Happy 1st Birthday, Dodd-Frank, part 2

We ended part i, with some questions. The answers to these questions could fill volumes. Yet, a high-level response is in order.

First, can Dodd-Frank prevent another similar crisis? This is far from certain. The law depends too much on regulators to actually use the powers they have been granted. Past behavior suggests that they will not. And, even regulators who wish to act will have trouble completing the job of derisking and downscaling the banks to prevent collapse. Given the various advantages of being too bit to fail, we cannot expect the firms themselves to complete that task.

Second, what should we celebrate and where are the gaps? There is much to celebrate. Getting this first law enacted and to its first year, was a tremendous accomplishment.  As noted yesterday, we just need more to follow in its footsteps to make up for its weaknesses. And, some parts of the statute, such as the consumer financial protection bureau deserve particular praise. However, even while the consumer protection measures are worth celebrating, it is shameful that the law fails to do more for troubled homeowners.

Let me provide an explanation for this skeptical view.Here goes. Dodd-Frank provides a number of tools to prevent banks and other financial firms from engaging in excessive borrowing and betting that result in taxpayer-funded bailouts. Some of these tools appear more effective than others. Without a doubt, many need to be strengthened. And, shadow banks that still remain outside of regulatory scrutiny need to be brought into the light. Similarly, Dodd-Frank provides strong tools to better protect consumers, but industry-funded politicians are trying to weaken this part of the law.

So what are the meltdown prevention tools?  First, Dodd-Frank attempts to reduce leverage. Section 171, the “Collins Amendment,” establishes, for the first time, a cap on how much bank holding companies, thrift holding companies and nonbank financial firms (“nonbanks”) can borrow. However, the leverage cap is still too high. About $96 in borrowing for every $100 in total (non-risk-weighted) assets is allowed, and possibly as high as $97. Experts like Professor Anat Admati suggest a 15 to 20% equity cushion – or only $80 to $85 in borrowing should be permitted for every $100 in assets. Moreover, the limit does not apply to all. While banks are broadly covered, only a small number of nonbanks will be affected.Even though nonbanks include a variety of financial firms such as  hedge funds, industrial loan firms and insurance companies, and though these have been prone to messy insolvencies and bailouts, they are not all covered. In fact, so far, none are. Only those nonbanks designated by the new Financial Stability Oversight Council (“FSCOC”) as systemically important financial institution (“SIFIs”) will be subject to this restriction. So far, the FSOC has not revealed the criteria by which nonbanks will be designated as SIFIs.

In addition, Dodd-Frank provides extra tools to control the borrowing and other risky activities of large bank holding companies (those with more than $50 billion in total consolidated assets) and nonbank SIFIs.  Once again, only those nonbanks that get designated, and so far none have been. Under Section 165, the Federal Reserve is given the power to impose enhanced supervision and prudential standards on these companies.  These “more stringent prudential standards” are supposed to “prevent or mitigate risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected financial institutions.”

While leverage is still too high, liquidity is barely even touched. A key weakness of the statute is the failure to deal with short-term debt. For example, it is unfortunate hat Dodd-Frank failed to roll back the special treatment in bankruptcy that repurchase agreements backed by mortgage-related collateral were granted in 2005. Policy makers and academics supported this rollback, including Florida Senator Bill Nelson, who attempted to get this into Dodd-Frank, yet his amendment never received a floor vote. There is continued support for such a roll back, including by Professor Stephen Lubben, Professor David Skeel and President of the Kansas City Federal Reserve Bank, Thomas Hoenig. Though under an FDIC “orderly resolution” there is a 24 hour hold on the safe harbors, this is not sufficient, as resolution, is hopefully rare. Many financial firms are only eligible or may otherwise end up in a Chapter 11 bankruptcy. So, this still needs fixing.

Another way the law tries to avoid another meltdown is through “early remediation.” Under Section 166, the Fed is required to take preemptive action, up to and including selling off assets of, (or breaking up) the giant bank holding companies and nonbank SIFIs. The Fed is supposed to take such action if the company experiences “increasing financial distress, in order to minimize the probability that the company will become insolvent and the potential harm of such insolvency to the financial stability of the United States.”

