The New Financial Deal E-Book

David Skeel

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 356

Veröffentlichungsjahr: 2010

Beschreibung

The good, the bad, and the scary of Washington's attempt to reform Wall Street The Dodd-Frank Wall Street Reform and Consumer Protection Act is Washington's response to America's call for a new regulatory framework for the twenty-first century. In The New Financial Deal, author David Skeel offers an in-depth look at the new financial reforms and questions whether they will bring more effective regulation of contemporary finance or simply cement the partnership between government and the largest banks. * Details the goals of the legislation, and reveals that how they are handled could dangerously distort American finance, making it more politically charged, less vibrant, and further removed from basic rule of law principles * Provides an inside account of the legislative process * Outlines the key components of the new law To understand what American financial life is likely to look like in five, ten, or twenty years, and how regulators will respond to the next crisis, we need to understand Dodd-Frank. The New Financial Deal provides that understanding, breaking down both what Dodd-Frank says and what it all means.

Leseprobe

Contents

Foreword

Introduction

A Few Major Characters

Chapter 1: The Corporatist Turn in American Regulation

The Path to Enactment

The Two Goals of the Dodd-Frank Act

A Brief Tour of Other Reforms

Two Themes That Emerge

Fannie Mae Effect

Covering Their Tracks

Is There Anything to Like?

Part I: Relearning the Financial Crisis

Chapter 2: The Lehman Myth

The Stock Narrative

Lehman in Context

Lehman’s Road to Bankruptcy

Lehman in Bankruptcy

Bear Stearns Counterfactual

Road to Chrysler

Chrysler Bankruptcy

General Motors “Sale”

From Myths to Legislative Reality

Part II: The 2010 Financial Reforms

Chapter 3: Geithner, Dodd, Frank, and the Legislative Grinder

The Players

TARP and the Housing Crisis

Road to an East Room Signing

Channeling Brandeis: The Volcker Rule

The Goldman Moment

Chapter 4: Derivatives Reform: Clearinghouses and the Plain-Vanilla Derivative

Basic Framework

Derivatives and the New Finance

The Stout Alternative

New Clearinghouses and Exchanges

Regulatory Dilemmas of Clearinghouses

Disclosure and Data Collection

Making It Work?

Chapter 5: Banking Reform: Breaking Up Was Too Hard to Do

Basic Framework

New Designator and Designatees

Will the New Capital Standards Work?

Contingent Capital Alternative

Volcker Rule

What Do the Brandeisian Concessions Mean?

Office of Minority and Women Inclusion

Institutionalizing the Government-Bank Partnership

A Happier Story?

Repo Land Mine

Chapter 6: Unsafe at Any Rate

Basic Framework

Who Is Elizabeth Warren?

Toasters and Credit Cards

The New Consumer Bureau

Mortgage Broker and Securitization Rules

Consequences: What to Expect from the New Bureau

What It Means for the Government-Bank Partnership

Chapter 7: Banking on the FDIC (Resolution Authority I)

Does the FDIC Play the Same Role in Both Regimes?

How (and How Well) Does FDIC Resolution Work?

Moving Beyond the FDIC Analogy

Chapter 8: Bailouts, Bankruptcy, or Better? (Resolution Authority II)

Basic Framework

The Trouble with Bailouts

Who Will Invoke Dodd-Frank Resolution, and When?

Triggering the New Framework

Controlling Systemic Risk

Third Objective: Haircuts

All Liquidation, All the Time?

Part III: The Future

Chapter 9: Essential Fixes and the New Financial Order

What Works and What Doesn’t

Staying Derivatives in Bankruptcy

ISDA and Its Discontent

Other Bankruptcy Reforms for Financial Institutions

Plugging the Chrysler Hole in Bankruptcy

Bankruptcy to the Rescue

Chapter 10: An International Solution?

Basic Framework

Problems of Cross-Border Cases

Scholarly Silver Bullets

Dodd-Frank’s Contribution to Cross-Border Issues

New Living Wills

A Simple Treaty Might Do

Risk of a Clearinghouse Crisis

Reinvigorating the Rule of Law

Conclusion

Notes

Bibliography

Acknowledgments

About the Author

Index

Copyright © 2011 by David Skeel. All rights reserved.

Introduction © 2011 by William D. Cohan. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Skeel, David, 1961–

The new financial deal : understanding the Dodd-Frank act and its (unintended) consequences / David Skeel.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-94275-8 (cloth); ISBN 978-1-118-01490-5 (ebk); ISBN 978-1-118-01491-2 (ebk); ISBN 978-1-118-01492-9 (ebk);

1. United States. Dodd-Frank Wall Street Reform and Consumer Protection Act. 2. Financial services industry—Law and legislation—United States. 3. Financial institutions—Law and legislation—United States. I. Title.

