Fixing Dodd-Frank: 3 Targets
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The new House Financial Services Committee has an ambitious financial regulatory reform agenda. Beyond explicit legislative action to reform Dodd-Frank, the Committee is also expected to monitor regulators’ implementation of the 243 rulemakings required by the legislation. The perception among many in Washington is that Congressional oversight will ensure that regulators are not able to use their broad administrative powers to further erode financial firms’ competitiveness and profitability.
Many of these developments are welcome, but more can and should be done. There are three specific areas where Congress should strengthen taxpayer protections and reduce Dodd-Frank’s prospective damage. Furthermore, these changes can and should be accomplished on a bipartisan basis. Let’s review some of the evidence that has emerged since the Dodd-Frank debate.
Eliminate the Consumer Financial Protection Bureau (CFPB)
The authors of Dodd-Frank – and many of its proponents – believed a key problem unmasked by the crisis was that predatory lenders took advantage of uninformed consumers to push them into mortgages they couldn’t afford. While there were undoubtedly cases of misinformation and outright fraud, the data suggest that, in general, consumers appeared able to manipulate a dysfunctional credit market to their advantage.
According to data collected by the Government Accountability Office (GAO), only about one-third of all subprime loans issued from 2000-2007 were home purchase loans; the remaining two-thirds were refinancings or home equity loans, 78% of which were “cash out” refis. As house prices rose rapidly from 2001-2005, homeowners converted the increase in house values into cash by taking on additional debt. Say a $250,000 home with a $200,000 mortgage increased in value to $500,000 – a cumulative price increase of 100% was actually the norm in places like Arizona, Nevada, and California. By taking out a $450,000 loan to refinance the existing mortgage or taking on incremental debt through a home equity loan, the household could withdraw $200,000 in cash and maintain a loan-to-value (LTV) ratio of 90. A paper authored by Alan Greenspan estimates that homeowners used home equity loans to withdraw more than $1 trillion of cash from their homes from 2002-2005 (see Table 2 in the link/paper).
Researchers that matched foreclosures in Los Angeles County to mortgage and house price data found that thanks to cash-out refinancings and home equity loans at the top of the market, owners of foreclosed properties earned returns of 40% per year on their housing investment, even after accounting for subsequent price declines. These data suggest that when house prices went up, borrowers cashed out through incremental debt; when house prices later fell, many of these same borrowers walked away from the house as is permitted by the nonrecourse nature of the lending. Even in the case of loans used for home purchases, by 2006 down payments were virtually non-existent, meaning that households with checkered borrowing histories were able to receive hundreds of thousands of dollars of mortgage credit on extremely favorable terms without any financial commitment of any kind. This is not a fact pattern consistent with consumer exploitation.
By increasing compliance costs and creating new legal risks, the CFPB regulations could actually harm many of the people the bureau is supposed to help if, as expected, banks offset increased non-interest expenses with higher interest rates and also withdraw from certain markets. This was precisely the initial response of lenders to the new rules on lending practices enacted by the CARD Act. Designed to combat the perceived exploitation of borrowers with checkered credit histories, the rules have led card companies to reduce balances available to marginal borrowers and focus more of the portfolio on borrowers with strong credit histories. As a result, many analysts predict the biggest winners will be payday lenders, whose short-term, high-interest collateralized loans will become the only source of incremental credit for certain households. A recent study from the Boston Consulting Group (BCG) reaches similar conclusions and expects the estimated $25 billion in lost revenue will be recouped through new charges for checking accounts, increased bundling of card and banking services (which reduces price transparency) and scaled-back reward programs.
The CFPB would be a bureaucracy with broad discretion to enact similarly counterproductive rules and regulations on a recurring basis. Although some have suggested Congress seek to exempt smaller financial institutions from some of these regulations, small businesses and households depend on credit from institutions of all sizes. The new Congress should eliminate the CFPB (or at least reign in and better define some of its authority) and focus the resources that would have been used to create the new bureaucracy on an increase in fraud enforcement in the retail financial transaction space.
Reform New Securitization Rules
The authors of Dodd-Frank also believed a key cause of the crisis was that banks lacked “skin in the game” in securitization deals. The quality of the loans that collateralized mortgage-backed securities (MBS) were so low, the proponents of the legislation reasoned, because the banks did not retain the risk of the securities but instead sold them to unsuspecting investors. Here too, this simplistic view of what transpired is totally at odds with subsequent research. As demonstrated by NYU Professor Viral Acharya and other academics, the most salient feature of the late-stage securitization markets was the extent to which risk was not transferred to third parties. Banks used the most complex forms of securitization like asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), and other variable interest entities (VIEs) to “concentrate, rather than disperse, financial risks in the banking sector while reducing their capital requirements.”