Dodd-Frank also attempts to limit public subsidies of private speculation through Sections 619 – 621 (the “Volcker Rule”). The Volcker Rule limits the ability of banking entities that have access to FDIC deposit insurance or the Federal Reserve discount window to also engage in certain high risk, speculative practices. This part of Dodd-Frank precludes them (subject to exceptions identified below) from owning or sponsoring hedge funds and private equity funds. It also forbids them from trading for their own accounts. Importantly, it also includes a prudential backstop, allowing regulators blanket authority to prohibit a whole host of activities if they create a threat to the financial system.  This part of Dodd-Frank also prohibits firms from betting against their clients and other similar conflicts of interest.

There are notable gaps in Volcker, largely due to political expediency. In order to get 60 Senators on board and thus avoid a filibuster, it was necessary to provide a number of exemptions. One such exemption permits banks to operate or invest in hedge funds and private equity to start them up, so long as the amount of such investments does not exceed 3 percent of their Tier 1 capital. (Roughly, but not exactly, the amount left after subtracting the amount the bank owes from the value of its assets). Much of the details of this rule are unknown. Some complain that the line between permissible “market making” and impermissible “proprietary trading” will be difficult to draw. It is expected that the regulators will leave a lot of discretion to the internal compliance organizations at the covered banks to make those determinations.

And if prevention doesn’t work, Dodd-Frank sets out tools for intervention. Under Title II, the FDIC was given, subject to certain approvals, orderly liquidation authority. This encompasses the power to close down and sell off failing bank holding companies and nonbank SIFIs. Resolution authority is a third alternative – instead of the choice between a government-funded bailout (a la Bear Stearns) and a chaotic bankruptcy (such as Lehman).   Whether resolution authority will be used or will be equally chaotic is a question many have raised.  Some believe it will create even larger firms as they will buy up pieces of failed ones. And others express concern about whether this will work in a cross-boarder, complex financial firm.

Moreover, the funding for an FDIC resolution is first provided by the US Treasury. The taxpayers are fronting the funeral expenses. This means, if the sale of the failed firms assets are not enough to pay back Treasury, large financial firms may be asked to chip in after the fact, possibly when they are also weak. Of course, we remember that a bank-assessment to fill the orderly liquidation fund was strenuously opposed by Republicans in Congress who curiously called it a taxpayer-funded bailout.

So what to do? Prevention tools are not strong enough (and may not even be used by captured regulators) and intervention tools may be too discretionary and untested. Meanwhile, banks are still too big. The top five banks’ assets amount to 60 percent of GDP. In 1980, the top five held assets equal to only 16 percent of GDP.  Perhaps we need a revival of the Brown-Kaufman “Safe Banking Act” amendment, which would have reduced bank size by limiting the total borrowing (liabilities) of any bank to no more than 3 percent of GDP.  This would include amounts banks have on deposit from customers. And, it would have limited the non-deposit liabilities of any bank to no more than 2 percent of GDP. Or, better yet, perhaps we need a new Glass-Steagall, fully separating utility banking from securities operations, swaps trading and other high-risk, complex activities that are unrelated to deposit taking and credit extension.

On the consumer protection front, unmitigated praise is due for the creation and “standing up” of the Consumer Financial Protection Bureau. Though we hear repeated complaints about the weakness of Dodd-Frank, the CFPB is an example of a very strong and potentially very effective agency. That is why in the case of the CFPB, the financial services industry and sympathetic politicians in Congress are working hard to undermine it at every turn. This new agency has three major powers – rulemaking, supervision and enforcement. It will efficiently consolidate authority for numerous federal statutes related to consumer financial transactions. It also has “organic” rulemaking authority. This means it can prohibit a range of “unfair and deceptive acts or practices.”  The CFPB is intended to create a level playing field and uniformity. For example, nonbanks such as payday lenders, mortgage brokers and private student lenders will now be subject to rules, oversight and enforcement.

While this part of Dodd-Frank has tremendous natural strengths, it is in a very tough environment. This is why the CFPB does not have a director. This week, the President bypassed Professor Elizabeth Warren (who initially conceived of the agency and stood it up before the transfer date) and nominated Richard Cordray, the former Ohio Attorney General. While this decision disappointed progressives, it did not mollify conservatives. A group of 44 Republican Senators have not budged. They recently vowed to block the appointment of any director of the CFPB unless the agency’s power and funding are substantially diminished.

