The Erroneously Diagnosed, Inopportune, Destabilizing and Job-Destroying Dodd-Frank Bill

The Erroneously Diagnosed, Inopportune, Destabilizing and Job-Destroying Dodd-Frank Bill
Carlos M Pelaez

The purpose of this post is to critically analyze the Dodd-Frank bill that is moving toward approval in Congress. Section I considers the erroneous diagnosis of the financial crisis; II analyzes the inopportune timing during a period of financial turbulence, sovereign debt risks linked to bank stress and the unsustainable government debt of the US; the destabilizing effects of the bill are considered in III and the job destruction effects in IV; V concludes.
I Erroneous Diagnosis of the Financial Crisis. The main objective of the Dodd-Frank bill is to curb by regulation the alleged causes of the credit/dollar crisis and global recession by making “Wall Street accountable.” The bill is based on the erroneous interpretation that speculative practices by financial institutions caused excessive risks, low liquidity, short-term financing, high leverage and unsound credit decisions that resulted in a meltdown of financial markets. Besides some lax regulation, such as inadequate standards on mortgage origination, the Dodd-Frank bill implicitly assumes that the government had a perfect role in rescuing financial markets, or “Wall Street,” and prompting the recovery of the production and investment side of the economy, or “Main Street.” The fact is that there are not such things as Wall Street or financial sector and Main Street or factories but rather one indivisible general economy that was devastated by a set of government policies. The combined effect of these policies was equivalent to writing a put option on house prices, that is, the owners of houses were led to believe that government policies guaranteed a floor of the houses at the price equivalent to the principal in mortgages. The government would use a set of policies to prevent house prices from declining below the level at which mortgages were contracted. There was a set of four government policies that interacted with each other in creating excessive risk, low liquidity, short-term financing, high leverage and unsound credit (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
First, the Federal Open Market Committee (FOMC) lowered the rate for lending reserves among banks, or fed funds rate, to 1 percent and held it at that level between Jun 2003 and Jun 2004, with the forward guidance of keeping it near zero percent until necessary to prevent deflation and recover the economy. Fed interest rate policy encouraged high risks in search of higher returns and penalized liquidity that was rewarded at near zero interest rates. The low short-term interest rate also encouraged adjustable rate mortgages (ARMS) and teaser mortgages without principal payment that lowered monthly payments well below those of fixed-rate mortgages charging much higher interest rates. The low short-term interest rate of near zero also eroded evaluation of creditworthiness of mortgage borrowers because if the Fed maintained interest rates at near zero percent house prices would increase forever as more people with lower incomes would afford to buy houses with ARMS and teaser payments. In this state of permanently near zero interest rates and house prices increasing forever, the only risk to the borrower was to live in a better house for a few years and then sell it for a profit that could be used as down payment for another and better house. The lenders believed that there was no risk in lending without verification of income, assets and jobs in NINJA mortgages based on “no income, no job and no assets.” There were also “piggyback mortgages” in which a second loan provided the funds for the mortgage down payment. There was even a “Mariachi mortgage” in which the only proof of business income was a photograph of the debtor dressed in the Mariachi costume used in a part-time job. The low interest rate policy spread throughout consumer goods such as buying a vacation home in more temperate climate, a luxury third car, home theaters and so on. The Fed encouraged the population not to save or be cautious about risks, including families and financial institutions. The Fed then increased the fed funds rate from 1 percent in Jun 2004 to 5.25 percent in Jun 2006, eroding the illusion of a floor on house prices that precipitated the real estate debacle. Sales of new single-family houses declined by 32.7 percent in May 2010 relative to Apr 2010, reaching an annual rate of 300,000 (http://www.census.gov/const/newressales.pdf ). Sales of new single family houses in July 2005 stood at 1,410,000 (http://www.census.gov/const/newressales_200507.pdf ). The decline in sales of new one family houses from Jul 2005 to May 2009 is 78.7 percent as the illusion of the government-supported floor on house prices collapsed. The interest rate and housing policies of the government have caused a tragedy of millions of families suffering foreclosure or owing underwater mortgages with prices under contractual principal and interest.
