Dodd-Frank: Solving the Wrong Problem

Right From the Start

Right From the Start

The past week marks the five-year anniversary of the Dodd-Frank Act allegedly designed to protect against another financial calamity like the precursor to the 2008 market collapse and the attendant Bush-Obama recession that for many continues today – seven years and counting. Never before had two congressional flyweights like Sen. Chris Dodd (D-CT) and Rep. Barney Frank (D-MA) gained such powerful positions over the economy of the United States and the Dodd-Frank Act was their swan song in ineptitude.

But let us digress a bit.

Mssrs. Dodd and Frank were instrumental in creating the “housing bubble” which then was the axis upon which turned the machinations of the banking industry and their allied investments business and allies. They led the congressional and administrative charge that claimed that an element of the “American Dream” – home ownership – was being denied a significant element of the population because of so-called “red-lining.”

In actuality “red lining” was primarily prudent lending practices requiring would be home buyers to contribute an equity stake – usually pegged between ten and twenty percent of the purchase price – before providing mortgages for the balance. By using the resources of the federal government and threatening unending audits and regulatory proceedings, these “do-gooders” forced the lending institutions to make loans to people who could not or would not ever repay them.

“Sub-prime” mortgages became the vehicles for accomplishing this. They began as “no equity” loans and metastasized into “no equity, no credit check” loans. The theory advanced by those like Mssrs. Dodd and Frank was that the increasing price of housing would provide the equity shortly after loans were closed. Like a “Ponzi scheme” that presumption would only hold true so long as the market value of homes increased annually without plateaus or downturns – an event unheard of in any sector of investment.

The superabundance of easy mortgage money created an artificially high demand in housing which drove up prices to unreasonable levels – thus bolstering, for the short term, the rationale advanced by the likes of Mssrs. Dodd and Frank. And with those artificially high prices came artificially high mortgages. And while many in government failed to understand the danger in artificially inflating a market, the banks and investment houses understood full well that they were holding millions of dollars of worthless securities. In response, they began to package these questionable sub-prime loans with other securities and channeled them into the marketplace where they were leveraged, repackaged, and leveraged again and again. When the inevitable crash of the inflated housing market came, the effect on the investors in those leveraged securities was compounded. This was the crash of 2008 – created and protected in large part by the demands and actions of the federal government in pursuit of social policy at the expense of economic reality.

The worst of the lot were the federally created Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). As concern began to increase about the credit worthiness of these sub-prime loans and the financial stability of Fannie Mae and Freddie Mac, Mssrs. Dodd and Frank spiked any congressional investigation of those institutions and the underlying wisdom of the sub-prime loans.

Mssrs. Dodd and Frank had each risen to the chairmanship of the Senate Banking Committee and the House Financial Services Committee respectively. Both had achieved their positions, not by knowledge, intelligence, or demonstrable skill, but rather by the antiquated seniority system in Congress. (Think about how incompetent teachers are promoted and protected in the public school systems – it’s the same thing.) When the market crashed they scrambled to avoid any responsibility for the wrong doing that they had helped create and protect. Of course they blamed Wall Street and the banking industry – easy villains who were used to being blamed by politicians and assured that there would be no serious repercussions because of their size and political influence.

And like clockwork, Mr. Dodd, mired in stupidity, and Mr. Frank, mired in leftist ideology, turned to their friends in the Wall Street banking and law firms for assistance. Both of these institutions rotate officers and employees through congressional and administration offices like a revolving door. These revolving professionals/bureaucrats know the processes, vulnerabilities and lack of attention to details that is the hallmark of presidents and members of Congress.

