By Paul Davidson, Paul Wiseman and John Waggoner, USA TODAY

Congress, in a pointed response to a historic economic downturn, is expected this week to pass a massive overhaul of financial regulations that would touch nearly every layer of the nation’s economy from home buyers and merchants to giant investment banks.

Now for the $700 billion question: Will it prevent the next meltdown?

No one doubts its ambitions. The nearly 2,000-page measure, finalized late last week by a House-Senate committee, is a legislative Veg-O-Matic. Among other things, it aims to better protect consumers, tighten the reins on financial institutions and stop rewarding executives for taking reckless risks to fatten quarterly earnings and their bonuses.

But the bill doesn’t revamp Fannie Mae and Freddie Mac. the money-losing, now government-run mortgage buyers that financed many subprime mortgages at the heart of the crisis.

Democratic leaders say there’s no alternative funding source for the giants, which the government took over in 2008. The measure is also speckled with loopholes. It doesn’t break up the nation’s biggest banks, potentially leaving the door open to future tailspins.

What’s more, the next crisis will likely stem from problems the bill doesn’t anticipate, says Tom Pax, head of the U.S. bank regulatory group for law firm Clifford Chance. An Associated Press poll found that 64% of Americans aren’t confident the bill would avert a future meltdown. Others say the bill would hurt bank profits and U.S. competitiveness, although stocks of many financial-services firms rallied Friday as investors decided the proposed measure might be less severe than they had expected.

Here’s a look at how the measure responds to the major causes of the crisis and its chances of preventing future problems.

Consumer protection

What went wrong?

In the easy-money years, millions of consumers took out mortgages they didn’t understand and bought houses they couldn’t afford. When the bubble burst, it triggered a massive wave of foreclosures, nearly ruined Wall Street firms that packaged the loans into securities, froze credit markets and hurled the economy into a brutal recession.

At the core of the spiral: No regulatory authority had sole responsibility for protecting consumers from predatory lending and other abuses. None of the agencies involved consider consumer protection their top priority. Without single-minded oversight, mortgage brokers steered home buyers into costly subprime mortgages they couldn’t handle: Fannie Mae estimates up to half of subprime borrowers could have qualified for conventional mortgages. The fractured system let banks and others shop around for the most pliable regulator.

What the bill does:

A new Consumer Financial Protection Bureau would be housed inside the Fed. The agency would write regulations on consumer financial products of all kinds from payday loans to mortgages. To ensure politicians don’t starve the bureau of funding, it would receive a percentage of the Fed’s budget, initially about $450 million a year. A council of banking regulators could veto the bureau’s rules with a two-thirds vote.

Does it fix the problem?

Consumer advocates had hoped to see a stand-alone agency and worry the new watchdog may suffer from being at the Fed, which until recently showed little interest in consumer protection. And Congress watered down the Obama administration’s original plan for the agency. For instance, auto dealers, who originate nearly 80% of auto loans, are exempted from the agency’s jurisdiction. Critics also worry about the council’s veto power over the bureau’s rules. But Harvard University law professor Elizabeth Warren. who conceived the idea for the bureau, says: For the first time, there will be a financial regulator in Washington watching out for families instead of banks.

Bank risk-taking

What went wrong?

Big bank holding companies, such as Citigroup. and investment banks, such as Bear Stearns. lost billions in the financial crisis because they used their money for speculative trades on mortgage-backed securities and other financial instruments.

When these bets soured amid the subprime mortgage crisis, the institutions were stuck with the toxic assets, decimating their balance sheets and freezing lending markets. The government had to spend hundreds of billions of dollars in taxpayer money to bail them out.

What the bill does:

Banks that take federally insured deposits would be barred from making speculative trades and would have to sell most of their interest in hedge funds and private-equity funds, but could keep 3% of their capital in them. Investment banks would have to set aside more capital to cover potential losses. Originators of mortgage securities would have to hold 5% of the credit risk so they have a stake in the assets’ performance.

Does it fix the problem?

Restricting speculative trading certainly makes sense, says Raj Date, head of the Cambridge Winter Center for Financial Institutions Policy.