Second, Treasury suspended the auctions of 30-year Treasury bonds from 2001 to 2005. The objective of the Fed supported or suggested policy was to lower mortgage rates. Insurance companies and pensions funds have long-term obligations that are matched or hedged with long-term Treasuries. The disappearance of new 30-year Treasuries caused the purchase of mortgages of equivalent maturities that increased their prices, which is the same as lowering their yields. Refinancing of mortgages at lower rates provided households significant monthly reductions in payments that were more important as a source of extra cash in some cases than the tax rebates. The policy also contributed to the increases in prices, sales and construction of houses. Price increases were so rapid that many families obtained home-equity loans used sometimes in making the payments on the houses or consuming other goods. The increase in prices of houses created the perception of an increase in wealth that motivated less cautious evaluation of risks and higher consumption.
Third, the US has maintained a yearly subsidy of housing of $221.1 billion consisting of: “$37.9 billion in government outlays for low-income housing assistance, $156.5 billion in federal tax expenditures for housing and $26.7 billion in credit subsidies, including the GSEs [Fannie Mae and Freddie Mac] and the VA [Veterans Administration]” (Dwight Jaffee and John Quigley, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 44). The policy of affordable housing encouraged sales, construction and increases of house prices.
Fourth, Fannie Mae and Freddie Mac expanded aggressively as part of the policy of affordable housing. The portfolio of retained and guaranteed mortgages of Fannie and Freddie rose from $740 billion in 1990 to $5,243 billion in the third quarter of 2008, which was equivalent to 43.5 percent of total mortgages in the US of $12,057 billion (Pelaez and Pelaez, Financial Regulation after the Global Recession, 45). Fannie and Freddie are authorized by Congress with a charter that requires their support for guaranteeing the secondary market for residential mortgages, assisting in financing mortgages for families with low and moderate income with concern for underserved areas. In Congressional testimony, the former chief credit officer of Fannie stated that Fannie and Freddie operated with a leverage ratio of 75:1 and purchased or guaranteed $1.6 trillion in nonprime loans and securities that will account for the default of one in every six home mortgages in foreclosure (Edward Pinto, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47, Regulation of Banks and Finance, 219-20). The government controlled Fannie and Freddie to create the illusion of affordable houses for everybody and ever increasing prices. The population and lenders were induced into buying and financing homes under the illusion there would not be any risks, that is, that government policy would maintain a floor of house prices at the level of contracted mortgages.
II Inopportune Timing. The timing of regulation may be perceived as opportune because of the November election but it is highly inopportune because of economic and financial uncertainty. Financial turbulence is manifested in downward trends of stocks, commodities and the euro with daily capricious oscillations. The percentage decline of major stock markets from Apr 15 to Jun 25 was: Dow Global -15, Dow Asia Pacific -9.6, Shanghai Composite -19.3 and STOXX Europe 50 -11.5. The percentage decline of US indexes from Apr 26 to Jun 25 was: DJIA -9.5, S&P 500 -11.5 and NYSE Financial -14.9. The dollar appreciated 22.3 percent relative to the euro from Nov 25, 2009 to Jun 25. The DJ UBS commodity index lost 11.2 percent from Jan 6 to Jun 25 (http://online.wsj.com/mdc/public/page/mdc_us_stocks.html?mod=topnav_2_3012 ). Financial turbulence is caused by four factors of risk perceptions in financial markets. First, a potential slowdown of the Chinese economy could cause downward pressure on commodity prices and contraction of interregional trade that could slow the Asian economy. Second, the sovereign debt crisis in Europe could paralyze financial markets through the increase in counterparty credit risk perceptions. Third, the eventual major risk factor in the world economy could be the unsustainable path of the government debt of the US resulting from record peacetime budget deficits. Fourth, the Dodd-Frank bill and continuing attacks on banks could slow credit required for rapid recovery and job creation.
