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Commentary By Nicole Gelinas

Americans Should Fear Dodd-Frank, Not Free Markets

Economics, Economics, Energy Regulatory Policy, Regulatory Policy

Two politicians — President Obama and former New Jersey Gov. Jon Corzine — made pronouncements last week about financial failures. One of them was hiding something, or just didn’t understand much about the job that he was supposed to do. The other one was Jon Corzine.

Corzine went before a House panel to testify about why and how the commodities brokerage he joined as CEO a year and a half ago failed in October. The firm bankrupted itself on bad European debt investments, and took as much as $1.2 billion in customer money with it. “I was stunned when I was told ... that MF Global could not account for ... client money,” he said. “I simply do not know where the money is.” But, at least, “I remain deeply concerned.”

The thing about Corzine is that he’s probably telling the truth.

As Fox Business correspondent Charlie Gasparino wrote, “based on what I know about Corzine, I really think he didn’t have a clue.”

Obama, too, may be clueless rather than disingenuous. In his Kansas speech last Tuesday, Obama had this to say about the Dodd-Frank financial-regulation law: “Now, unless you’re a financial institution whose business model is built on breaking the law, cheating consumers and making risky bets that could damage the entire economy, you should have nothing to fear from these new rules.”

To the contrary, Americans have plenty to fear. Dodd-Frank took the fatal errors that American politicians and regulators made in their stance toward the financial industry in the years leading up to 2008 — and wrote them all down as a model.

Dodd-Frank’s biggest problem is that it treats big, complicated financial firms differently from how it treats littler, simpler firms. That happened before and during the acute phase of the financial crisis; in 2008 and 2009, for example, 165 smaller banks failed, but Citigroup, Bank of America, and AIG (which wasn’t even a bank) got bespoke bailouts.

Dodd-Frank’s Failings

Dodd-Frank makes the special treatment official. The new “financial stability oversight council” — a group of existing regulators — determine which financial firms pose an outsize risk to the financial system as a whole.

These firms get special treatment in life. Dozens of regulators embed themselves permanently at big firms like Citi and Morgan Stanley to make sure they’re not taking too much risk, at least as the regulators perceive risk.

In 2009, then-Morgan Stanley chief John Mack said he “love(d) it” that regulators were in-house daily, as “it forces firms to invest in risk management.”

The firms also get special treatment in death. If regulators determine that a financial company can’t fail without posing undue risk to the economy, they’ll “resolve” it outside of the traditional bankruptcy process — including, possibly, by guaranteeing short-term creditors and counterparties to stem a panic.

But regulators’ determination of which companies will get this treatment involves circular reasoning. Regulators are supposed to consider “the likely disruptive effect ... on the reasonable expectations of creditors,” for one thing.

In other words, if creditors expect a bailout and don’t get it, that would be bad.

Thus, to get future bailouts, creditors should simply expect them, and say so loudly in the press in the hours leading up to a financial-firm failure.

Another problem is that Dodd-Frank ensures that the financial system will continue to make the same mistake all at once.

Remember, in the years leading up to the 2008 meltdown, regulators had determined that triple-A rated securities were perfectly safe, and determined, too, that housing finance was perfectly safe. Financial institutions loaded up on the same “safe” stuff — and crashed all at once.

The new law admirably directs regulators to stop relying on ratings agencies. But those regulators who “work” at individual firms likely will think alike. Plus, politicians have made sure to protect the investments they prefer — even at concentrated risk to the financial system.

Loopholes Galore

The new ban on banks’ using taxpayer-guaranteed deposits to make speculative bets on financial markets, for example, still allows for such trading in Fannie Mae securities as well as in federal, state and local debt.

The law favors certain investments, too, in its prescriptions for future bailouts. Firms are more likely to get special treatment if regulators determine that “default” would impact “financial stability for low-income, minority or underserved communities.”

Americans should fear Dodd, as special treatment for any class of companies or investments harms the economy. The free marketplace can’t determine, for example, that banks should be smaller, if the government keeps rewarding lending to big banks.

Nor can it determine, say, on a case-by-case basis that a mortgage is safer than a private-equity investment, if the government favors the mortgage.

Finally, Dodd-Frank’s shortcomings bring us back to Corzine.

More attention to discretionary regulation — officials deciding what’s risky and what’s not, according to Dodd-Franks’ prescription — means less regulatory attention to the kind of rules the financial system needs.

Regulators should have had no business determining, for example, whether it was a dumb idea for Corzine to bet the farm on distressed European debt. Indeed, regulators didn’t bother — because MF Global was small enough to fail. Corzine gambled badly — and lost.

But regulators did have a job to do in making sure that Corzine didn’t lose his customers’ money. They didn’t.

MF Global’s demise is a success for free markets, but a failure for regulators. The Dodd-Frank law is a success for regulators, but a failure for free markets.

This piece originally appeared in Investor's Business Daily

This piece originally appeared in Investor's Business Daily