The Dodd-Frank bill was passed with much fanfare by the politicians and amid fake despair by the major banks and Wall Street firms. It created a new bureaucracy mostly populated in senior levels by those who rotated from industry to government and back. It created a blizzard of reporting and paperwork that buried all but the largest institutions – those principally responsible for the crisis that proceeded its adoption. As Rep. Jeb Henserling (R-TX) the current chairman of the House Financial Services Committee wrote recently in The Wall Street Journal:

“Tuesday will mark five years since President Obama’s signing of the Dodd-Frank law, the most sweeping rewrite of the country’s financial laws since the New Deal. Mr. Obama told the country that the legislation would ‘lift our economy.’ The statute itself declared that it would ‘end too big to fail’ and ‘promote financial stability.’

“None of that has come to pass. Too-big-to-fail institutions have not disappeared. Big banks are bigger, small banks are fewer, and the financial system is less stable. Meanwhile, the economy remains in the doldrums.”

But two underlying problems continue to exist. First, in the current market stagnation, institutions are creating growth through mergers and acquisitions rather than expansion of services and customer bases. And second, the consolidation of those markets, particularly the financial markets, are creating behemoths whose success adds little to economic growth but whose failures can cripple the nation’s financial stability. In other words “too-big-to-fail” is being institutionalized by federal action and taxpayers will bear the burden of another trillion dollar bailout somewhere down the road.

Mr. Hensarling’s remedy is the so-called Consumer Protection and Regulatory Enhancement Act, a bill introduced by Republicans when they knew that a Democrat led Senate would never pass it. With the Republicans now in control of both houses, Mr. Hensarling’s remedy remains – like most of the big talk from Congressional Republicans – idle and unfulfilled. I haven’t read the act, but it is safe to assume that it, like the Dodd-Frank Act, was primarily engineered by the same banking and investment interests that assisted in the crafting of Dodd-Frank. And just as likely it will create burdens that fall primarily on those least able to withstand a new bureaucratic enforcement regimen.

I am a dedicated capitalist and ardent supporter of a free market. However, underlying both is the notion that there must exist a vibrant, competitive market. The opposite of a free market is one dominated by government or by an entity with “market power.” For too long we have measured that “market power” by the ability of an entity to set prices without experiencing elasticity in demand. In such instances, the discipline of competition in a free market disappears and these entities become inefficient in production and effectively delay innovation. (Having worked for U S WEST after the breakup of the Bell System, I am in a unique position to appreciate that the introduction of competition into the telecommunications market spurred technical innovation much more than price reductions – in fact, the price reductions were mostly a direct result of technological innovation rather than competition.) That definition is still valid but now incomplete.

Institutions have now grown so big that their economic well being substantially impacts the economic well being of the entire nation. In such cases these entities likewise become inefficient and instead of focusing on consumer needs, focus instead on government metrics. It is not only true in the rash of consolidations in the financial industry but also true in the consolidation of the healthcare industry and pharmaceutical industry (both accelerated by Obamacare), the airline industry, and the communications/entertainment industry.

I hate to hearken back to the “good old days” but let’s remember that it was President Theodore Roosevelt (R), the original “trust buster,” who moved to break up the megafirms that monopolized oil, coal and steel that threatened the financial health of the nation. It is high time that we do that again. Size matters. And the size of mega institutions permitted by Republicans and Democrats alike have become excessive. There is little efficiency gained for the benefit of consumers in these mergers and acquisitions but rather additional levels of bureaucratic controls, reports and internal metrics. Gigantic salaries are afforded many in these mergers and acquisitions not for creating goods but for creating size.

It is not difficult to project the impact of the failure of any single business on the economy. Setting a point past which mergers and acquisitions should be prohibited should likewise not be difficult. The only exception to this rule should be with regard to firms who grow significantly because they have seized upon innovations to create and respond to consumer demands (think Apple) as opposed to those firms that have grown significantly by acquiring other firms’ innovations (think Microsoft).

The cynicism of the American public is driven largely by its distrust of the institutions that claim to exist for their benefit. When Americans see that yet another “grand solution” by the President and Congress has failed to deliver (think Dodd-Frank and Obamacare) the cynicism increases.