The Big Flaws in Dodd-Frank

The Big Flaws in Dodd-Frank by GENE EPSTEIN

A financial historian warns that it's done nothing to prevent the government subsidy of mortgage risk that fueled the financial crisis.

Charles Calomiris is nothing if not intense -- and tireless. The Henry Kaufman professor of financial institutions at Columbia Business School has published numerous scholarly papers in refereed journals on banking and finance, and is the author of the book U.S. Bank Deregulation in Historical Perspective. More recently, he has published pieces in the financial press, including The Wall Street Journal and Barron's, about the causes of the 2008 financial crisis, and has delivered talks and given interviews on this topic. His latest project is the forthcoming Fragile by Design: Banking Crises, Scarce Credit, and Political Bargains, co-authored with Stanford University political science professor Stephen Haber; the book takes a fresh look at the connection between politics and banking in several countries, including a detailed analysis of the U.S. I recently recorded an interview with Calomiris in his office at Columbia, from which edited excerpts follow.

Barrons: When President Obama signed the Dodd-Frank bill into law on July 21, 2010, he was photographed embracing former Federal Reserve Chairman Paul Volcker, who helped shape some of its provisions. Can Dodd-Frank prevent another financial crisis?
Calomiris: I don't know anyone who understands what happened who would say that Dodd-Frank solves the problems that created the financial crisis. The legislation runs 2300 pages, and so it would take some time to explain what Dodd Frank got wrong and what it should have done instead.

Gives us some idea of what it got wrong.
You mention Paul Volcker, so let's discuss the part of Dodd-Frank called the Volcker Rule. The Volcker Rule tries to ban proprietary trading within banks. The first problem with that -- which I foresaw along with many others -- is that it would be hard to define proprietary trading, because obviously, an essential role of banks is to help make markets in various financial instruments and to execute trades for their clients.

So the question is, how do you define the limits of proprietary trading? From the hundreds of questions that they asked people and the thousands of complicated responses that they have gotten, it's become clear that there is no hope of being able to describe what it is they are trying to prohibit in a way that can be predictably identified, so that banks can know whether or not are they are in violation.

Even if it can't be done, might it still be helpful to get rid of proprietary trading by banks?

I don't think so. One thing for sure: there is no story about proprietary trading having anything at all to do with the crisis. Even Paul Volcker practically admits that.

Then what do you think was motivating Volcker?
We all have our laundry lists of what we would like to see done. Paul Volcker is somebody who has been around for a long time, and has a long laundry list. Proprietary trading by banks is just something he doesn't like, and Barack Obama wanted to hear Volcker's ideas. So basically he gets a free pass to bring his laundry list to the Dodd-Frank bill.

"There is a powerful political interest that wants real-estate lending to be sponsored by the government." -- Charles Calomiris

You don't let the crisis go to waste.
You put it to a lot of different uses, except the ones that matter. Did the crisis have anything to do with women and minorities not being hired sufficiently by financial institutions? I could come up with a cockamamie theory that it might have, because women are more conservative than men. If we had more women running banks maybe we would have seen fewer imprudent risks. I haven't heard anyone make this argument, so why has Dodd-Frank created new quotas for financial institutions to hire women and minorities? I don't think any of us believe that was a crisis-mitigation policy. It was just politics.

Do you think the partial repeal of Glass-Steagall had anything to do with the crisis?
No, and the irony is that even the original of the Glass-Steagall Act, as passed in 1933, had nothing to do with the crisis it was supposed to address. Senator Carter Glass, who had been Chairman of the House Committee that drafted the Federal Reserve Act under President Woodrow Wilson in 1913, in 1933 played the same role as Volcker did some 75 years later.

On Carter Glass's laundry list was the notion that mixing investment banking with commercial banking was a bad idea. There was no evidence for that, and all subsequent research has rejected Glass's view. It's not even a close call. The Bank of United States' failure here in New York in 1930 had nothing to do with securities markets; it was exposed to Manhattan real estate and suffered losses related to the New York real-estate crash in Manhattan in 1929. Most of the other U.S. banks that failed in the 1930s did so as a result of farm problems and especially farm real-estate problems.

The Steagall part of the 1933 Act was federal deposit insurance, which was actually opposed at the time by Glass, the secretary of the treasury, the Federal Reserve, and President Franklin D. Roosevelt himself. But who did want it? Small banks in rural areas; Steagall was from Alabama. So we had ideology without evidence combined with special interests, and we got Glass-Steagall.