This finding is actually perfectly logical: How could it be that banks simultaneously had no “skin in the game” but yet still managed to suffer trillions of dollars in fair value losses on those same securitized assets? Given banks’ cumulative losses on structured securities, it seems more accurate to say banks had too much skin in the game and should have dramatically reduced exposures. The problem was inadequate capital regulation and disclosure rules, not insufficient exposure to the credit risk of the underlying loans.
Part of the problem, of course, were the ratings assigned to many of the MBS and related derivatives. The undeserved AAA ratings secured by the senior tranches reduced capital requirements, increased leverage, and dramatically intensified the crisis. This is a complicated problem to solve, but Dodd-Frank didn’t even try, as it elected instead to throw the rating agencies to the trial bar, hoping instead that a series of lucrative class action lawsuits would somehow solve the problem. By repealing Rule 436(g) under the Securities Act of 1933, Dodd-Frank would expose rating agencies to new lawsuits by treating their rating as an expert-certified part of the registration statement for a new security. Fitch Ratings, Standard & Poor’s and Moody’s Investor Service responded by refusing to be named as experts in registration documents. This temporarily froze the market, until the SEC stepped in to allow deals to go forward if ratings were not included in the prospectus.
The new Congress should repeal both the risk retention requirements and reinstate Rule 436(g). Given the huge losses on structured securities and poor performance of related credit ratings, market participants are not eager to fund mezzanine collateralized debt obligations (CDOs) or similar products. That truth is that the market has already eliminated so many of the excesses these regulations are designed to combat. The new standards are instead impairing the recovery of legitimate parts of the securitization markets that are critical to supplying credit to households and businesses. The risk retention requirement complicates syndication and reduces liquidity, while the uncertainty over Rule 436(g) will continue to undermine confidence in the ultimate sustainability of the securitization market’s recovery. Both should be eliminated.
Strengthen Capital Requirements
Finally, the new Congress will need to resist banks’ appeals to relax capital requirements, or use U.S. government bargaining clout to weaken the proposed Basel III international capital standards. Indeed, Congress should actually go in the opposite direction by replacing the Dodd-Frank “study” on contingent convertible capital with an explicit requirement that a portion of large financial firms’ senior debt automatically converts to equity. With no plan to reform bankruptcy law, address the payment priority for derivatives payables, increase the capacity of creditors to withstand losses, or otherwise introduce market discipline for creditors to the largest banks, the only thing standing between taxpayers and another bailout is bank’s equity capital.
The Basel Committee released the final Basel III rule in mid-December. It would require 7% Tier 1 common equity (after accounting for a 2.5% buffer) and an additional systemic risk capital surcharge for the largest institutions thought to be about 1%. As the proposal goes through the formal comment process in the U.S., Congress should consider ways to augment the new standard with mandatory conversion of senior debt into common equity capital. When a large financial institution runs into trouble and suffers losses, market participants become concerned that the firm’s assets are insufficient to cover its liabilities. There are two ways to assuage these concerns: provide additional equity capital to increase net assets, as was done with TARP; or reduce liabilities by converting a portion of them into common equity after some trigger (based on market prices or spreads) is reached. Opting for a mandatory conversion will ensure that instead of a bailout, a crisis will result in a “bail-in” as the uncertainty about negative equity is resolved through automatic changes in capital structure.
Although banks will complain that this will increase their cost of capital, in reality these changes will actually make bank equity safer, reduce its cost, and also encourage banks to hold less risky portfolios. Right now, bank equity is so expensive because leverage is so high and debt is implicitly protected, forcing equity holders to bear all of the risk. Reducing leverage and shifting some of the risk from equity to debt holders will make equity less expensive and convertible senior debt more expensive, leaving the total cost of capital unchanged. This change is also especially important now because of the uncertainty created by the new “orderly resolution authority” and the manner in which the rules governing this authority are being implemented.
As ill-conceived as much of the Dodd-Frank bill was, a wholesale rewrite seems infeasible. The new Congress would be better served to target the three provisions above to reduce the damage caused by the bill and strengthen its protection for taxpayers.