KF969.58201A2 2010

346.73'08—dc22

2010042162

For H.P., T.G., and B.B.

For H.P., T.G., and B.B.

Foreword

September 15, 2008, was a day of infamy for the global financial markets. The increasing financial stress precipitated by a free-fall subprime mortgage crisis, and fueled by excessive risk taking and greed, exploded. At approximately 2:00 a.m. of that day, at the virtual insistence of the U.S. Treasury, the Federal Reserve System, and the Securities and Exchange Commission, Lehman Brothers Holdings Inc., the fourth largest U.S. investment bank, with extensive international operations, filed a Chapter 11 bankruptcy case. This unleashed a tsunami that threatened to destroy the worldwide financial system. The bankruptcy of the Lehman enterprise has produced a plethora of articles, books, strange bedfellows, and all types of political intrigue and deal making.

David Skeel has entered the stage to succinctly focus sunlight on the events that occurred and resulted in the Dodd-Frank financial reform bill of 2010. David has undertaken a most difficult and sensitive task. To explain and critique a statute that has been the subject of intense public and private debate, media attention, and voluminous congressional hearings, replete with congressional competition for primacy of jurisdiction, requires a high degree of courage and intelligence. David has exhibited both.

The process that resulted in the Dodd-Frank reform has the makings of at least three challenging documentaries or films. The threat of financial reform galvanized a broad base of opposition. The financial community, which ironically may be charged with having been a primary culprit in causing the financial crisis that almost dismembered the global financial system, generally was unalterably opposed to any meaningful financial reform. It mounted an extensive and extremely costly lobbying effort that enlisted the extensive cooperation of the House minority leader, Congressman John Boehner, who worked closely with the lobbyists in the attempt to defeat financial reform.

The New Financial Deal comprehensively and skillfully navigates the circumstances that created an environment for financial reform. The book illuminates the strains, pressures, and vicissitudes of attempting to enact a remedial statute that may materially affect the way business is conducted. The book describes the new world of finance that had evolved during the first decade of the twenty-first century that included new forms of investments and securities, such as derivatives, which were barely understood because of their esoteric and opaque characteristics. They befuddled regulators, to the extent they were regulated at all, and enabled huge risk taking. Also, access to credit enabled excessive leverage that put investors and the economy at great risk.

The crushing circumstances of the financial disaster are vividly described in The New Financial Deal. The crosscurrents that arose in respect of the need for financial reform and the scope of any financial reform are presented with clarity. The New Financial Deal properly raises the issue of whether the Dodd-Frank reform and its failure to deal with global concerns will result in real, meaningful financial reform that will prevent another financial crisis similar to that of 2008. The answer is not crystal clear, as The New Financial Deal illustrates.

The New Financial Deal is mandatory reading for all those interested in the financial markets and the global economy. David Skeel is to be commended for casting sunlight, the best disinfectant, on the events preceding the enactment of the Dodd-Frank reform, its efficacy, and the potential consequences, intended and unintended.

Harvey R. Miller

Lead Bankruptcy Attorney for Lehman Brothers

Introduction

Just as surely as little boys on sleds follow a winter snowfall—to paraphrase the Yale economist Arthur Okun—a rip-roaring financial crisis is bound to result in a new swath of financial regulation.

Such, famously, was the case during the years following the stock market crash of 1929, when Congress passed—and President Franklin Roosevelt signed into law—a slew of financial reforms designed both to reduce the rampant speculation and risk taking that infected the nation’s banking system and to increase the disclosure about companies seeking to sell their securities to public investors. The Securities Act of 1933 was the first federal law to regulate the sale of securities to investors, and required corporations to register their securities by filing a mountain of disclosure with the Securities and Exchange Commission (SEC), which was established the following year. (In the one-year interim period, the Federal Trade Commission approved the issuance of corporate securities.) The so-called 1933 Act required the SEC to approve an issuer’s “registration statement” before the securities could be sold to investors. By and large for the past 77 years, the system has worked well and prevented most egregious scams.

There also was the Banking Act of 1933—more commonly known as the Glass-Steagall Act—that not only created the Federal Deposit Insurance Corporation but also forced banks to choose between commercial banking, which took deposits from the general public, and investment banking, which focused on the supposedly riskier activities of underwriting stocks and bonds. The Glass-Steagall Act gave banks until 1936 to make their decisions and was relatively straightforward: Choose one or the other, with the idea being that American savers would be protected from the tendency of bankers to take unwarranted risks with their money.