Federal deposit insurance has not been repealed.

No, but repeal would not matter; it has been trumped by "too big to fail." The government has made it clear that it will insure all deposits and bank debts without limit. So even if we got rid of the Federal Deposit Insurance Corporation, the difference would mainly be symbolic.

But what about the Glass part of Glass-Steagall? Did the ability of commercial banks to merge with investment banks have anything to do with the crisis?

Probably even less than the under-representation of women and minorities. Remember some of the illustrious names that got into deep trouble during the crisis -- Bear Stearns, Lehman Brothers, Merrill Lynch. They were all stand-alone investment banks at the time, unaffected by the partial repeal of Glass-Steagall. And we can only wish that commercial banks had done more of the relatively low-risk underwriting of securities that the repeal of Glass-Steagall permitted them to do, instead of accumulating toxic mortgages, which Glass-Steagall had not prevented them from doing.
And to make the whole argument about Glass-Steagall even more ludicrous, the repeal of the Act in 1999 made it possible for JPMorgan Chase [ticker: JPM] to acquire Bear Stearns and for Bank of America[BAC] to acquire Merrill Lynch, which helped stabilize the system.

You mention toxic mortgages. How does Dodd-Frank address that problem?
Not at all. There is no attempt in Dodd-Frank to address the key problem of government subsidization of mortgage risk, and the exposures of Fannie Mae [FNMA], Freddie Mac [FMCC], and the Federal Housing Administration are still growing.
How do you explain the omission?

There is a powerful political interest that wants real-estate lending to be sponsored by the government. Starting about 1830, an important influence on the politics of banking came from farming interests, which increasingly promoted bank exposure to farm real-estate risk. What has changed since World War II is the huge demographic shift toward the cities. And so the power of the agrarian populist movement has been replaced by the power of the urban populist movement, which has to do with subsidizing lending to housing in cities.

Organizations like Acorn [the Association of Community Organizations for Reform Now] and other urban community activists led the fight to subsidize risky mortgage lending. Christopher Dodd and Barney Frank of Dodd-Frank, our supposed reformers, have been poster-politicians for this movement. Dodd was driven from the Senate in a mortgage scandal involving Countrywide Financial, the former mortgage giant that was long a favored client of Fannie Mae. And Frank has been a major Fannie and Freddie supporter, as well as one of the great deal makers in one of the most important waves of bank mergers in U.S. history. Housing and banking are Frank's mutually supporting interests. But Democrats were not the only ones; President George W. Bush and Speaker Newt Gingrich were also prominent proponents of subsidizing mortgage risk and facilitating the political deals that made so many risky mortgages possible.
Could you give an example of what you mean?

Remember Washington Mutual, the bank that collapsed in 2008? WaMu has practically become a synonym for bad lending practices. The background on what happened is significant. When Washington Mutual signed a merger agreement in 1999, it was permitted to do so only after it also signed a written agreement to make loans to urban constituencies, especially poor and minority constituencies, under the Community Reinvestment Act. WaMu's combined resources after the merger came to about $150 billion in total assets. It was required to make a 10-year CRA commitment of $120 billion, plus contributing 2% of its pretax earnings to not-for-profits, which eventually helped to bring about its collapse.

That's just part of the larger story. The experience of the 1980s alone should have taught us to limit government subsidies of real-estate lending risks. There was the savings and loan crisis, which was all about speculation in real estate. There was the commercial real-estate crisis in the east after the 1986 Tax Reform Act caused some problems in commercial real-estate values.

So what did we do? In 1989 and 1991, we tinkered with capital ratios. But did we do anything to limit government subsidization of real estate risk? Quite the opposite -- the government doubled down.

Doubled down as in blackjack?
Yes, except the blackjack player doubles down by just doubling his original stake. The government effectively multiplied the bets many-fold.

How so?
The government geared up Fannie Mae and Freddie Mac -- "government sponsored enterprises" -- by allowing them to operate on very thin capital and by imposing new mortgage-lending mandates through the Department of Housing and Urban Development beginning in 1995. These mandates set growing minimum proportions of Fannie Mae and Freddie Mac mortgage lending targeting inner cities, low-income borrowers, and minority groups. That was the major part of it. There were also CRA mandates for commercial banks, of which WaMu was a notorious example. And, as if to keep the action even harder to track, the 12 Federal Home Loan Banks started lending to any financial institution that agreed to make mortgages.