Sen. Jeff Merkley. D-Ore. co-author of that provision, says banks should not take outsize risks or draw from deposits that could be used for lending. They’ve been choosing to trade instead of lend, says Heather McGhee of advocacy group Demos.

Date says the constraint is considerably harder to police. That’s because the bill would allow banks to make proprietary trades for reasons other than speculation. For example, the companies often act as market makers, using their funds to buy or sell a security to set a price in that market. They typically make a small profit on the transaction.

They also could continue to buy or sell from their own accounts to hedge against other investments. Currently, internal company records distinguish between speculative trades and market-making deals or hedges. But, Once you prohibit the activity, all of a sudden you have an economic incentive to blur the lines, Date says.

Some think the constraint goes too far. Bob Profusek, a partner in law firm Jones Day. says it will slash U.S. banks’ revenue and make them less competitive.

Executive compensation

What went wrong?

Top executives at the nation’s largest banks and financial firms reaped big bonuses for pumping up quarterly earnings by buying and selling mortgage-backed securities in the housing bubble. When the subprime mortgage market imploded, it drove the firms into ruin; the government had to bail them out to avert a financial system collapse.

What the bill does:

Shareholders would get a non-binding vote on executive pay. The SEC would gain legal authority to let shareholders for the first time nominate candidates for seats on corporate boards, which management does now. Only directors independent of the company and management could sit on compensation committees. Finally, companies would be required to take back pay that was based on accounting statements later found to be inaccurate.

Does it fix the problem?

Giving shareholders a non-binding vote on executive pay would put political pressure on directors to heed their concerns, says Jeff Mahoney, general counsel for the Council of Institutional Investors, which represents pension funds. And allowing shareholders to nominate directors likely would yield boards that are more focused on a company’s long-term growth than short-term profits, he says.

But conferees axed a provision that would have made it easier for shareholders to remove directors that approve outsize pay packages.

Ending ‘too big to fail’

What went wrong?

During the crisis, the government had the legal authority to safely wind down banks but not large non-bank financial companies, such as insurance giant AIG. When the firms faltered, the government bailed them out, believing that letting them go bankrupt would devastate the financial system.

What the bill does:

The Fed eral Deposit Insurance Corp. would gain new authority to safely shut down non-bank financial firms. Certain secured creditors would be made whole to limit damage to the economy. Taxpayers initially would foot the bill for liquidation, but the money would be recouped from shareholders and unsecured creditors, who would bear losses. Banks with more than $50 billion in assets would pay fees to establish a $19 billion fund to cover any extra costs for shutting down the firms.

Does it fix the problem?

The measure would provide a new safeguard that in theory should let the government close a failing company and avoid a taxpayer bailout. But many experts say that if the nation faced another massive financial crisis, Congress would be hard-pressed not to bail out wobbly giants anyway.

If you have a massive meltdown like we had, (liquidation) is not going to work, partly because too many interconnected players would be threatened at the same time, says Kurt Schacht, managing director of CFA Institute. a non-profit group of investment professionals.

Even closing a single financial firm could be a challenge. Some serve as major financial hubs for the economy. Placing such a company in the hands of the FDIC has never been tested, Date says.

Credit-rating agencies

What went wrong?

The top credit-rating agencies Moody’s, Standard & Poor’s and Fitch gave thumbs-up ratings to billions of dollars in mortgage securities that turned toxic and almost brought down the financial system. When the housing market tanked, the agencies scrambled to downgrade the assets.

Critics say it’s no accident the ratings agencies botched the job: They are paid by the firms issuing debt, not by the investors who rely on their ratings. That lets debt issuers shop around for the most favorable ratings and gives agencies an incentive to build business by inflating credit ratings.

What the bill does:  

The Securities and Exchange Commission would inspect the biggest agencies annually and report its findings publicly. The SEC could fine agencies for failing to comply with financial regulations and deregister agencies that pile up a bad record over time. And agencies would have to disclose how they assign ratings and abide by more conflict-of-interest rules. The legislation also would make it easier for investors to sue ratings agencies for failing to adequately investigate debt issuers. The bill would eliminate many federal requirements that banks and other investors rely on the agencies’ ratings. Congress rejected a proposal to require the SEC to set up a board to randomly pick which agencies rate securities. Instead, it ordered the SEC to come up with a way to eliminate ratings-shopping.