III Destabilizing Effects. The Senate-House conference reached agreement on the Dodd-Frank Bill (http://banking.senate.gov/public/index.cfm?FuseAction=Issues.View&Issue_id=380e9256-0461-ff42-937a-cf820569c52e http://banking.senate.gov/public/index.cfm?FuseAction=Newsroom.PressReleases&ContentRecord_id=6eb3db3b-a672-fc05-17a2-35abd1c333c9 http://professional.wsj.com/article/SB10001424052748703615104575328430427126018.html?mod=wsjproe_hps_LEADNewsCollection The summary of the Senate-approved version reveals the intent of the legislation: “Restoring American Financial Stability. Create a sound economic foundation to grow jobs, protect consumers, rein in Wall Street, end too big to fail, prevent another financial crisis” (http://banking.senate.gov/public/_files/ChairmansMarkofHR4173forConference.pdf ). The 1974 pages of the conference base-bill do not accomplish those objectives. The primary objective is to “prevent another financial crisis.” There is no rigorous theory of financial crisis that was used to analyze regulation, supposedly known only by the architects of the Dodd-Frank bill, which can prevent financial crises. The individual provisions of the bill could be destabilizing and even more so when acting simultaneously. Regulation commonly results in effects that are entirely different than those intended by legislation. The Dodd-Frank bill is not the product of protracted reasoning and consultation but of a process of give and take compared in the press to “sausage making.” Even if the initial provisions were sound, they would become unsound after the negotiation. There are at least seven evident sources of financial instability that are added by the Dodd-Frank bill, which could be jointly a major source of financial instability. (1) Amputation and resolution of companies. The regulators can take over and break financial firms without using taxpayer funds. However, Treasury would provide upfront funds for the workout that would be recovered by fees on financial institutions with more than $50 billion in assets. There is no hard knowledge by regulators or actually anybody as to what are the business lines of financial companies that contribute to financial instability. Companies that are viable as a whole may become unviable after capricious amputations of business lines. The financial system may be viable as a whole but may become unstable after surgeries of companies by regulators. The upfront Treasury contribution is with taxpayer funds but in practice will rescue those firms “too politically important to fail,” as it is the ongoing case with Fannie and Freddie that may result in a trillion-dollar bailout fully paid with taxpayer funds because both companies are now part of the budget of the US. (2) Financial Stability Council. If there had been knowledge about anticipating and controlling the crisis, the Board of Governors of the Federal Reserve Bank would have known that knowledge and required policy tools to prevent or resolve the crisis. The ten-member new agency has politicized an unknown grand concept without definition, theory and reality labeled as “systemic risk.” The new council has superimposed on the Fed a new central bank board with less knowledge and experience under ultimate control by Congress and the executive. The council will erode the Fed’s independence, interfering with best-practice central banking.
(3) Volcker Rule. Proprietary trading, hedge funds and private equity were not part of the credit/dollar crisis and global recession or of prior crises. This rule does not contribute to financial stability, constituting merely a transfer of business from some financial institutions to others under the pretence of protecting taxpayers from bailouts caused by careless risks of banks. The alleged risks would fall outside regulation. The bill weakens banks by concentrating their business on lending, foregoing diversification into other sources of income that cushioned their balance sheets during the crisis. (4) Derivatives and swaps desks spin-off. The problem was not derivatives and swaps that served to price and transfer financial risk but the clogging of financial markets with mortgage-backed securities and derivatives indexed or based on cash flows of mortgage loans that were not sound. There were few if any direct problems with derivatives that were not linked to mortgages. If financial innovations were restricted to those understood by everybody, there would be a return to the stone age of banking, much the same as there would not be any air travel unless everybody understood how a jet plane functions. (5) Trust-preferred securities. There have been no problems with trust-preferred securities that are now banned as part of capital for no understandable reason. Banks calculate economic capital that includes regulatory capital and their own extra capital cushion to weather crises and engage in acquisitions according to their business models. Without specialized knowledge and wide consultation, the Dodd-Frank bill has anticipated the Basel III capital agreement that is likely to be finalized this year and prudently implemented after banks have fully adjusted to the crisis. (6) Securitization. The objective of securitization is to transfer risk from individual bank balance sheets to many investors. The requirement that banks keep 5 percent of the transfer of risk by securitization, allegedly committing them to quality in asset-backed securities, will weaken balance sheets, interfering with overall bank risk management. (7) Hedge funds. The compulsory registration of hedge funds may reveal transactions that are required in price discovery in temporarily stressed markets. There is no evidence that hedge funds had any role in the crisis.