And what did we see happening in the mortgage industry? We saw mortgage leverage ratios skyrocketing. The share of mortgages requiring a down payment of 3% or less went from about zero in the mid-1990s to about 40% just prior to the crisis, an unbelievable surge. We saw a boom in things called low-doc and no-doc mortgages, where "doc" stands for documentation. And guess what? When you don't ask people for documentation, they lie, and if you a hang a sign out your window that says ,"I am not going to ask for any documentation," you become a magnet for liars.

The mortgage lenders knew that. They did some experimenting with faster mortgages on a low-documented basis in the 1980s, and once they found out it was a bad idea, they abandoned it. Fannie and Freddie crossed the Rubicon in 2004, when they decided to take the caps off all their lending involving no docs and low docs. Why did they do it? Their risk managers objected, but they were steamrolled. The HUD mandates told them that they had to give an increasing amount of their mortgages to targeted groups, and to meet those targets they kept relaxing their underwriting standards.
With all this highly leveraged and undocumented borrowing, fueled by government policy, no wonder home prices assumed bubble proportions.

Are you against any government subsidy of homeownership?
Well, we could debate whether it is a good idea. But let's suppose it is a good idea. There are lots of ways to do it that are better than subsidizing risk, especially since subsidizing risk does no favor to people when they lose their homes through foreclosure.

One way to promote homeownership would be through matching down payments. This is along the lines of what the Australians do to help first-time homeowners. On a means-tested basis, we could help first-time buyers make their down payment. That would be rewarding thrift. We could also give special tax deductions for people who put money aside for their house. These measures would subsidize housing without subsidizing leverage.

But what do we do instead? All of our housing assistance subsidizes people only to the extent to which they borrow.

You would abolish that kind of subsidy altogether?
I would phase it all out over time, including the tax deduction for mortgage interest. By subsidizing the down payment on a means-tested basis for the purchase of the first home, we would reduce leverage and risk. And we'd make a bigger difference in encouraging homeownership, since the down payment, in a mortgage industry that has been taught to care about risk, is often the biggest hurdle.

And we would no longer subsidize credit risk. We would not encourage any institutions -- banks, Fannie, Freddie, the FHA, or the Federal Home Loan Banks -- to make or guarantee bad loans.

Do you think that idea would fly?

To begin with, the American taxpayer might vote thumbs down and say we can't afford it. But I would point out that subsidies already are happening through the back door. Fannie's and Freddie's losses together might ultimately cost the taxpayer $300 or $400 billion, but nobody knew they were spending that. Not only are we subsidizing housing, we aren't subsidizing it in a very smart way. We are subsidizing it in a way that creates financial instability and that hides from the taxpayers what they are spending.

And that greater transparency ultimately explains why my proposal has such a hard time finding support in Washington -- and perhaps why Dodd-Frank does not even address the problem.

The opposition would be too formidable?
You know who are the constituents that aren't going to like it? If you are Acorn, you won't like it, because that means you lose your hefty broker fees and political power. Acorn is a major intermediary for this whole racket. Members of Congress aren't going to like it because they get fees, too, called campaign contributions, from those who benefit from the subsidies, and lots of favorable press from attending ribbon-cutting ceremonies.

We are basically talking about undoing the deal between the urban populists and the too-big-to-fail financial institutions (banks and "government-sponsored entities"), who are given enormous market power and protection that boost their profits in exchange for agreeing to distribute some of those profits to favored constituencies. That is the deal Washington has brokered over the past 30 years, and it was done on a bipartisan basis.

I guess we can read more about that in the book you're completing with Stephen Haber. But let's try a counter-factual. Say that your radical proposal had been in place since 1995, and that the government's aggressive encouragement of high-risk mortgage lending had not occurred. Would that have been enough to prevent the 2008 financial crisis from happening?

Yes, it would have been enough. We would not have had the crisis. But I hasten to add that even if you'd had these government housing subsidies, they alone were not enough to cause the crisis. Had prudential regulation functioned properly for Fannie and Freddie and for the banks, you wouldn't have had this crisis, even with the mortgage risk subsidies. Even though risky mortgages would have been made, financial intermediaries would have been maintaining more capital against that risk. So the government created this concentration of risky mortgages and then the institutions who were intermediating those mortgages were highly levered. So we got leveraged banks on top of leveraged mortgages. The combination is what gave us the crisis.
So we have to find ways to make our regulatory system avoid the incentives to under-capitalize and to pretend, when losses start to mount up, that you don't have losses.
And in your view, we have to give up on the idea of imposing discipline on banks by taking measures like denying them the protection of federal deposit insurance?
Yes, I'm afraid I think proposals like that are lost causes, although I certainly agree that in a rational world, the abolition of federal deposit insurance would be a huge improvement.