Does it fix the problem?

The bill leaves intact the issuer-pays business model that many critics blame for the agencies’ failures. But making the SEC find a way to end ratings-shopping gets to the heart of the problems with rating agencies, says James Hamilton, analyst at research firm CCH/Wolters Kluwer Law & Business. The bill would take steps toward removing federal mandates that gave the biggest ratings agencies a government stamp of approval and effectively protected them from competition, says Lawrence White, professor of economics at New York University. But overall White calls the bill one step forward and one step back. He worries increased regulations would raise costs and keep new competitors from entering the ratings business.

Derivatives

What went wrong?

Derivatives played a role in worsening the credit crisis, and could provoke future crises. A derivative is a synthetic security whose value depends on the movement of something else interest rates, commodity prices, or securities indexes. Although derivatives can help companies hedge against risk, they can also fail spectacularly, because small amounts invested can mean big gains or losses. For example, derivatives played a big role in the downfall of American International Group. one of the biggest bailouts of the credit crisis. Super investor Warren Buffett has called derivatives weapons of mass financial destruction.

What worries Congress most are derivatives that are negotiated privately between two companies. Credit-default swaps, for example, work somewhat like insurance: Party A agrees to make a series of payments to Party B, who, in turn, will pay up if a bond’s issuer defaults. Privately negotiated derivatives are also more difficult for regulators to track and assess for risk.

What the bill does:  

Standardized derivatives would have to be traded on exchanges to increase transparency and routed through clearinghouses to ensure companies that use them post collateral.

Banks would have to spin off their riskier derivatives trading into affiliates, including those that deal in energy, commodities, agriculture and mortgage credit-default swaps. They could continue to trade derivatives in-house for interest rates and foreign exchanges and to hedge risk.

Does it fix the problem?

Some of the bill’s provisions heightened supervision, for example, and requirements to hold more collateral might have helped in the 2008 crisis, says Ian Cuillerier, partner in White & Case’s derivatives practice.

William Isaac, former chairman of the FDIC, criticized the requirement to spin off derivatives trading into affiliates, arguing that if a bank’s affiliate collapses because of derivatives trading, the bank will probably bail out the affiliate anyway. The bank still has the risk if things go wrong, Isaac says.

Stronger oversight

What went wrong?

No regulatory authority was looking out for whether troubles at one or more firms were posing broader risks to the entire financial system and the broader economy. Some banks used a complex web of oversight rules to shop for the most lenient regulator, a practice known as regulatory arbitrage. And the trading activities of many banks and investment banks weren’t examined closely enough by either the SEC or the banking regulators.

What the bill does:  

A new Financial Stability Oversight Council would identify financial companies banks or non-banks that could pose a threat to the financial system. Its voting members would be the heads of the major regulatory agencies, including the chairman of the Federal Reserve. With council approval, the Fed would have the power to break up large complex firms that pose a threat to the financial system. The Fed could also require those firms to increase their cushion against losses.

The central bank, which critics say failed to prevent the mortgage crisis, itself will be subject to more oversight. The Government Accountability Office will be able to audit the Fed’s emergency lending during the 2008 crisis, as well as its loans via its discount window.

Hedge funds will have to register with the SEC as investment advisers and provide information about trades and portfolio holdings. And the Office of Thrift Supervision will be absorbed into the Office of the Comptroller of the Currency.

Does it fix the problem?

Some say it closes gaps. It will eliminate many opportunities for banks to play regulators off each other, says Travis Plunkett, legislative director of the Consumer Federation of America.

Others say the bill doesn’t go far enough. An early version would have created a super-regulator to oversee most financial companies. Instead, the new bill would eliminate one regulator, the Office of Thrift Supervision, but create a new one the consumer protection bureau. This bill is woefully inadequate, says Isaac, the former FDIC chairman. It’s sad that they didn’t seriously address a broken regulatory system.

Yet on balance, others say, the overhaul may be the best that can be achieved in the short run. The bill will not eliminate financial crises, says Brookings Institution fellow Douglas Elliott, but it will make them less frequent and considerably milder, which is all we can realistically accomplish.