"The Dodd-Frank Act - Color it Gray"

Sydney M. Williams

Thought of the Day

“The Dodd Frank Act – Color it Gray”

June 28, 2010

My hike in the White Mountains turned out a little different than expected. Two and a half hours into our climb up Mount Madison along the Daniel Webster Trail – purportedly among the steepest in the White Mountains – a good friend who was with us experienced a pulse rate that reached 120. When the rate did not decline as quickly as we thought it should the decision was made that he should walk back out. I went with him, leaving the younger generation (including a younger brother of mine) to continue the trip, which they did. (My friend seemed tired that evening, but appeared fine the next day, and even better the day after.)


The next afternoon he and I drove up the Mount Washington auto road and met the group at the top when they emerged from a damp and cold fog, about an hour and a half later than they were initially expected. The temperature was in the low 40s with wind gusts up to 70 miles per hour. The fog was so dense that visibility was limited to no more than 15 or 20 feet. That last mile of their hike was one that my grandchildren (and their father and friends) will not soon forget.

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The compromised version of the financial reform bill, now termed the Dodd-Frank Act, voted out at 5:45AM on Friday morning, reflects the late-night strategies of the many participants, but may prove to be the best that 535 idiosyncratic, egotistical individuals could do. Of course, with many provisions not being implemented for several years and at 2000 pages, it provides a lot of hiding places; the full ramifications of this bill will likely remain undiscovered for some time. In the meantime it will prove a lawyer’s delight.

Bank earnings will take a hit, as proprietary trading desks will be curtailed, investments in hedge funds and private equity funds will be limited to 3% of Tier 1 Capital and most derivative products will be traded on exchanges – providing some sunlight on the dark recesses of these markets –requiring more margin (capital), resulting in less profitability. Of course, increased transparency may permit these markets to expand, thereby benefiting exchanges, such as the CME (Chicago Mercantile Exchange) or the ICE (Intercontinental Exchange). Concerns of job losses for New York City are exaggerated in my opinion, as banks will spin off operations and new firms will fill the voids created as banks curtail or sever departments. But I agree with Gretchen Morgenson, writing in Sunday’s New York Times, that “the nation’s financial industry will still be dominated by a handful of institutions that are too large, too interconnected and too politically powerful to be allowed to go bankrupt…” The concept of too big to fail has not been deterred.

(Limiting the banks proprietary desks to primarily investing in U.S. Treasuries may be consigning those operations to investing in junk, given that our Federal debt at $13.1 trillion represents 92.3% of 2009 GDP and that the Federal deficit is about 10% of GDP – both numbers would normally place the U.S. in the intensive care units of financial prudence. Even Michael Milken would likely deem these securities as too risky.)

There is much that remains unclear. Its deliberately gray areas have been deemed by some wags as a “job creation bill for lawyers.” Fannie Mae and Freddie Mac, both beneficiaries of the two “dignitaries” whose names this bill carries, remain unmentioned, despite the fact that their debt alone, if added to the Federal debt, would swell that $13.1 trillion by 38% to $18 trillion, or 127% of GDP – far above that of Greece! The rating agencies will be able to be sued – a surprising win for trial lawyers (he wrote, cynically), but an even-closer relationship with government will provide an even deeper government imprimatur than heretofore – making worse an already bad situation. (As an aside, I still don’t understand why we need the current system of rating agencies. Public and private financial firms would fill any gap created by their absence. Equity research has always been paid for by buyers, not issuers. The same is generally true in high yield. The conflict of interest inherent in the current bond rating system, in which the issuer pays to be rated, provides too much opportunity for fraud, monkey business and disingenuous opinions.)

The $20 billion dollar fund (paid for through taxing certain financial organizations) that Congress hopes to establish to serve as means of preventing future taxpayer funded bailouts is mistaken on two counts: first, it rewards the prodigal at the expense of the frugal (a bad message), and, second, $20 billion is nowhere near enough, given that the last crisis required at least $700 billion.

The SEC, which was notably absent from duty in those days leading up to financial Armageddon, as the Bernie Madoff case most explicitly screams out, is rewarded with increased authority over rating agencies. In the recent past, it was not so much a lack of regulatory authority as it was a failure to enforce the rules. On the positive side of the ledger, the Federal Reserve, despite its role in augmenting the housing bubble by keeping interest rates too low for too long, remains the one truly independent agency (or the least political.) Under the proposed bill it will stay independent and, in fact, gain powers, housing what is expected to become a Consumer Protection Agency. While there is no question that consumers should be protected against willfully fraudulent hucksters, I often wonder how smart it is for the government to persist in protecting people against their own bone-headed decisions. Perhaps politicians simply want a more dependent electorate?

I have been a believer in the notion that commercial banks have become too big, especially since the demise of Glass-Steagall, and involved in too many conflicting operations; at least this bill trims their sails. But I believe that merchant and investment banks serve different markets and customers than their commercial cousins, so should be separate. The principal assets of a commercial bank should reflect the fact that their principal liabilities are deposits, now to be insured up to $250,000. The businesses of merchant and investment banks, by definition, entail greater risk, so should either be set up as partnerships – where the liability for loss is carried by the general partners, jointly and severally – or, if set up as large, public corporations, they should be subject to very strict capital rules. Fear of loss and financial pain, however, is always the best regulator.

While having some positive attributes, in general the bill seems, to me, to move us toward a collective good and away from individual responsibility. Behind its pleonastic language, the bill risks taking us one more step down Friedrich Hayek’s “Road to Serfdom.”