For most banks, this decision was simple, since few dabbled in both commercial and investment banking. Goldman Sachs, which to this day has little interaction with the public, stuck with investment banking, as did Lehman Brothers and Lazard Frères & Co. J.P. Morgan & Co., which had feet in both camps, chose commercial banking and jettisoned the investment-banking partners, who together formed Morgan Stanley & Co., which this year is celebrating its 75th anniversary. In 1932, the First Boston Corporation was founded as the investment banking arm (through the combination of a few firms) of the First National Bank of Boston; in 1934, per Glass-Steagall, First Boston was spun out of the commercial bank and became the first publicly traded Wall Street firm.

In the wake of Glass-Steagall, Wall Street seemed to mature, steady, and settle into a reliable pattern of behavior, none of which particularly threatened the stability of the financial system. By and large, the small, private partnerships that comprised Wall Street took prudent risks with their partners’ money. Many thrived, and their partners got rich.

Not that Wall Street had stopped being a dangerous place. For instance, there was the—long forgotten now—back-office crisis of the late 1960s and early 1970s, which started during 1967 when trading volumes on the major stock exchanges exploded, and the poorly capitalized Wall Street partnerships were ill equipped to handle the extensive paperwork of settling trades occasioned by the sudden and unexpected upsurge in trading. Many firms were slow to add the back-office personnel required to handle the new flow. Unfortunately, when the personnel were eventually hired—in a rush, of course—talent suffered. Some firms were drowning in a sea of unprocessed, and inaccurately accounted for, paper.

But by the end of 1969, “the worst of the paperwork problems had been surmounted,” according to Lee Arning, then a New York Stock Exchange executive. The crisis, though, had just begun, for at the very moment that many brokerages had increased their personnel costs to scale the mountain of paper, the volume of business fell off a cliff. There was a feeling that 1970 was capitalism’s most acute test since 1929. “We were looking at the world from a 650 Dow Jones, the Penn Central bankruptcy, a credit crisis, Cambodia, Kent State—and we didn’t know where anything was going and it was a pretty grim world at this time,” Felix Rohatyn, one of the senior partners at Lazard Frères & Co., told the New York Times.

By midsummer 1970, Rohatyn had a full-fledged crisis to resolve as head of the New York Stock Exchange’s Crisis Committee: The near dissolution of the old-line, blue-blood retail brokerage Hayden, Stone & Co., where Joseph P. Kennedy had begun to build the fortune that would be used to propel his second son to the presidency. (Joseph Kennedy was also the first chairman of the SEC.) Hayden, Stone had 62 offices nationwide, but its back-office systems were a mess. Compounding its problems, the firm’s older partners, upon retiring, were withdrawing their capital from the firm. This, combined with the failing fortunes on Wall Street in general, created operating losses that together pushed Hayden, Stone dangerously close to default. Although Wall Street would be aghast, Rohatyn quickly found a savior for Hayden, Stone in Sandy Weill, the wunderkind financier who had presciently built a state-of-the-art securities clearing operation at his firm, Cogan, Berlind, Weill & Levitt (known as “Corned Beef with Lettuce” among Wall Street wags). Rohatyn decided that Weill, who would go on to create the financial behemoth Citigroup, was one of the few people able to grapple quickly with Hayden’s accounting deficiencies. Rohatyn then proceeded to orchestrate a few more mergers, matching struggling brokers with their healthier brethren. Eventually, the crisis passed.

By the early 1990s, though, commercial banks—with J.P. Morgan, Citibank, and Chase Manhattan in the forefront—began encroaching on the turf of the investment banks, and sought to underwrite debt and equity securities and to provide mergers and acquisitions (M&A) advice. Commercial banks figured that, since they were taking the balance sheet risks by lending to corporate America, they might as well also get a slice of the lucrative fee-based business that Wall Street was hoovering up without seeming to take balance-sheet risk. In 1998, thanks to Sandy Weill, the Rasputin of finance, and his proposed merger between Travelers, which owned Salomon Smith Barney, and Citibank, the walls that separated commercial banking and investment banking came crashing down. In 1999, President Clinton signed the Gramm-Leach-Bliley Act, which made de jure what was already de facto: the Glass-Steagall Act was dead.

In the following decade, all hell broke loose. And the rest is history. Thanks to the financial crisis of 2007 and 2008, we have the Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law in July 2010. Unlike the financial reform that emerged in the 1930s, which was fairly clear and explicit about what compliance meant for Wall Street, the Dodd-Frank Act’s 2,300 pages seem to have muddied the already choppy waters: Must banks dump their proprietary traders? Can they still own hedge funds? What about private equity funds? Are banks actually limited to having just 3 percent of their Tier 1 capital invested in alternative investments? What types of derivatives will end up being traded on an exchange? How many clearinghouses will there be? The answers to these questions—and many others—must await the laborious process of drafting new regulations by the SEC, the Treasury, and the Federal Reserve, among others, as required by the new law.