IV Job Destruction. There are sources of inefficiency and job destruction in the Dodd-Frank bill. (1) Exporting the financial industry. The Dodd-Frank bill is hailed as “we are poised to pass the toughest financial reform since the ones we created in the aftermath of the Great Depression” (http://www.whitehouse.gov/the-press-office/remarks-president-wall-street-reform-1 ) The new financial regulatory framework is likely to cause an exodus of the financial industry to other jurisdictions, exporting jobs when 26 million are unemployed or can only find part-time jobs. The Banking Act of 1933 (12 U.S.C. § 371a) prohibited payment of interest on demand deposits and imposed limits on interest rates paid on time deposits issued by commercial banks implemented by Regulation Q (12 C.F.R. 217) (Peláez and Peláez, Financial Regulation after the Global Recession, 57). This depression rush to regulation was motivated by the erroneous belief that banks provided high-rate risky loans to pay high competitive market interest rates on deposits, which allegedly caused banking panics in the 1930s. An added motivation was the allocation of savings to housing by maintaining low interest rate ceilings benefitting savings banks and savings and loan associations that complained of unfair competition from higher deposit rates of commercial banks. Milton Friedman analyzed in 1970 that the rise of inflation above Regulation Q interest rate ceilings caused halving of issuance of certificates of deposit (CD), which was the banking innovation created to finance rising loan volumes. Banks accounted higher-rate CDs in their European offices as “due from head office” while the head office changed the liability to “due to foreign branches” instead of “due on CDs.” Friedman predicted the future as revealing as his forecast of 1970’s stagflation: “the banks have been forced into costly structural readjustments, the European banking system has been given an unnecessary competitive advantage, and London has been artificially strengthened as a financial center at the expense of New York.” (Journal of Money, Credit and Banking 2 (Feb 1, 1970), 26-7, cited by Pelaez and Pelaez, Financial Regulation after the Global Recession, 58). The Dodd-Frank bill is anticipating global regulation with tighter US regulation. Other jurisdictions will adjust their regulation to attract the exodus of US banks and financial institutions. Jobs and the financial industry will migrate to those jurisdictions, leaving behind a backward banking system concentrated on lending that has proved to be riskier than trading. (2) Jobless recovery. US GDP increased at the annual seasonally-adjusted percentage rate of 2.2 in QIII09, 5.6 in QIV09 and 2.7 in QI10 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2009&LastYear=2010&Freq=Qtr ). These rates of growth may be insufficient to recover full employment. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. High rates of economic growth require dynamic financing by banks and other financial institutions. The Dodd-Frank bill creates a plethora of transactions and funding costs that will restrict credit and increase interest rates. Transaction costs of regulation can be quite high because of the need to seek advice, hire specialized compliance staff, redesign and implement new lines of business while phasing out older ones, revamp systems and risk management and so on. (3) Interest rates. The cost of credit to consumers and business will be higher with the Dodd-Frank bill than otherwise. There are new fees for a $19 billion fund supposedly to pay for regulation reform and an increase in insured deposits to $250,000. Bank capital will become costlier because of the new requirements. The elimination of lines of business will make banks less profitable. The concentration on lending will require higher provisions for loan losses. The combined effect will be banks and financial institutions that have higher costs of doing business. The new costs will be wholly or partially passed on to consumers and business in the form of higher cost of lower volume of credit. (4) Credit volume. The proposed solution is to politicize consumer credit by creating an agency inside the Fed led by an independent director appointed by the President and confirmed by the Senate. The result is likely to be higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation. Investors will withdraw funds from stocks of financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. The consumer will be harmed instead of protected.
V Conclusion. The Dodd-Frank bill is the wrong legislation at the wrong time. The analysis of the credit/dollar crisis supporting this bill is erroneous, camouflaging the true origins in government policies of near zero interest rates and subsidies to housing. The bill is being approved at the time when the economic recovery is just beginning at a slower pace than after earlier deep recessions with 26 million people without jobs or working part-time because they cannot find another occupation. The new regulatory framework incorporates seven sources of instability in the financial system that jointly may well cause another financial crisis. It also sanctions a new “too politically important to fail,” creating the first one with the trillion-dollar bailout of Fannie and Freddie with taxpayer funds. The costs and prohibitions of banking and finance will cause the exporting of the financial sector to other jurisdictions. The lower volume of finance at higher interest rates and the unsustainable government debt will prevent recovery of the economy and full employment. The progress of the US has been through technological innovations. The bill restricts progress with hurdles on financing innovation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )