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).