While we wait and wonder what the true denouement of the Dodd-Frank Act will be, we are blessed with Professor David Skeel’s timely, informative, and lucid explanation of the ins and outs of the new law. For readers trying to understand what Dodd-Frank will likely mean for Wall Street’s future—and for ours—Skeel skillfully dissects the Act’s nuances and intricacies and provides regulators a road map for how to make sure Wall Street doesn’t double-cross us again anytime soon.

William D. Cohan

Author of House of Cards, The Last Tycoons, and an upcoming title on Goldman Sachs to be published in 2011

A Few Major Characters

Ben Bernanke: Chairman, Federal Reserve, 2006–

Ben Bernanke had been a longtime economics professor at Princeton University when he was nominated to be a Governor of the Federal Reserve in 2002. As a scholar, he was best known for his studies of the causes of the Great Depression. Bernanke has often vowed not to repeat the Depression-era Fed’s mistake of restricting access to funds during a crisis. Whatever one thinks of Bernanke’s performance, there is no doubt that Bernanke and his fellow Federal Reserve Governors made good on his vow, steering funds to Bear Stearns, American International Group (AIG), the commercial paper market, and other recipients. He, Henry Paulson, and Timothy Geithner were the three musketeers of the regulatory response to the Panic of 2008.

Christopher Dodd

A three-term senator from Connecticut, Christopher Dodd announced in late 2009 that he would not be running for reelection in 2010. Dodd’s decision not to run was construed by many as a response both to a minor scandal—he had been given a below-market home loan by Countrywide Financial, the leading subprime lender—and to the dimming electoral prospects for congressional Democrats. As chair of the Senate Banking Committee, Dodd was the point person for the legislation in the Senate. Dodd was critical of some of the populist additions to the Act, such as the Volcker Rule.

Barney Frank

A longtime member of Congress from Massachusetts and chair of the House Financial Services Committee, Barney Frank was the point person for the legislation in the House. Frank was criticized during the Panic of 2008 for having resisted reform of Fannie Mae and Freddie Mac earlier in the decade. Frank was a strong advocate of the new Consumer Financial Protection Bureau and the more populist additions to the Act.

Richard Fuld: Chief Executive Officer, Lehman Brothers, 1994–2008

Richard Fuld was seen as something of a Lehman hero early in the decade, having risen through the ranks in a long career at the bank. His reputation quickly changed after the fateful summer of 2008, when Lehman failed to reach a deal with any of several possible buyers and investors, and then collapsed in September.

Timothy Geithner: Secretary of the Treasury, 2009–

The son of a diplomat, Tim Geithner has often been described as a former Wall Street banker, but he never actually worked in the private sector on Wall Street. After a short stint in Henry Kissinger’s consulting firm, Geithner worked in the Treasury Department during the Clinton administration in the 1990s. This period saw bailouts of Mexico in 1994–1995 and (with funding from Wall Street banks) the hedge fund Long-Term Capital Management in 1998. As president of the New York Federal Reserve Bank, a position he held from 2003 to 2009, Geithner joined Henry Paulson and Ben Bernanke as the key architects of the bailouts of 2008. He and Larry Summers were the most important Obama administration advisers on the Dodd-Frank Act.

Henry Paulson: Secretary of the Treasury, 2006–2009

Henry Paulson was the head of the investment bank Goldman Sachs, after a long career as a investment banker at Goldman, when he joined the Bush administration as secretary of the Treasury in 2006. Paulson initially declined consideration, but then agreed to take the post on the condition that he have regular access to the President. He appears to have favored the Bear Stearns and AIG bailouts, and to have argued against a bailout of Lehman to send a signal that no company could count on receiving a bailout. He later claimed that the government did not have the power to bail out Lehman, because Lehman did not have adequate collateral to secure a loan under the Federal Reserve’s emergency lending powers. He asked Congress for the funding that became the $700 billion Troubled Asset Relief Program (TARP) legislation in October 2008, and spearheaded the use of $17 billion of the money for loans to General Motors and Chrysler.

