Solemn First Impressions of the Dodd-Frank Act-Part One

By R. Tamara de Silva


More than two years after the burst of the housing bubble and the ensuing Credit
Crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank
Act”) becomes law. This act of well over 2,300 pages constitutes an unprecedented
enlargement of the Federal Government with new Federal agencies and truly Byzantine
laws that while said to protect Wall Street and the average American, will likely be one of
the most expansive job creation initiatives for lobbyists and attorneys of all time.
It is estimated by the United States Government Accountability Office that Dodd-
Frank cost in excess of $1.25 billion and creates 2,849 Government positions. Dodd-
Frank fails to address what are arguably the two greatest causes of the last financial
debacle, the credit ratings agencies’ inaccurate ratings and the lack of transparency in
over the counter, unregulated securities.

Consumer Financial Protection Bureau
Dodd-Frank creates a Consumer Financial Protection Bureau (CFPB), as the love
child of the rulemaking and enforcement authorities of seven distinct Federal agencies.
Congress establishes this new Federal authority ostensibly dedicated to consumer
financial protection, because consumers were unprotected from procuring bad loans and
mortgages they could not afford- the Government failed to stop them from themselves.
The low interest rates of the early 2000s were a huge factor in the growth of the
housing bubble. The Feds easy credit policies allowed banks to obtain money so cheaply
that they could in turn lend out money and write mortgages that resulted in huge profits
because the difference between what the banks borrowed the money for, from the Federal
Reserve and what they got paid back in interest for lending money to the consumer was
substantial. What Dodd-Frank does not address is the Federal Reserve’s printing of
money, and the fact that unless this printing is pegged to actual assets, combined with its
easy credit policies, the Federal Reserve’s practices may normally lead to cycles of
expansion and bubbly busts-expectedly creating further financial crisis.
However, low interest rates were not the causal variable in the housing bubble,
the other was low quality mortgages. Perhaps some who have read this so far and are
more cynically inclined will have thoughts about how the Act’s namesake and his
colleagues in 1992 gave Fannie Mae and Freddie Mac (long ago broke with $5 trillion in
what one may euphemistically call “off-balance” sheet transactions because no one, not
even Dodd-Frank has addressed them or this issue), a mandate, together with the
Department of Housing and Urban Development and the Community Reinvestment
Act, to provide loans in “underserved communities” to those that banks would not write
mortgages.

Credit Ratings Agencies
Dodd-Frank creates a new regulatory structure to oversee credit ratings agencies.
These are the same three credit rating agencies, S&P, Moody and Fitch that were hailed
into Congress to testify for having substantial conflicts of interest in issuing rating.
During the housing bubble, sketchy loans (I offer this as a new legal term of art)
were repackaged by investment banks into investment pools and other mortgage backed
securities and received the gold standard of financial ratings, the coveted and in theory
elusive, AAA rating by the largest credit ratings agencies, including S&P and Moody’s.
The agencies’ granting of triple AAA ratings to companies and investment vehicles that
turned into junk ratings caused billions if not trillions of dollars in losses to everyone that
relied on them-basically, everyone. The credit ratings agencies are paid by the issuers
(their clients) of the securities they were supposed to evaluate, creating an inherent
conflict of interest.
SEC’s report on Credit Ratings Agencies from June 2007 identified another
problem other than having the referee in a match being paid by one of the sides, (not the
investors or the public’s side mind you), that prevented the agencies from giving accurate
ratings. The agencies could not give accurate ratings of many of the instruments involved
in the housing bubble and credit crisis because of the complexity of the transactions
involved and the inability of agencies to understand what they were analyzing.
One could argue that the agencies were not engaging in a deliberate fraud, that is
having a public position of trust, being paid and knowing they cannot do what they are
assigned to do but pretending to do it anyway. What may let the agencies off the hook is
that they relied on the issuers’ (the clients again, usually investment banks) audit
committees. The fact that these committees represented having signed off on the
financial instruments in question should mean something-if not, why have these corporate
committees?
Furthermore, one could argue that the credit ratings agencies must not be held
responsible for their ratings because they did not and could not have understood the
trading transactions taking place at the investment banks because they had to rely on the
information they were given which was not itself transparent.
One possible solution is to take away the compensation structure of the credit
ratings agencies and deregulate them completely in-order to discourage inherent conflict
of interest or use the Credit Spread Market-problem solved! Institute investor paid credit
ratings agencies, which could open up the market and privatize the industry. Without
credit ratings agencies, the market may determine value more efficiently than the analyst
at the agencies—it cannot really have done worse!
Dodd-Frank fails to address any of these issues and instead offers a new agency
perhaps staffed by the SEC to oversee credit rating agencies-there is a complete absence
of any examination of the real issues involved, just an enlargement of bureaucracy.

