The Federal Reserve scored a victory and mortgage bankers suffered a defeat on Wednesday as the U.S. Senate took aim at bank supervision and housing finance in its sprawling Wall Street reform effort.

Reversing an earlier plan drawn up by Senator Christopher Dodd, the Senate approved an amendment by a 90-9 vote to preserve Fed supervision of hundreds of smaller banks, instead of transferring them to other regulators.

The vote was a setback for Dodd, the Democratic chairman of the Senate Banking Committee, in his bold effort to rationalize the patchwork U.S. bank supervision system, widely faulted for missing the 2008-2009 financial crisis.

The Senate also attacked several lending practices implicated in the mortgage meltdown behind the crisis, which prompted Congress last year to undertake the biggest overhaul of financial regulation since the 1930s.

President Barack Obama has pressed lawmakers for broad reforms to make banks and markets less prone to crises. Final approval of the Senate bill could come next week.

The future profitability, risk capacity and growth potential of financial firms hangs in the balance.

The Senate voted 63 to 36 to end mortgage kickbacks and liar loans, two practices that led to a proliferation of shaky mortgages in the years before the crisis.

Incentives known as yield spread premiums encouraged brokers to steer consumers into risky, high-interest loans even if they qualified for cheaper loans.

Liar loans allowed consumers to qualify for loans they could not possibly repay if they opted to simply state their income or other assets, rather than waiting for verification.


Amid a report that U.S. investigators are probing whether Morgan Stanley misled investors about mortgage derivative products, the Senate also voted to keep a measure in the bill, opposed by the mortgage industry, that would require lenders who bundle and resell mortgages on the secondary market to retain at least a 5-percent stake in their products.

By a vote of 42 to 57, the Senate rejected a Republican measure offered by Senator Bob Corker that would have gutted that skin in the game provision.

In a related matter, the Federal Deposit Insurance Corp formally proposed giving federal protection to home loan and other debt securitizations if they meet higher standards and banks retain some of the risk associated with the products.

The FDIC proposal and the Senate's measure on risk retention will make it more expensive to originate and securitize mortgages, but they will not devastate the market, said Concept Capital policy analyst Jaret Seiberg.

The Democratic bill attacks the mortgage market from multiple directions, but avoids the central problem of fixing Fannie Mae and Freddie Mac, the giants of housing finance seized by the government in 2008.

Democrats on Tuesday defeated a Republican amendment that would have ended government control of the two firms, arguing that the issue should be dealt with separately next year.

With more than 200 amendments filed on the bill, the Senate has resolved a number of contentious issues.

So far, it has settled on a method to unwind troubled financial firms, while defeating a Republican attempt to water down consumer protections.


The Senate has also voted to examine the Federal Reserve's actions during the crisis, heeding widespread public frustration with the widespread Wall Street bailouts that experts say averted a deeper crisis.

Lawmakers still have not resolved how to ensure that speculative trading activity by banks does not again put the financial system as a whole at risk.

Later this week, the Senate could toughen a measure that would bar banks from high-risk speculative trading and require nonbank financial institutions to set aside more capital for speculative activity.

Lawmakers also could soften a proposal that would prevent banks from participating in the lucrative swaps market.

Any legislation that clears the Senate must be reconciled with a reform bill that passed the House of Representatives in December before Obama can sign it into law.

If approved, the Wall Street reform bill would give Democrats a major legislative victory ahead of November's elections. Republicans have worked for months to weaken and delay the bill, although they are keenly aware of the issue's widespread appeal.

So far, the debate has been markedly more civil than the all-out warfare that marked the health-care overhaul.