Franklin D. Roosevelt himself made the prescient forecast in October 1932 that deposit insurance would "lead to laxity in bank management and carelessness on the part of both banker and depositor." At the time, postal savings accounts offered small depositors protection against loss. Today, depositors who want protection can be encouraged by banks to keep their funds in short-term Treasury bills, and rich depositors can buy their own insurance, if that's what they prefer. We don't need the FDIC for any of this.

Before federal deposit insurance, we find abundant examples of banks accumulating cash through times of stress in order to assure depositors that they were solvent and were prudently managing risk. The banks' incentive was simple; like any business, they didn't want to lose customers. But now that all deposits of any size are effectively insured by the federal government, along with the overriding ethos of "too big to fail," the laxity and carelessness which FDR warned against has become an ongoing nightmare.

There is no need for prudential regulation to tell our neighborhood deli how to manage risk; we can count on the market system to do that. But because the market system has been abrogated in crucial ways for our financial institutions, we need prudential regulation of finance.

But hasn't your own analysis put us between a rock and a hard place? You indict the government for subsidizing risk in mortgage lending. But who else except government will be imposing prudence on our financial institutions? Isn't that the fox guarding the chicken-coop?

Quite right. The regulators are willing accomplices. That's why you shouldn't even be allowed to talk about regulatory reform unless you can answer two important questions. First, how will the regulated banks not be able to get around it? And second, why will the regulator have an incentive to enforce it?

It turns out that it is not that difficult to think of rules that are so simple and transparent -- so automatic and nondiscretionary -- that the regulator would go to prison if they weren't enforced. For example, I would impose a rule requiring that banks hold cash at the central bank equal to 20% of their assets. They would earn the Treasury bill interest rate on those cash reserves. That would not cost banks very much because they are in normal circumstances holding Treasuries not far from that amount. So they would reduce their Treasury holdings commensurately and hold this cash.

Why at the central bank?

Because if they are holding them at the central bank, the regulator will know they are holding them continuously -- not just on the day that coincides with each accounting quarter.

Any other ideas?

Yes, about nine more. Here is just one: I would establish a minimum uninsured debt requirement for large banks in the form of subordinated debt, known as contingent capital certificates, or "CoCos." The CoCos would automatically convert to equity based on predetermined market triggers, which would be very dilutive to pre-existing shareholders. One banker who understood my proposal for CoCo's said, "You are putting an electric fence behind me."

He was exactly right. Since the bank managers would have every incentive to prevent the triggering of a CoCo conversion, it would force them to act prudently. It would be saying to the bank CEO, "If you don't manage your risk properly, it is not the taxpayer who is going to be subsidizing you. You're either going to have to go out into the marketplace repeatedly to raise equity, and that is going to be dilutive because you are going at the worst possible time. Or you are going to end up doing so badly that you trigger the CoCo conversion, which is even more dilutive, and in which case you are going to get fired immediately.

What all these ideas have in common is that they are incentive-robust, which mean they take into account the incentives of regulators and bankers.
Sounds feasible.

But it may not be feasible politically because anything that would work undermines the political coalition that is in charge of our financial system. They see types like me coming a mile away.

Did Dodd-Frank do any of this? Dodd-Frank said that we should study CoCos. Over 2300 pages, that's all we read on the subject. Remember the regulators are appointed by politicians. In Fragile by Design our first chapter on the U.S. is called "Crippled by Populism." I look forward to reading it. Thanks, Charles.


Source: Barron’s 4/14/12 HTTP://ONLINE.BARRONS.COM/ARTICLE/SB50001424053111904857404577342680482638196.HTML?MOD=BOL_HPS_MAG#TEXT.PRINT
SATURDAY, APRIL 14, 2012

Comment:

Repealing Dodd-Frank and repealing the Community Reinvestment Act and all other associated legislation and regulations is a start. Ending all bailouts and subsidies should be the basis of the next Bill. Setting hiring quotas should not be the business of government. Somewhere in here it will be necessary to guarantee sound money. That sounds like the end of government overspending and the end of the Fed. That should lull the bankers into being responsible for themselves. .Unless we close down their slush funds, global Marxists will have us saluting the U.N. flag.

Norb Leahy, Dunwoody GA Tea Party Leader