Bad Foundation

Most attempts at financial reform have been burdensome, created unintended consequences and have been harmful to economic growth. But compared to the Dodd-Frank Wall Street Reform and Consumer Protection, which just celebrated its first anniversary on July 15, 2011, they had one virtue: their relative brevity.

More than 400 rules stem from the law, most of which haven’t even been proposed yet. These rules are contributing greatly to the uncertainty that is preventing firms from hiring and keeping unemployment at 9%.


A House Financial Services Committee report about compliance states the Dodd-Frank Act “will suppress innovation simply because companies (both financial and non-financial) will need to devote so much of their time and resources to anticipating, understanding, and complying with the law’s broad new mandates.”

The report also finds that compliance with the 30 regulations proposed so far from Dodd-Frank (less than 10% of all rules required by the law) will require an estimated 2,260,631 labor hours every year.

The report also notes that much uncertainty also stems from the law’s vagueness and tight deadlines. In the commodities regulation area, “key terms such as ‘swap,’ ‘major swap participant,’ and ‘eligible contract participant’ remain undefined, making it impossible for interested stakeholders to understand the consequences of proposed rules on their business lines and provide meaningful comment on those rules.” The deadlines to interpret these terms and other rules of Dodd-Frank are “wildly aggressive,” said former Democratic SEC Commissioner Annette Nazareth.

Nazareth argues that “these deadlines could actually be systemic risk raising.” The pending rules will affect many types of businesses, from manufacturers that use derivatives to hedge inflation and interest rates to small stores that extend credit through layaway plans.


Ironically, about the only two firms Dodd-Frank doesn’t touch are the two most responsible for the crisis: the governmentsponsored enterprises (GSE) Fannie Mae and Freddie Mac. In their new book Reckless Endangerment, New York Times financial reporter Gretchen Morgenson and market analyst Joshua Rosner write that Fannie “led both the private and public sectors down  a path that led directly to the financial crisis of 2008.” At the end of the book, the authors note that the law doesn’t lay a glove on Fannie and Freddie.


GSE reform is coming, promises the Obama administration. In a July 20, 2011, Wall Street Journal op-ed, which blasts Republicans for efforts to lessen Dodd-Frank’s impacts, Treasury Secretary Timothy Geithner says Fannie Mae and Freddie Mac changes will come with the mortgage market reformation.

Yet Fannie and Freddie are bigger than ever, securitizing nine out of 10 home mortgages and receiving unlimited guarantees from the taxpayer, thanks to the Obama administration’s Christmas Eve Bailout of 2009. And one provision of Dodd-Frank has not only slowed momentum to reform GSEs, but threatens to make them even bigger.

The Dodd-Frank Act sets overly strict rules for down payments for mortgages to be securitized. However, any home loan insured by the Federal Housing Administration or purchased by Fannie or Freddie is exempt.

The rules from Dodd-Frank Section 941 are a multistep process. They start with a requirement that firms originating mortgage loans retain 5% of the risk on their books. Because this requirement would price out many small financial institutions the law creates and allows for various exemptions. The American Enterprise Institute’s Peter Wallison has written that such risk “can only be carried by a securitizer that has a substantial balance sheet.”


The regulators created one exemption for mortgages with down payments of 20% or more. Mortgages with very low down payment — and sometimes no down payments — were indeed part of the problem. They were also, as Morgenson and Rosner document, greatly encouraged by Fannie, Freddie and the mandates of the Community Reinvestment  Act. These loans also were encouraged by the Federal Housing Administration’s lowering of standards in the Clinton and Bush administrations for the mortgages it would insure.

But 20% is, as Jimmy McMillan would say, too damn high and would price out many mortgages and refinancings to responsible borrowers. And such a high threshold could hurt families in states where the housing market has tanked if they need to move or refinance. Not to worry, say the Obama administration and Dodd-Frank’s architects. If a loan is bought by Fannie or Freddie and/or insured by the FHA, none of this applies. Loan originators do not have to retain 5% credit risk, and borrowers do not have to meet the high down payment requirement. Borrowers would only have to comply with these agencies’ minimal guidelines — and these guidelines may be lowered even further. The Wall Street Journal reported in July 2011 that the administration is considering “having taxpayer-owned mortgage giants Fannie Mae and Freddie Mac relax their rules for loans to investors.”

In the proposed mortgage rule, the administration also closed the door on the option of creating any exemption for private mortgage insurers to create models to reduce risk, as some have proposed.


The good news is that a strong bipartisan block in Congress has demanded the rule be scrapped. However, if Congress doesn’t move fast on mortgage provisions, the administration likely will dig in its heels, and the GSE expansion option will become more appealing, even to some Republicans. Witness Rep. John Campbell’s bill, which would create a single GSE potentially more costly than Fannie and Freddie.

Anticipation of the rule and the hundreds adding to the precarious state of the housing market and job market is helping to fulfill the contrived prophecy that the GSEs are needed, because the private sector won’t provide mortgages on its own. Private sector firms certainly won’t if they are handcuffed while their GSE competitors roam free. On this first anniversary of the latest financial reform, it is clearer than ever that the road back to growth and innovation as well as real reform of too-big-to-fail policies and Fannie and Freddie must first cross the road of repeal of provisions from Dodd-Frank.