Lawrence Summers: Director, National Economic Council, 2009–2010

The son of two economists and the nephew of two others (Nobel Prize winners Paul Samuelson and Kenneth Arrow), Larry Summers was a wunderkind who earned tenure at Harvard University at the age of 28. He served as assistant secretary of the Treasury under Robert Rubin, then took over as Treasury secretary at the end of the Clinton administration. Summers became president of Harvard in 2001, but his tenure turned rocky after he suggested at a conference that scientists should study the possibility that there are more intelligent men than women “at the high end.” One year and several more controversies later, he was forced to step down. Summers crept back into the public eye in a more favorable way as a result of a series of columns he wrote on economic issues for the Financial Times in 2007 and 2008. He was an important adviser to Barack Obama during Obama’s presidential campaign. Many observers suspect that Obama would have nominated him as Treasury secretary if it weren’t for the controversies at Harvard. In his post as director of the National Economic Council, which did not require Senate confirmation, Summers has been a key adviser to President Obama. He and Geithner appear to have significantly shaped the administration’s contributions to the Dodd-Frank Act.

Paul Volcker

Paul Volcker is revered by many in Washington and elsewhere for his tough-minded handling of the rampant inflation of the late 1970s. As chair of the Federal Reserve, he and his fellow Federal Reserve Governors ratcheted up interest rates. Although some believe that the Fed stance cost President Carter reelection, it is widely viewed as having tamed inflation. During the 2008 campaign, Volcker was an important adviser to Barack Obama. But his role sharply diminished after the election. Volcker’s signature position during the debates on the Dodd-Frank Act was a proposal that commercial banks be banned from engaging in proprietary trading—trading in derivatives and other financial instruments for their own accounts. The administration initially was cool to the proposal, but President Obama endorsed it—calling it the Volcker Rule—two days after the election of Scott Brown to Senator Edward Kennedy’s seat in Massachusetts suggested that populist discontent with health care reform and the bailouts of 2008 was widespread.

Elizabeth Warren

A law professor at Harvard, Elizabeth Warren is a longtime critic of the credit card industry and advocate of the interests of consumer debtors. Prior to the recent crisis, Warren was best known as the co-author of two books based on extensive empirical studies of consumer debtors, as well as The Two-Income Trap. Written with Warren’s daughter, The Two-Income Trap argues that the two-income families that emerged after women began entering the workforce in large numbers in the 1970s are actually more economically vulnerable than their predecessors, not less. In late 2008, Warren was named by Senator Harry Reid to serve as chair of the TARP Oversight Committee, which has issued regular reports on monitoring expenditures under the TARP legislation that gave Treasury $700 billion to quell the crisis in the banking system. The proposal for a new consumer regulator was conceived by Warren, and outlined in articles she wrote in 2007 and 2008. Although Warren was the obvious choice to head the Consumer Financial Protection Bureau, it was unclear whether she could be confirmed over the opposition of Republicans and some moderate Democrats. To sidestep this impediment, President Obama named her as his assistant and as a special adviser to Treasury Secretary Geithner—and thus as de facto initial head—for the new Consumer Bureau.

Chapter 1

The Corporatist Turn in American Regulation

When President Obama signed the Dodd-Frank Act into law on July 21, 2010, he began a new epoch in financial regulation. The old epoch dated back to the early 1930s, when President Roosevelt and the New Deal Congress enacted the securities acts of 1933 and 1934, as well as banking reforms that broke up the giant Wall Street banks and put deposit insurance in place for the first time. Never again, they promised, would investors be forced to live by their critical wits in unregulated markets, or ordinary Americans lose their life savings if their bank failed.

The new legislation comes in the third year of the worst American financial crisis since the Great Depression, a crisis that was exacerbated by financial instruments and new forms of financing that were not dreamed of in that earlier era. Most Americans had never even heard of the financial assembly line known as securitization before the collapse of major mortgage lenders like Countrywide and the more cataclysmic failures of Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group (AIG). Many still don’t understand just what this process is all about—other than to repeat familiar clichés about the “slicing and dicing” of mortgages—but they know that the failure to adequately regulate these innovations has figured prominently in the crisis.

After watching the government bail out Bear Stearns and AIG in 2008, and pump well over $100 billion into Citigroup, Bank of America, and the other big banks the same year, Americans also know that the existing regulatory framework could not adequately oversee our largest financial institutions. Perhaps the best evidence of just how rickety that old regulatory structure was can be found in the best-selling books about the financial crisis. Bill Cohan’s House of Cards showed just how little the nation’s top regulators—then-Treasury Secretary Henry Paulson, Federal Reserve Chair Ben Bernanke, and then-head of the New York Federal Reserve Bank Timothy Geithner—knew about Bear Stearns’s financial condition as they decided the investment bank’s fate. Andrew Ross Sorkin’s riveting page-turner on the crisis, Too Big to Fail, revealed just how unscripted and unnervingly ad hoc the decisions whether to nationalize (as with Fannie Mae and Freddie Mac), let go (as with Lehman Brothers), or bail out (as with AIG) were in the calamitous months that followed. The picture of one page from Henry Paulson’s phone log in Sorkin’s book is enough to make one’s heart stop.1

