Politics & Policy

Don’t Bank on this Bill

In a final amendment to the far-reaching overhaul of the nation’s financial-regulatory framework that is expected to become law, House and Senate negotiators named the bill after its chief authors, House Financial Services Committee chairman Barney Frank (D., Mass.) and Senate Banking Committee chairman Chris Dodd (D., Conn.). The bill is intended, in President Obama’s words, to “prevent another financial crisis like the one that we’re still recovering from.” Before we get into the details of the bill, let’s briefly review the track record of the two men who authored it. How did they perform in the run-up to the crisis?

In a floor speech on homeownership in 2004, Frank said, “those who argue that housing prices are now at the point of a bubble seem to be missing a very important point . . . we are talking here about an entity, homeownership, homes, where there is not the degree of leverage that we have seen elsewhere.” This view turned out to be entirely mistaken. Frank applauded efforts to “make homeownership available to people who might not on their own in a market situation be able to afford it.” The pursuit of this policy led to the erosion of lending standards, the proliferation of risky mortgages, and the inflation of a bubble in housing prices. Frank added that “you will not see the collapse that you see when people talk about a bubble.” He certainly didn’t see it — coming, that is.

At a Senate Banking Committee hearing in 2004, Alan Greenspan warned that Fannie Mae and Freddie Mac presented a classic moral-hazard problem: The perception that the government would not let them fail allowed them to take bigger risks than other companies. Dodd ignored him, calling Fannie and Freddie “one of the great success stories of all time.” Four years later, their share prices collapsed as investors learned that they had hidden their true exposure to the subprime-mortgage market using clever accounting tricks. Dodd said, just days before the government was forced to bail them out, that the firms were “fundamentally sound and strong.” Bailouts for the firms could end up costing more than $1 trillion; they were recently delisted from the New York Stock Exchange.

Considering the content of the bill these men have cobbled together, we couldn’t imagine a better name. The legislation is just as lacking in foresight, and just as dedicated to a flawed understanding of the government’s regulatory abilities, as its namesakes. Its primary failure is that it assumes that policymakers — even ones with better records than Frank and Dodd — are able to predict financial crises, which are so severe precisely because they upend widely shared assumptions. The bill establishes a ten-member Financial Stability Oversight Council tasked with monitoring and addressing risks to financial stability. But it is highly unlikely that such a council would have seen the housing bubble as a risk at the time. Its membership will be drawn from the same pool of high-ranking government officials who failed to see the last crisis coming. They failed, not because they were not concerned with financial stability before, but because almost all of them shared the assumption, which Barney Frank so eloquently expressed, that home-price inflation was not a speculative bubble and everything would be fine.

The folly of this council is twofold: It creates the impression that the government has its eye on the ball, which breeds laziness and incaution in the banking sector, and it gives bankers an excuse to fall back on when things go wrong, enabling them to say, “How can we be to blame for this crisis when the Financial Stability Oversight Council failed to foresee it as well?” This is the sort of framework that makes bailouts inescapable — in fact, the assumption that future bailouts will be necessary is built into this bill. The Dodd-Frank Act gives the FDIC the power to seize insolvent financial institutions and wind them down in an orderly fashion, the way that it does now with insolvent depository banks.

The problem is that the sophisticated creditors of large financial firms do not deserve the kind of protection that the FDIC provides to depositors: They should bear the brunt of the losses if the firm fails, or else they will have little incentive to lend carefully. In one of the few victories for Republicans in this bill, GOP negotiators were able to win concessions that limited the FDIC’s ability to spare such creditors from losses. But some loopholes remain. Particularly worrisome is the Federal Reserve’s authority to make broad extensions of credit to struggling financial entities, which this bill enhances. The Fed is only supposed to use this authority to help firms that are illiquid, not insolvent. But the line between the two is blurry, and regulators tasked with preserving “financial stability” have every incentive to blur it further during a crisis, as witnessed when former Treasury Secretary Hank Paulson forced TARP money on healthy and weak banks alike.

Perhaps the worst element of the bill is the creation of a new Consumer Financial Protection Bureau, housed in the Federal Reserve, with nearly unlimited rulemaking and enforcement authority and a funding mechanism that appears to involve taking whatever money it finds lying around Fed headquarters. This is a recipe for an out-of-control regulator with the incentive and the means to restrict forms of credit based on the outside chance that an irresponsible minority might use them unwisely. Some liberals are unhappy that a last-minute amendment placed auto dealers beyond the bureau’s reach. They should grow accustomed to the politicization of financial activity in the wake of this legislation, in which most businesses would be wise to invest more in their D.C. lobbying shops than in expanding their commercial operations.

The banking lobby was able to win a few other concessions at the eleventh hour: Sen. Blanche Lincoln’s (D., Ark.) derivatives title was watered down, as many expected it would be after she won her primary election. Having posed as tough on Wall Street in order to beat a liberal challenger, Lincoln apparently now sees the wisdom in allowing broad exceptions to the rule that banks must spin off their derivatives desks: Instead, banks can continue to trade interest-rate, currency, gold and silver derivatives, and — this is the big one — to hold derivatives that offset “balance sheet risk,” a broad term that will allow banks to keep trading most derivatives. A weakened version of the “Volcker Rule” — prohibiting commercial banks from trading with their own funds — would allow for limited investments in internal hedge and private-equity funds.

For all the attention they’ve gotten, these are marginal changes. If the provisions had gone through in their original forms, it is highly likely that shrewd financial operators would have found ways to get around them. This is not to strike a defeatist tone and say that no regulatory changes could have improved the financial sector. Limits on leverage, for instance, might have put limits in fact on bank size, reducing the damage they could inflict on the economy if they failed. Changes to the bankruptcy code could have made bank failures more orderly when they occurred. Breaking up the rating agencies’ oligopoly would have encouraged smarter risk assessment on Wall Street. Most important, a new approach to housing policy — starting with a plan for dealing with Fannie and Freddie — would have removed an enormous distortion in the economy that contributed to the crisis.

But the bill that Congress has produced, which President Obama is eager to sign, did not include any of these measures. Instead, it doubled down on an approach to regulation that has failed in the past and added a number of extraneous provisions besides — such as new price controls on debit-card fees — because the Democrats “never let a serious crisis go to waste.” We’re very glad that negotiators named this bill the Dodd-Frank Act. When the next crisis hits, it will be much easier to hold these men accountable.



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