Volcker Rule
Dodd Frank institutes the Volcker Rule, colloquially named after Paul Volcker,
the former head of the Federal Reserve who was its champion. The Volcker Rule
prevents banks from engaging in "proprietary trading" -- making investments and trades
on their own behalf, rather than for clients.
During the credit crisis, the investment banks speculated widely in mortgage backed
securities using highly (this is an euphemism here for “way over”) leveraged
securities. When those securities went south, banks like Merrill Lynch and Citigroup
followed. A report by the United States Senate Permanent Subcommittee on
Investigations states that this scenario of proprietary trading, "led to dramatic losses in the
case of Deutsche Bank and undisclosed conflicts of interest in the case of Goldman
Sachs." To comply with the Dodd-Frank’s Volcker Rule, Morgan Stanley and Goldman
Sachs and other banks have jettisoned their internal hedge funds and private equity firms.
Why would they not? Arguably most of revenue made by the investment banks
comes from a form of proprietary trading that due to successful lobbying by banks like
Goldman Sachs and the treasury department was loop-holed out of the definition of
“proprietary trading” that went into the Volcker Rule. High frequency trading is now
perhaps the largest single trading based profit center of investment banks and it is not
covered by the Volcker Rule.1

Derivatives
Dodd-Frank seeks to remake the multi-trillion-dollar derivatives market arena into a
transparent, regulated market, by calling for most derivatives to be traded on exchanges.
This is really not possible and it is too large of a topic to be covered here. The Acts’
treatment of derivatives trading does not suggest a sufficiently sophisticated or private
sector based understanding of the topic.

Transparency
Derivatives were not per se the causes of the credit crisis. The lack of transparency
in mortgage related investment vehicles with a value that was at once unascertainable and
not pegged realistically to the value of anything and not capable of being marked to
market was.
Transparency refers to the degree of information that is available. In a perfectly
transparent market all relevant information about a market transaction, price, order size,
order flow, trading volume, identity of traders/counterparties, bids and offers available,
etc. would theoretically be discoverable.
The value of transparency in the marketplace is possibly best explained by its
absence-opaqueness. It was an opaque, in fact a downright murky environment that led
to the current crisis. In the current mortgage debacle, few of the players knew what the
baskets of mortgages they were packaging, buying and selling were actually worth. The
1 This topic is covered in Part-Two to this paper
participants in instruments that led to this current crisis operated in a very opaque if not
downright murky environment. Certain mortgage related securities were not pegged to
the value of anything tangible. One could make the case that they were not even
derivatives because their value was effectively not derived from an underlying anything.
All market transactions involve a degree of risk. In the law as in the markets,
there is a presumption, albeit arguable, that the greater the amount of information a
market participant has, the better able the participant is to assume and understand the
risk behind the transaction.
Price is the single most relevant information provided in a transparent market.
“What did you pay for that?” is more than vaguely related to “what is it worth?” While
the price paid for a piece of art is often not a precise indicator of what it is worth, it is a
good starting point. However, regardless of the price paid for a Monet or a November
Soybean contract, the important question soon becomes, “what is it worth?” Soybean
contracts are marked to market; owners could look at the spot or cash market and know
immediately what the value of what they own. A stock portfolio of listed stocks has an
immediately discoverable value because listed stocks are marked to market everyday as
buyers and sellers determine what listed equities are worth at any given moment. The
owner of a financial instrument unlike the owner of a Monet, has an after market to
which he can go to instantly determine the value of the instrument and where he can sell
it.
In cases where financial instruments are not commoditized, regulated or listed,
their value must often necessarily be determined by the assignation of a notional value.
Notional value is an assigned value and there are varying definitions of what notional
value means in different contexts. The assigned notional value takes on different
meanings in various contexts. The notional value of many of the collateralized debt
obligations (“CDO”) have simply been created by one or more of the counterparties to
the transactions. What is worse is that the notional value of a CDO or of a mortgage
security bears no relation the market value.
It was argued that the notional value of unregulated securities transactions one
year ago approached $1 quadrillion ($1000 trillion). While CDOs may be collateralized,
the market value of the collateral may be much less than the notional value. This begs a
larger question, what are CDOs collateralized to? Are they even collateralized?
If you cannot mark to market, then trade at your peril, because you are in every
way, trading in the dark. Perhaps the Legislature ought to enact regulations that prohibit
trades that cannot be marked to market. Transparency should be encouraged. After all,
regulation is not possible without transparency.
Dodd Frank does not address transparency.
Congress was able to use the crisis and through the Dodd-Frank Act create seven
more Federal agencies and enlarge the reach of Government’s regulation of the private
sector to an unprecedented extent. Sadly, the root causes of the credit crisis have been
left unattended. This sets the stage for the next financial crisis and if even a superficial
examination of the history of these crisises is performed, it promises to be so much larger in
scope than the last one. Congress had a chance to make meaningful reforms but instead
has hastily put forth 2,300 pages of incomprehensible regulation whose intent may be
sterling but will put a heavy cost on the private sector and by extension, the economy.

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