The Dodd-Frank Wall Street Reform and Consumer Protection Act—the Dodd-Frank Act for short—is the response to Americans’ call for help, for a new regulatory framework for the twenty-first century. To understand what American financial life is likely to look like in 5, 10, or 20 years, and how regulators may respond to the next crisis, we need to understand the Dodd-Frank Act: both what it says and what it means. This, in a nutshell, is what the book you are reading is about.

The Path to Enactment

The Dodd-Frank Act got its start in March 2009, when the Department of the Treasury released a framework it called “Rules for the Regulatory Road” shortly before a major meeting of the G-20 nations. Treasury released a more complete White Paper and proposed legislative language several months later. The White Paper would provide the template for all of the major parts of the legislation that eventually passed.

Throughout the summer and fall of 2009, Treasury Secretary Tim Geithner and other defenders of the proposed legislation were hammered by critics. On the right, the emerging Tea Party movement lumped the financial reforms together with the health care legislation as evidence of the Big Government inclinations of the Obama administration, and condemned the reforms as institutionalizing the bailout policies of 2008. Many on the left were equally critical. For liberal critics, the bailouts and the proposed legislation suggested that the administration was catering to Wall Street, while doing very little to ease the suffering that the financial crisis had brought to Main Street.

In response to these criticisms, the administration tightened up portions of the legislation that could be construed as inviting bailouts. They also insisted that the legislation wouldn’t perpetuate the bailouts of the prior year. By giving regulators the power to dismantle systemically important financial institutions that were on the brink of collapse, they argued, it actually would end the use of bailouts.

The next major step toward enactment came when Congressman Barney Frank steered a version of the proposed legislation through his Financial Services Committee, and then, on December 11, 2009, through the House of Representatives.

In January 2009, the Obama administration was forced to make a major concession to populist criticism of the legislation by the stunning victory of Republican Scott Brown in the election to fill Edward Kennedy’s Senate seat in Massachusetts. Two days after Brown’s election, President Obama endorsed a proposal by former Federal Reserve Chairman Paul Volcker that would ban banks from engaging in proprietary trading—that is, trading for their own accounts. Until the Brown election, the administration had resisted the proposal as an undesirable interference with the activities of the big banks.

Even after this shift, the fate of the legislation remained uncertain for several months. Given the heavy Democratic majorities in Congress and the obvious inadequacies of existing regulation, most observers thought some version of the legislation would pass. But it wasn’t clear what version, or when.

The pivotal push once again came from outside the halls of Congress. On April 19, the Securities and Exchange Commission (SEC) sued Goldman Sachs, which had emerged as a principal villain of the financial crisis—“a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money,” in the immortal words of Rolling Stone magazine. Approved by a 3 to 2 vote of the SEC’s commissioners, the SEC lawsuit alleged that Goldman had defrauded investors by failing to tell them that the mortgage-related investments it had sold them were picked in part by a hedge fund that was betting that the mortgages would default. The securities fraud allegations transformed the political landscape, shifting the momentum decisively in favor of the legislation. On May 20, the Senate passed its version, known as the Dodd Bill after Senate Banking Committee Chair Christopher Dodd. In the ensuing two months, a conference committee worked out the differences between the two bills, and with the President’s signature, Dodd-Frank was born.2

The Two Goals of the Dodd-Frank Act

Contrary to rumors that the Dodd-Frank Act is an incoherent mess, the Wall Street Reform portion of its 2,319 pages (a mere 800 or so when the margins and spacing have been squeezed) has two very clear objectives. Its first objective is to limit the risk of contemporary finance—what critics often call the shadow banking system; and the second is to limit the damage caused by the failure of a large financial institution. (Although the Wall Street reforms are this book’s particular focus, it also devotes a chapter to the new consumer regulator, which is the heart of Dodd-Frank’s contribution to consumer protection.)

The Dodd-Frank Act tackles the first task by putting brand-new regulatory structures in place for both the instruments and the institutions of the new financial world. The principal instruments in question are derivatives. A derivative is simply a contract between two parties (each called a counterparty), whose value is based on changes in an interest rate, currency, or almost anything else, or on the occurrence of some specified event (such as a company’s default). An airline may buy an oil derivative—a contract under which it will be paid if the price of oil has risen at the end of the contract term—to hedge against changes in oil prices. Southwest Airline’s judicious use of these derivatives was one of the keys to its early success.

