Tuesday, August 24, 2010

Dodd-Frank: My Final Take

The Dodd-Frank Act can only be termed an epic failure of policy. The Act includes some positive elements such as the corporate governance reforms and predatory finance prohibitions. Nevertheless, the importance of these reforms pales in comparison to the risks of another financial meltdown as well as deeply impaired macroeconomic performance far into the future. In fact, not only do I share the concerns voiced by Joseph Stiglitz and others regarding the risks of a future crisis, I fear that the Act fails to deal appropriately with the current crisis and instead seems predicated on the erroneous assumption that the subprime debacle and the financial crisis of late 2008 and 2009 are over.

For example, bank capital remains under siege. European debt could explode at any moment and the bailout of last spring appears inadequate. Student loans will inexorably erode bank capital because of the dearth of job opportunities for graduates. The residential real estate market continues to meltdown, with the commercial real estate market now inflicting comparable losses on the financial sector. One trillion dollars of consumer debt suffers from serious delinquency. Consumer deleveraging will continue to suppress demand for quite some time. This will continue to mean employment problems that will lead to more losses on debt. Dodd-Frank does nothing to address any of this and instead reaffirms the lack of real restructuring in the financial sector and virtually zero help for anyone other than the most economically powerful. Without any restructuring in the financial sector expect the same financial elite faced with same financial balance sheets to engage in the same conduct as today—hoarding cash.

The Act allows massive government guarantees to persist and therefore continues the massive subsidies implicit in the TBTF problem. Indeed, the Act directs the FDIC and the Fed to promulgate bailout programs that are “widely available” or that provide “broad-based eligibility” for bailout benefits. The Act formalizes the power of the FDIC and the Fed to bailout systemically critical financial institutions. The implicit guarantee now appears increasingly explicit, under sections 1101 and 1105. Moreover, even if a financially significant firm somehow fails notwithstanding such extraordinary support the orderly liquidation process offers further bailout mechanisms. Dodd-Frank therefore continues the regulatory indulgence, even facilitation, of excessive risk in the financial sector. Creditors have already concluded that Dodd-Frank preserves the too-big-to fail subsidies. In fact, the credit ratings agencies specifically give the mega-banks much higher credit ratings than otherwise due to the presence of government backing notwithstanding Dodd-Frank.

This Act’s approach to securities and derivatives trading exacerbates this fundamental distortion towards risk. The exceptions to the prohibition of derivatives trading within banks swallow the rule. The Act allows banks to trade securities and invest in hedge funds into the next decade. Thus, the Act gives large banks a subsidized cost of capital while largely preserving their ability to gamble in the derivatives and securities markets. CEOs and other senior bank managers therefore face the identical incentives to gorge on risk that they faced before 2008 to ring up short profits without regard to future losses that may come to fruition only after the payment of incentive based compensation. Even if the firm approaches insolvency the payment of golden parachute arrangements further blunts the disincentives senior managers face for excessively risky conduct.

The orderly liquidation regime under Title II of Dodd-Frank could operate to dissuade mangers from excessive risk, but most firms will never enter that process. No firm enters that regime without a recommendation of the Treasury and 2/3 majority votes of the Fed and the FDIC. Only the FDIC, under the admirable leadership of Sheila Bair, seems likely to have the fortitude to pull the trigger, and then probably only on the eve of a major meltdown, under the plain language of the statute. The gross negligence standard for director and officer liability for firms entering the regime precludes the applicability of insulating statutes like Delaware General Corporation Act section 102 (b) (7), but the FDIC historically displays a reluctance to pursue such claims although that may be changing. If a firm should find itself in the orderly liquidation regime senior managers will lose their jobs and their employment contracts and benefits (including severance payments) will generally be paid out last.

The Act mitigates these negative elements through the possibility of corporate governance reform. Unfortunately, the Act offers a package of reforms on this front that will likely prove too little too late. For example, non-binding shareholder resolutions seem exceedingly unlikely to stop the runaway executive compensation train. There is no shareholder say on golden parachute payments except for merger and acquisition shareholder votes. In 2011 we may look forward to independent compensation committees but in the past definitions of independence proved inadequate to actually stem CEO autonomy. The SEC holds the keys to major reform through their now explicit power to reform corporate democracy, combined with an immediately effective ban on broker votes. Unfortunately, the SEC traditionally failed to embrace shareholder suffrage.

So, the upshot of Dodd-Frank is that it continues and even formalizes massive subsidies for the largest financial firms (at the expense of smaller competitors as well as the economy) regardless of the recklessness (or worse) of their conduct. It continues CEO primacy and permits continued enrichment of managers for reckless (or worse) risk taking. This is a deeply suboptimal economic outcome and we as a society will pay the costs implicit in allowing capitalism to continue to degenerate into a rigged game in favor of those controlling the most vast amounts of wealth. Dodd-Frank may well entrench this pernicious economic reality by allowing it to fester within a more stable financial context. By outlawing consumer predation and exploitative finance future financial crises are unlikely to be as painful as the subprime debacle. A leveraged asset bubble that derails both the financial sector as well as the consumer base of our economy may be forestalled in the long run by Dodd-Frank’s outlawing of abusive consumer loans. It is difficult to oppose these regulatory improvements.

Nevertheless, Dodd-Frank may well operate to transmogrify a reform moment into an opportunistic and cynical effort to slowly bleed the American economy through the overweening power of a narrow and backward political and financial elite that is ever more divorced from concerns about the general economic well-being of the United States. If Dodd-Frank operates to prevent major financial cataclysms at the cost of subpar macroeconomic performance stunted by an entrenched elite that saps our collective economic strength in the name of short term wealth, then it may prove to be more costly than if Congress had done nothing. Whether Dodd-Frank is thus worse than nothing is still to be determined. But, by any measure it preserves the power and economic prospects of the very financial elites whose misconduct caused the crisis in the first instance. In my view, the estimated $591 million invested in lobbying (since January of 2009) and the $112 million invested in campaign contributions to the members of the conference committee (since 1989) yielded precisely the returns expected and demanded by our financial elite: the ability to play in the high risk securities and derivatives markets with continued government backing, without any prospect of being broken up. Moreover, Dodd-Frank encourages more lobbying by punting many issues to regulators and financial elites are already greasing the revolving door for a massive new lobbying blitz.

Finally, additional concerns should be raised, beyond macroeconomic costs and benefits. Government guarantees of the most powerful financial interests in our society simultaneously violate any norm of moral propriety as well as economic logic. If I am correct about the net effect of Dodd-Frank, then it raises red flags about our society that transcend mere economics. When a people in a democratic republic allow themselves to be milk cows for the very wealthy there is something wrong beyond the economic structure of that society. The ultimate irony may well prove to be that the pervasive loss of empathy for the disempowered ultimately empowers a small elite to exploit an entire society. When we lose suspicion of concentrated power and blame the weakest among us for our plight we are surely lost as a people. A people that are convinced that their plight is caused by the powerless in our society rather than those who control our society have lost the ability to hold power to account and to hold power in check. Dodd-Frank raises precisely this specter. Dodd-Frank evinces a near total void of suspicion with regard to concentrated economic power.

So, in the end, the most optimistic thing I can say about Dodd-Frank, is perhaps very pessimistic. It is so radically incomplete that it will surely spawn more financial and economic costs that could well support more appropriate reform efforts. Other than that ray of sunshine, Dodd-Frank proves the problem of allowing excessive concentration of economic resources to persist: regulatory and legal subversion in favor of entrenching the powerful at the expense of sound policy and the general welfare. Dodd-Frank stands as a monument to a deeply misguided, if not actually corrupt, political and economic elite.

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