The demands fit the acronym, “B.A.D.”  Board. Appropriations. Diminished authority. They want a board and not a director to guide the agency. They want to subject the agency to the Congressional appropriations process. This would put the budget of the bureau in jeopardy based on Congressional whim. Even the expected $400 million budget is barely enough, given what industry lawyers estimate are 35,000 entities that might fall under its jurisdiction. Such lawyers have noted that the SEC has oversight over half as many firms with about three times that budget.  And, the 44 wants to diminish the agency’s ability to make rules by giving the new Financial Services Oversight Counsel (FSOC) greater veto power.

Meanwhile, without a director, it may be that the Bureau is restricted from making rules in certain areas. And, some contend that the CFPB cannot supervise or bring enforcement actions against payday lenders, mortgage brokers and other nonbanks until a director is appointed. Unless the Republicans bend, there will not be enough votes in the Senate to block a filibuster. Thus, many believe that President Obama may resort to a recess appointment in August to assure that Cordray is appointed.

While Dodd-Frank via the CFPB and other provisions may help future homeowners, it does not do enough for existing homeowners who are drowning in debt. An individual who owes more on his mortgage than his home is worth is still not able to use the bankruptcy process to reduce the principal outstanding to the home’s value.  Yet, a wealthier person with a vacation home can do so. And, a business with commercial real estate can as well. The bankruptcy code should have been amended long ago to fix this anomaly. The existence of the bankruptcy principal-reduction option would give all homeowners more bargaining power when they face foreclosure. Moreover helping consumers deleverage will be good for the economy and will discourage lenders in the future from using overvalued appraisals, risky mortgages, and poor underwriting standards, to extract too-big-to-pay commitments from borrowers.

In short, Dodd-Frank provides many tools for prevention and intervention. But it also has notable weaknesses. No surprise; the one-year-old law is not perfect. Yet, we should not throw the baby out with the birthday cake.  We can and must do more to help this law succeed and to enact future legislation to compensate for its limitations. But, we had better act fast. As Professor Tom Ferguson notes  ”the big banks are more dangerous and reckless than ever” and Admati warns that “the next crisis will happen sooner than later."

(This post and part i, initially appeared on The Pareto Commons)


Happy 1st Birthday, Dodd-Frank, part 1

People are talking. And, they are not being kind.  Word is, a year has passed, and Dodd-Frank is not living up to his potential.  This observation is painful, but true. Yet, we should not blame the birthday boy.  Here’s why. We expect him to be a doctor already, curing the bloated banking disease and immunizing consumers, yet he has not even taken his first steps. We have heaped upon this infant unreasonable expectations. Given his nature, the code itself, some goals are now and forever beyond his reach. Moreover, some folks intentionally are slowing the poor kid down and putting obstacles in his path. With such an environment, no law can do its best.

It is easy to point to places where Dodd-Frank falls short. Even at birth, gaps in the legislation were visible. At this young age, we can now also see gaps in how the numerous regulators are implementing the law. Yet instead of berating or abandoning this one-year-old, we should celebrate his strengths. And, we should find a way to fix the problems with strong implementing rules and additional legislation. In other words, add some siblings. It may take a family.

Previous reformers did more than lambast the limitations of a fledging statute. And, this approach paid off. For example, the New Deal era financial reforms kept us free from major panics and crashes for about fifty years. But this was not the result of a single statute. The Truth in Securities Act of 1933 was the first federal securities law. But it only covered initial offerings of securities. No problem. The following year, the Securities Exchange Act of 1934, was given life to focus on secondary market sales and the stock exchanges. Even Carter Glass had to push through two different banking laws, the Glass-Steagall Act of 1932 and The Glass-Steagall-Act of 1933, to ensure the FDIC was created and commercial banking was separated from securities operations. More securities law kin appeared in 1940 when the Investment Company Act and the Investment Advisers Act were added to address abuses in the investment trust industry and the provision of investment advice. These were concerns that arose before the Great Crash of 1929, but were not within the securities siblings’ DNA.

