pull out debit for small-ticket items, that 2% fee can take a serious bite out of profits.

Under the new law, the Fed will come up with rules ensuring that debit interchange fees are in line with the cost of processing the sale -- probably lowering the fees by 25% to 30%, says Credit Suisse bank analyst Moshe Orenbuch.

The Flaws: Merchants will also be able to set a $10 minimum for debit card purchases, taking away the convenience of never having to carry cash. And to help the government and colleges save on interchange, both groups can now set a maximum for credit card payments, a loss for anyone who charges taxes or tuition to rack up reward points.

Best-Case Scenario: The law does not require merchants to pass on their savings, but they may since they will now be able to offer discounts if you pay with cash, checks, or debit.

Feared Rollback: Debit interchange fees total $20 billion a year, and banks are poised to take a hit -- Bank of America, the biggest debit card issuer, says it expects to lose as much as $2.3 billion a year. So you may see fewer debit card rewards programs, says Bill Hardekopf, CEO of LowCards.com and author of "The Credit Card Guidebook." After Australia capped interchange fees in 2003, annual fees rose and rewards shrank, says the Reserve Bank of Australia.

Unintended Consequence: This comes on the heels of a ban on credit card inactivity fees and a crackdown on overdraft fees. Banks are already looking for ways to replace lost revenue by adding new fees. A deep cut to debit income is simply more fuel on that fire.

Bottom Line: Stores win, banks lose. And you? At best, you'll find more discounts. At worst, you'll see little change at the cash register but bad news on your bank statement.

Regulators may put pressure on Wall Street sales tactics

Protection Rating: 2 shields

The Law: One of the biggest battles of financial reform was whether brokers should be held to the same high standard as registered investment advisers. Right now, brokers are required to recommend suitable investments, while advisers have a more stringent "fiduciary duty" to act in your best interest when they offer advice. So an adviser can't push a fund from a company that pays him a bonus to sell that fund without telling you. The final bill punted, simply directing the Securities and Exchange Commission to conduct a six-month study.

The Flaws: Brokers and investment advisers aren't the only pros doling out financial advice. The law says nothing about insurance agents, who hawk investment products like variable annuities, and others who call themselves advisers but aren't brokers or registered advisers.

What's more, the law exempts equity-indexed annuities from SEC oversight, even though those insurance products have been the subject of numerous investor complaints and lawsuits (state insurance regulators will continue to oversee them).

Best-Case Scenario: Once the study is completed, the SEC can impose a fiduciary duty on securities brokers, which would force them to disclose any conflicts of interest before an investor hands over a dime. Mary Schapiro, the chairman of the SEC, is on record supporting a uniform fiduciary standard.

Feared Rollback: Even with tougher sales rules, investors could see a proliferation of hybrid investment and insurance products, which brokers could sell without disclosing any conflicts because they aren't classified as securities.

Bottom Line: "This is just one aspect of a larger problem," says Barbara Roper, head of investor protection for the Consumer Federation of America. "We need to tackle all the conflicts of interest in the industry and give the SEC the money and power to go after the bad guys."

Seeing your number costs nothing -- but only for some

Protection Rating: 3 shields

The Law: You can already get a free copy of your credit report every year from each of the three credit rating agencies (Equifax, Experian, and TransUnion) -- go to annualcreditreport.com for yours -- but you still have to pay for your credit score. And the bureau score you buy doesn't necessarily match the one lenders and insurers calculate.

Under the new law, if you're denied a loan, turned down for an insurance policy, or quoted a high interest rate or jacked-up premium based on your credit history, you'll be entitled to a free copy of the score the lender or insurer used.

The Flaws: You'll get just the numerical score, not the information behind it (what's called the subscriber report). That would give you a better window into your credit.

Best-Case Scenario: Just as free credit reports for loan denials paved the way for free reports for everyone in 2005, this limited fee waiver could be the first step toward universal free scores.

Unintended Consequence: Credit bureaus have found lots of ways to make money from your credit history, from selling scores to offering credit monitoring services. With a group of potential customers getting scores for free, the industry might jack up the cost for everyone else ($6 to $16 now) to cover the lost revenue, says Mierzwinski. Or you may be pitched a host of dubious new services. Credit monitoring, for example, exploded after credit reports became free.

Bottom Line: Bringing more transparency to an industry that isn't heavily regulated is a good thing," says Mierzwinski. "But it would be better if every consumer got their credit score for free every year."

Arbitration may no longer be your only option in a fight

Protection Rating: 3 shields

The Law: When you open an account at most brokerages, you must agree to arbitration if you later have a beef with your broker. It's typically less costly and time consuming than going to court. But the arbitration system is run by FINRA, a securities-industry-funded organization, which names at least one of the three arbitrators when your claim is for more than $100,000. Of the cases that come before an arbitrator -- more than half are settled -- investors win damages less than half the time. The new law lets the SEC ban or limit these mandatory arbitration clauses, which would let you take your broker to court.

The Flaws: Many other consumer contracts, from credit card and cell-phone agreements to nursing home contracts, still have mandatory arbitration clauses (though the new Consumer Financial Protection Bureau will study whether to limit or ban them for financial products).

Best-Case Scenario: The SEC must still write the rule, and the best outcome is a ban on arbitration as your only option. Most investors will still find it faster and cheaper to use arbitration, and recent changes, such as increasing the size of claims that a single public arbitrator (meaning one not affiliated with the industry) can hear from $50,000 to $100,000, have improved the system. But the threat of a lawsuit could discourage brokers from running amok.

Feared Rollback: Some investor advocates fear that large brokers may dump arbitration altogether, preferring their odds in a court battle. A likelier negative consequence is that once brokers have lost the fight to stay out of court, the industry will no longer have an incentive to improve the arbitration system.

Bottom Line: "Many investors are being pushed into a system that doesn't work for the kinds of disputes they have, so it's good to have choice," says Roper. "But even for investors who have a strong case against a broker, going to court is expensive."