The Irrelevance of Dodd-Frank & Memories of the Crisis

The Irrelevance of Dodd-Frank & Memories of the Crisis

There has been some political excitement of late concerning the repeal of part of the Dodd-Frank statute, which was the great post-crisis reform bill that sought to remake the financial regulatory system in the United States.

On Thursday, May 24, President Trump signed a bill that exempts dozens of banks from Dodd-Frank regulations, saving them from yearly Federal Reserve stress tests and higher capital requirements. The new legislation rolls back the old one a good deal less than some in the Republican Party had hoped it would, but it does give them, and their moderate Democrat allies in this matter, an example of “regulatory excesses trimmed” that they can trumpet to interested constituents and campaign contributors.  

Meanwhile, though, Matthew C. Turk, of Indiana University, has written a bracing article about Dodd-Frank that may help us put this political disputation in a realistic context.

The Bullet Points

Turk assures is, in particular, that there has been less to Dodd-Frank than meets the eye. He is especially interested in securitization form. He makes the following points:

  • Dodd-Frank was flawed because it presumed that fraudulent securitization played a big role in the global financial crisis, whereas in Turk’s view, it was poor risk management in the securitization context, well short of “traditional notions of fraud,” that played that role;
  • Since Dodd-Frank, actual policy making has been accomplished not by the statutory rulemaking process encouraged by the statute, but by enforcement actions against large financial institutions, which in turn have produced a series of large (multi billion dollar) settlements;
  • The process of regulation by settlement has worked out pretty well, coming “surprisingly close to a first-best policy intervention,” and;
  • A rollback of the provisions that mandate rulemaking will probably have a more-of-the-same consequence: still more reliance on regulation by settlement.

This article will appear in a forthcoming issue of the Review of Banking & Financial Law.  

Turk is an assistant professor of business law at Indiana University, Kelley School of Business.

Securitization and the Crisis

In what follows I will focus on the first of those bullet points. The financial crisis was, Turk writes, “a complex multi-causal event that defies easy explanation.” Two of the factors in this complicated event did involve securitization: there was a collapse in the value of assets that were related to securitized home loans on the one hand, and there was a disproportionate concentration of these assets in the hands of a few very large institutions that were not careful about their risk management on the other.

Turk associates the Dodd-Frank rulemaking processes with the theory of the crisis outlined in the Sony movie “Inside Job” (2010). This view holds that home finance lenders “profited by knowingly offloading the risks associated with securitization” to two groups of naive outsiders. The first group of outsiders were the home buyers, who were lured into exploding mortgages by lenders eager for the origination fees. Another group of naive outsiders? The “unsuspecting investors in mortgage-backed securities that were sold by the Wall Street banks.”

But that view of the crisis has not aged well, he writes. One consideration he adduces is the institutions at the center of the blow-up did not themselves as a rule survive the crisis intact. Every major mortgage originator from the days of the housing bubble has gone bankrupt. This reduces the appeal of the binary line-up of canny insiders versus naive outsiders.

More generally, whenever a bubble bursts, fraud is exposed. But it doesn’t follow from this that the fraud (in this case largely the foul play of lower level loan sharks) was the cause of the bubble. What is generally true, as demonstrated by the long history of cyclical economies, is that the supply of corruption increases in a bullish environment, much as does the supply of credit.

Further, the Wall Street banks weren’t selling collateralized mortgage obligations to naive outsiders. The insiders were selling the junk to each other. This, again, ruins the morality play of canny sharks and naive prey. Turk says, “the industrial organization of securitization markets was a closed circuit of informed insiders.”

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