Back to the birthday boy. Dodd-Frank was supposed to be a doctor, created to provide bloated bank disease prevention and intervention. A challenging task.  We faced a kind of debt dependency disease. While we all indulged, depending upon home prices to rise forever, when the hot air started to leak out of the $8 trillion housing bubble, the suffering began. Wall Street received trillions of dollars in bailouts, low interest loans and other “liquidity” supports when home prices reversed, but Main Street was left to suffer. Financiers gained bonuses, kept jobs and grew wealthier. The middle class lost savings, lost jobs, lost homes or saw home values plummet, and with reduced tax revenues and budgetary pressures, lost public services.

How did this happen? Many giant banks (and other financial firms) had borrowed more than $97 for every $100 of assets they owned.  A 33 to 1 assets to equity leverage ratio. A decline of less than $3, or 3% percent in those assets spelled insolvency.  What’s worse, a good deal of the money they borrowed was due in the very short term, sometimes overnight. But the assets they owned were very hard to sell.  And, to make things even more shaky, it was not even clear that the mortgage-linked securities they loaded up on were worth the value they presented to shareholders, lender or regulators. The values of the mortgage-linked securities depended upon homeowners making their monthly mortgage payments in full and on time. And, the timely, full mortgage payments depended upon in part, the capacity of homeowners to pay, but more so, on the underlying home to increase in value.

This Ponzi scheme began to collapse after  home prices began to stabilize and fall, and homeowners began to default in larger numbers. Then in the summer of 2007, many mortgage-linked securities were downgraded. This combination of extreme leverage, overvalued, illiquid assets, and maturity mismatch would put any individual borrower at risk of insolvency. When the borrowers were giant, interconnected banks and nonbank financial firms, a domino effect of failures ensued.

What ability does Dodd-Frank have to prevent another similar crisis? What should we celebrate and where are the gaps?

Answers provided in part 2.

(This post also appeared on July 21 on The Pareto Commons website).


The Implications of Dodd-Frank: Executive Compensation and Financial Regulators

The FDIC announced a rule proposal today that was co-sponsored by Treasury, the SEC, the Fed, the National Credit Union Administration, and the Federal Housing Finance Agency, that would impose limits on executive compensation for large financial institutions.  The proposal is here.  We will have comments on the proposal in subsequent posts. 


Bubbles Happen: Partisan Divide, the Minority Report, and the Financial Crisis Inquiry Commission (Part 2)

We are discussing the Report of the Republican Minority on the Financial Crisis Inquiry Commission.  The Report was issued on December 15 in an effort to meet the deadline set out in the enabling statute.  While meeting the deadline is a laudatory goal, it should not come at the expense of quality.  This is not a good report.  Despite more than a year of work and investigatory authority, it adds little to the debate over the causes of the financial crisis.

The Minority Report begins inauspiciously by noting that "[b]ubbles happen" as if the explanation is in part the inevitability of these things.  Indeed, in describing bubbles, the Minority Report notes that "[t]he recent housing bubble was no different" than prior instances.  

True enough that bubbles are recurring events but this particular "bubble" was anything other than ordinary.  It was unique (at least since the Great Depression) in its severity and, having been particularly centered on housing, in its impact on ordinary people.  The high tech boom in the late 1990s and early years of the new century also had the attributes of a bubble but one that was far less severe and painful than the current example.  Had the Minority Report been describing the high tech bubble, the introduction would have been more fitting.

Much of the blame in the Minority Report for the current "bubble" is placed on Fannie Mae and Freddie Mac.  See Report at 2 ("Through the GSEs [government-sponsored enterprises], FHA loans, VA loans, the Federal Home Loan Banks, and the Community Reinvestment Act, among other programs, the government subsidized and, in some cases, mandated the extension of credit to high-risk borrowers, propagating risks for financial firms, the mortgage market, taxpayers, and ultimately the financial system.").  There is no doubt that Freddie and Fannie contributed to the crisis.  But did they cause it?  Not everyone thinks so. See Testimony of Thomas H. Stanton, Committee on Oversight and Government Reform U.S. House of Representatives, Dec. 9, 2008 ("That said, it is useful to note that Fannie Mae and Freddie Mac did not cause the housing bubble or the proliferation of subprime and other mortgages that borrowers could not afford to repay.").   Pinning blame for the crisis on these pseudo-government agencies required far more thorough analysis than what appeared in the Minority Report.  