The Dodd-Frank Act’s main strategy for managing the riskiness of these contracts is to require that derivatives be cleared and traded on exchanges. To clear a derivative (or anything else, for that matter), the parties arrange for a clearinghouse to backstop both parties’ performance on the contract. If the bank that had sold Southwest an oil derivative failed, for instance, the clearinghouse would pay Southwest the difference between the current and original oil price or would arrange for a substitute contract. If the same derivative were exchange traded, it would have standardized terms and would be purchased on an organized exchange, rather than negotiated privately by Southwest and the bank. Clearing reduces the risk to each of the parties directly, while exchange trading reduces risk to them and to the financial system indirectly by making the derivatives market more transparent.

To better regulate institutions, the Dodd-Frank Act seeks to single out the financial institutions that are most likely to cause systemwide problems if they fail, and subjects them to more intensive regulation. The legislation focuses in particular on bank holding companies that have at least $50 billion in assets, and nonbank financial institutions such as investment banks or insurance holding companies that a new Financial Stability Oversight Council deems to be systemically important. (“Bank” in this context means a commercial bank—a bank that accepts customer deposits. A bank holding company is a group of affiliated companies that has at least one commercial bank somewhere in the network, or has chosen to be subject to banking regulation, as Goldman Sachs and Morgan Stanley did in the fall of 2008. I will sometimes use “bank” to refer to either.) Banks like Citigroup or Bank of America automatically qualify, as do 34 others, whereas an insurance company like AIG will be included only if the Council identifies it as systemically important. The Dodd-Frank Act instructs regulators to require that these systemically important firms keep a larger buffer of capital than ordinary financial institutions, to reduce the danger that they will fail.3

If Dodd-Frank’s first objective is to limit risk before the fact—before an institution or market collapses—the second objective is to limit the destruction caused in the event that a systemically important institution does indeed fail, despite everyone’s best efforts to prevent that from happening. For this second objective, the legislation introduces a new insolvency framework—the Dodd-Frank resolution rules. If regulators find that a systemically important financial institution has defaulted or is in danger of default, they can file a petition in federal court in Washington, D.C., commencing resolution proceedings, and appoint the Federal Deposit Insurance Corporation (FDIC) as receiver to take over the financial institution and liquidate it, much as the FDIC has long done with ordinary commercial banks.

Like the New Deal reforms, which gave us the FDIC and the SEC, among others, the Dodd-Frank Act creates several new regulators to achieve these two objectives, including the Financial Stability Oversight Council, whose members include the heads of all the major financial regulators, and a new federal insurance regulator. I have already mentioned that the other major new regulator (the Consumer Financial Protection Bureau) will also come into our story, in part as a foil to the key Wall Street banks.

A Brief Tour of Other Reforms

Throughout, the book focuses primarily on the reforms that relate most directly to the two goals just described. Although these are the most important of the reforms, several others have received significant attention. I give each at least glancing comment elsewhere in the book, but it may be useful to identify them briefly and more explicitly here.

The first two are a pair of corporate governance reforms, each of which is designed to give shareholders more authority. The more important of the two is a provision that simply gives the SEC the power to require a company to include shareholder nominees for director along with the company’s own nominees when it sends proxy materials to all of its shareholders before its annual meeting. The SEC has already taken advantage of this authority, approving a regulation that will allow shareholders with at least 3 percent of a corporation’s stock to include nominees for up to 25 percent of the directorial positions. The second, which was one of President Obama’s campaign promises, will require that shareholders be given a nonbinding vote on the compensation packages of the company’s directors and top executives. Neither is likely to have a particularly large effect, although the first—known as proxy access—has generated anxiety in directorial circles. These critics complain that unions and pensions will use the new shareholder power to promote their own agendas.4

The Dodd-Frank Act also took aim at a few of the problems plaguing the credit rating industry. The credit rating agencies—Standard & Poor’s, Moody’s Investors Service, and Fitch—did a notoriously poor job with the mortgage-related securities at the heart of the subprime crisis, handing out investment grade ratings to many securities that later defaulted. One problem with the current system is that the bank whose securities are being rated pays for the rating. (As my students like to say, it’s as if a school used a grading system in which students paid for their grades.) Although the legislation did not eliminate the “issuer pays” feature of credit ratings, it requires financial regulators to change the many rules that require entities like pension funds and insurance companies to buy securities that are certified as investment grade by a credit rating agency. These changes, it is hoped, will diminish the pressure to rely on credit rating agencies. Removal of the artificial demand for credit rated securities could indeed significantly improve the credit rating process. Dodd-Frank also includes a variety of new rules for the governance of a rating agency.5

Finally, the legislation requires hedge funds to register for the first time. In the past, the defining characteristic of hedge funds was their exclusion from securities laws and related regulation that would otherwise require disclosure and oversight. Under the Dodd-Frank Act, hedge fund advisers must now register and make themselves available for periodic inspections.6

Each of these new provisions is related to the two principal objectives of the Act, but each is more at the periphery than the center. The core is Dodd-Frank’s treatment of derivatives, its regulation of systemically important financial institutions, and its new rules for resolving their financial distress, together with the counterweight of the Consumer Financial Protection Bureau.

