Thoughts on the Dodd Bill

Yesterday, the president made a new push for Wall Street reform rules. It is an important topic. It is badly needed reform. It is an issue Congress is screwing up.

Leading the financial services reform charge right now is Sen. Chris Dodd. The House already passed its bill, incredibly flawed, problematic for the industry, but most importantly not dealing with the problems that caused this mess in the first place. Now we have Dodd’s bill, which is moving fast through the Senate.

Here are some problems with it:

  • Permanent bailouts

The bill plans to charge Wall Street banks a fee, and pool that money into a permanent $50 billion bailout fund. The idea is that if a major bank like Lehman were to go down, an FDIC-styled resolution authority would be able to step in an wind down the failed institution, using the bailout fund to cover short-term obligations of the defunct bank so as not to tie up too much credit and create a liquidity shortage. There are several sub-problems here:

First, this is a bailout fund! This is a safety net to save the creditors of large, complex financial institutions. With this kind of guarantee, lenders can rest assured that if their lendee goes down, the bailout fund will be there for them. This eliminates an important signal in the marketplace and it does not provide an incentive against risk taking.

Second, while an FDIC-styled wind down has worked for small banks, there is no evidence it would work any better than an expedited bankruptcy process. Consider that the largest bankruptcies the FDIC has had to take on are Illinois Continental (around $40 billion) and most recently IndyMac (something like $32 billion). In contrast the Lehman bankruptcy was over $600 billion and AIG had $1 trillion in assets. (Note that Washington Mutual was not wound down by the FDIC but taken over and sold to J.P. Morgan Chase practically in one motion.)

Defenders of the Dodd bill will argue that under its plan taxpayers won’t have to bailout the banks. But a $50 billion bailout fund would be swamped by AIG. That may be seen as an argument by some to break up large, complex financial institutions. But such a solution wouldn’t be necessary if the bailout fund problem didn’t exist. There is no guarantee taxpayers would not wind up shouldering some losses. After all, the FDIC fund, once thought to be impervious to destruction, is now running in the red and may need a Treasury Department bailout.

Third, this is an attempt to solve a problem that did not exist. During the heat of the crisis, the Fed diagnosed the market troubles as a shortage of credit. In their view, firms didn’t have enough capital to lend around because it was getting tied up in thrifty lenders. But the real problem was one of confidence in regulators. The Fed began to act sporadically. No one knew what Paulson or Bernanke were going to do next. And so everyone just held on to their money, freezing credit and the marketplace. When Lehman went bankrupt, the counterparty risk that came to fruition, freezing some capital in the market, was not what caused problems. In fact, the market didn’t move very much on the Lehman bankruptcy announcement relative to the rest of September and October 2008. What eventually caused the full collapse of the stock market was the confusion created by a Bear Stearns bailout, posturing that there would be no more bailouts, letting Lehman go, but then a few days later saving A.I.G. When the House made the right move to vote down the bailout, Wall Street panicked, thinking the saviors of AIG and magic workers for WaMu and Wachovia could save the day. Having a bailout fund to cover counterparty risk would not solve another climate of uncertainty.

  • Consumer Financial Attacking Agency

There is still a consumer financial protection agency in the Dodd bill, even thought it is not a stand alone organization. I won’t go into the problems with a CFPA here, since they are well catalogued in previous posts on this blog. The Dodd bill is a bit sneakier than the Frank bill in the House though. Although this CFPA will be housed at the Fed, it will have an independently appointed director, an independent budget, and autonomous authority to issue regulations on what products can and can not be sold.

  • Excessive faith in an Oversight Council

The Dodd group assigned to prevent another crisis is going to fail. It is inevitable with the business cycle supported by recoveries only built on government spending that there will be another boom-and-bust. This conversation takes place after every recession, and is always ignored. The next time could be worse (though unlikely, it will still be bad) since the market will be overly reliant on the Oversight Council as a safety net. They can only regulate the past, meaning they will miss the next one and/or restrict growth by incorrectly trying to stop something. And this does not solve the problem of firms failing in proper due diligence. This is not actually requiring firms to watch themselves as closely.

  • Volcker Rule

See here for what is wrong with the Volcker Rule. Suffice to say here that it is in the bill and it is trouble. Welcome back Glass-Steagall, you were missed as much as we miss that skitzophrenic, kleptomaniac Aunt who always seems to think she is invited for Thanksgiving dinner.

  • Banking regulations are still fractured

We go from four to three main bank supervisors. One giant leap for mankind right there. And the Fed is getting more supervisory oversight authority to watch for systemic risks.

  • Populist CEO pay rule that does nothing

The bill also contains the “say on pay” executive compensation rule that will nothing more than a nuisance to banks, raising their compliance costs, requiring the government to spend money trying to enforce the useless rule, and potentially creating hiring problems for financial institutions. The law is a move to quell populist anger, and doesn’t address the perverse incentives that were put in place regarding compensation during the bubble build up.

Anything good in here?

All that said, I can live with the exchange rules set up for derivatives. Transparency is a good thing. And this should help create a few more market signals. And there is a shared disapproval for the ratings agencies. Yesterday, Rep. Al Green conveyed to me his distaste for what the ratings agencies were allowed to do. This view is shared by many on the Hill, and it is an important step towards realizing reforms that will actually fix the problems in the system. Unfortunately, the Dodd bill does not end bailouts and taxpayers are still on the too big to fail hook. That is unacceptable. We can do better.

Anthony Randazzo

Anthony Randazzo is a senior fellow at Reason Foundation, a nonprofit think tank advancing free minds and free markets.