As for the private sector participants, they mostly provided a positive service. See Report, at 3 ("However, important financial firms principally involved in pure credit intermediation—that is, providing the link between investors and borrowers—were exposed to the downturn as well, but did not understand the risks they were taking at the time.").  Their failure?  They ultimately, "did not understand the risks they were taking at the time."  Report, at 4.  As for credit rating agencies, they could be compared to ordinary investors and, as a result, "made many of the same mistakes as mortgage investors."   As the Report sums up:  "Put simply, the risk of a housing collapse was simply not appreciated. Not by homeowners, not by investors, not by banks, not by rating agencies, and not by regulators."  Id. at 5. 

As for the immediate cause of the crisis, here is the explanation:

  • Following the successive collapses of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group (AIG), what had begun in the second half of 2007 as a run on those firms that the market identified as having large mortgage exposures and acute liquidity risks exploded into a generalized market panic. Depository institutions had failed. Investment banks had failed. A major insurance holding company was rescued by the U.S. government. Even the GSEs, with their implicit guarantee, were taken into conservatorship by their regulator. Few firms were considered safe, and if they were, it was only because they had a government backstop.

Certainly the market was, by September 2008, edgy from many of the examples given in the prior paragraph.  But the Minority Report more or less ignored the singular importance of the collapse of Lehman.  Most of the examples mentioned in the paragraph above resulted in direct or indirect government bailouts.  In other words, the crisis was largely averted as long as the government stood ready to intervene.  The market was assured that despite the uncertainty, the government would step in and prevent large failures. 

That belief went out the window when Lehman was allowed to fail.  Only then did the financial system freeze, the interbank market effectively shut down, and commercial paper markets dried up.   In other words, it was the absence of government intervention that set off the crisis.  Yet the Report has little to say about this.  Instead, it concludes:

  • These were the best of a series of bad options, and policymakers had extremely limited information to work with. While we believe that the government deserves quite a lot of the blame for getting our financial system and our nation into trouble in the first place, we applaud the quick and decisive actions taken by our nation’s leaders during the panic.

There are differing views on the cause of the crisis.  The debate can benefit from multiple viewpoints, as long as they are well reasoned.  This Report, however, provides little insight into what actually happened and why.  It provides little help to policy makers should similar circumstances arise again. 

One can hope that when the Majority Report is issued in January it will provide more insightful analysis.      


Bubbles Happen: Partisan Divide, the Minority Report, and the Financial Crisis Inquiry Commission (Part 1)

The Financial Crisis Inquiry Commission was created in 2009 in the Fraud Enforcement and Recovery Act of 2009 and tasked with the responsibility for examining the causes of the financial crisis. The membership was to be bipartisan, with six appointed by the majority parties in the House and Senate (controlled by the Democrats at the time) and four by the minority (Republican appointees).  The effort was to be a serious one.  The FCIC could even compel testimony through the use of subpoenas. 

The Act created a December 15, 2010 deadline for any report by the Commission.  The deadline passed without a report by the entire Commission. This was not a surprise.  A majority of the Commission had voted in November to delay the Report until sometime in January 2011. 

Nonetheless, the 15th did not come and go without activity.  The four Repulican members issued a Report titled "Financial Crisis Primer" presumably in an effort to meet the statutory time period.  The Minority Report begins in an inauspicious manner, noting that "[b]ubbles happen."

The decision to issue the Minority Report apparently came as a surprise to the remaining members of the Commission.  See FCIC Press Release, Dec. 15, 2010 (noting that "some members of the Commission made public their personal views on the financial crisis. The Commission had not previously seen or had an opportunity to review what was released today.").

The action and reaction reflect an obvious partisan divide on the FCIC.  This is unfortunate.  What is needed is serious reflection on the causes of the worst financial crisis since the Great Depression, not a forum for partisan discord.  On the other hand, Congress gave to the majority/minority leaders in Congress the authority to appoint the members so perhaps it was to be expected that the partisan divide in Congress would likewise be reflected on the FCIC. 

In the next post, we will take a look at the contents of the Minority Report.