Two Themes That Emerge

I wish I could say that the new regulatory regime will be as successful as the New Deal legislation it is designed to update. But I fear it won’t be. Unless its most dangerous features are arrested, the legislation could permanently ensconce the worst tendencies of the regulatory interventions during the recent crisis as long-term regulatory policy.

The problem isn’t with Dodd-Frank’s two objectives. The objectives are right on target. The problem is with how they are handled. The two themes that emerge, repeatedly and unmistakably, from the 2,000 pages of legislation are (1) government partnership with the largest financial institutions and (2) ad hoc intervention by regulators rather than a more predictable, rules-based response to crises. Each could dangerously distort American finance, making it more politically charged, less vibrant, and further removed from basic rule-of-law principles than ever before in modern American financial history.

The first theme, as I just noted, is government partnership with the largest Wall Street banks and financial institutions. Dodd-Frank singles out a group of financial institutions for special treatment. The banks that meet the $50 billion threshold, and the nonbank financial institutions designated by the new Financial Stability Oversight Council as systemically important will be put in their own separate category. Unlike in the New Deal, there is no serious effort to break the largest of these banks up or to meaningfully scale them down. Because they are special, and because no one really believes the largest will be allowed to fail, they will have a competitive advantage over other financial institutions. They will be able to borrow money more cheaply, for instance, than banks that are not in the club. Dodd-Frank also gives regulators a variety of mechanisms they can use to channel political policy through the dominant institutions. The partnership works in both directions: special treatment for the Wall Street giants, new political policy levers for the government.

The second theme overlaps with the first: Dodd-Frank enshrines a system of ad hoc interventions by regulators that are divorced from basic rule-of-law constraints. The unconstrained regulatory discretion reaches its zenith with the new resolution rules for financial institutions in distress. Dodd-Frank resolution is designed for systemically important financial institutions that have been singled out for special treatment. But the rules do not even require that an institution be designated as systemically important in advance. If regulators want to take over a struggling bank, they can simply do so as long as they can say with a straight face that it is “in default or in danger of default” and its default could have “serious adverse effects” on stability. Not only this, but they may be able to take over every affiliate in the bank’s network. Once the institution is in government hands, the FDIC can pick and choose among creditors, deciding to pay some in full while leaving the rest with the dregs that remain after the favored creditors are paid.

The basic expectations of the rule of law—that the rules will be transparent and knowable in advance, that important issues will not be left to the whim of regulators—are subverted by this framework. Nor is the tendency limited to the end-of-life issues I have been discussing. The Dodd-Frank Act invites ad hoc intervention with healthy financial institutions as well.

The two tendencies I have just described will not come as a surprise to anyone who followed the legislative debates that led to the Dodd-Frank Act. Massachusetts Institute of Technology (MIT) Professor Simon Johnson and Nobel Prize economist Joseph Stiglitz, among others, insisted that the largest banks need to be broken up because they are too big to effectively regulate and because they distort the financial markets. I will refer to this perspective throughout the book as Brandeisian, in honor of Louis Brandeis, the Roosevelt adviser and Supreme Court justice, who advocated this view throughout the early twentieth century.7

Similarly, many critics complained about the dangers of the new legislation’s casual disregard of the rule of law during the legislative debates. The contrast between the new resolution rules and the more predictable, transparent, rule-oriented bankruptcy process was a frequent subject of concern.

The administration and advocates of the legislation did not simply ignore these criticisms. At several points, they were forced to make concessions. The most important concession is the provision now known as the Volcker Rule. Promoted by Paul Volcker, the popular former chairman of the Federal Reserve and an adviser to President Obama during the 2008 election campaign, the Volcker Rule is a throwback to New Deal legislation that made it illegal to conduct commercial and investment banking under the same umbrella. As noted earlier, the Volcker rule prohibits commercial banks from engaging in proprietary trading—that is, trading and speculating for the bank’s own account—which is central to contemporary investment banking, and limits their investment in hedge funds or equity funds.