A Review of the Impact of the Reform Bill

Much is hazy about the Dodd-Frank bill, even though it has passed. But, there is also much to like (so far…)

On July 15, the Dodd-Frank Wall Street Reform and Consumer Protection Act passed 60-39 in the Senate. Next week, President Obama is expected to sign it into law.

The primary goal of Dodd-Frank is to protect against systemic financial risks. In brief, the bill gives federal regulators broad power to ward off possible bank collapses and intervene in financial transactions. Regulators will now be able to make too-big-to-fail determinations, set bank capital ratios, regulate lending terms, create ceilings on financial industry executives’ compensation, and rule on the types of proprietary investments allowable for banks. The legislation represents a substantial expansion of explicit government control over the financial sector and isn’t without its flaws, but overall, we expect the impact of Dodd-Frank to be a net positive to our clients.

The underlying agenda of Dodd-Frank is to encourage more conservative lending and investment practices in the banking sector and discourage financial firms from becoming too large. To accomplish that goal, the strategy of the legislation is to create dis-economies of scale, resulting in de-concentration of risk. It is reasonable to expect that the financial institutions most likely to benefit will be smaller consumer and investment banks, as it effectively curtails the profitability and expansion opportunities for large financial firms. The net result will be for investor capital and the best banking executives to gravitate towards smaller and riskier financial institutions.

The argument that the legislation institutionalizes the notion that some financial institutions are ‘too big to fail’ is essentially correct. More accurately it reinforces the notion which was effectively proven in the financial crisis. Because of the explicit government protections that Dodd-Frank delivers, it’s reasonable to expect that regulators will function in more aggressive manner towards larger financial firms going forward and this will, in turn, compel them operate in a manner similar to the more conservative practices before the repeal of the Glass-Steagall Act in the 1990s. If it operates as intended, the net result will be to make the large financial institutions less profitable and innovative. The net effect will be to make large banking stocks less attractive while it makes their bond and preferred stocks safer.

A drop in lending standards largely caused the financial crisis and the most important parts of Dodd-Frank for individual clients relate to the consumer protections it establishes. The bill creates a Consumer Financial Protection Agency (CFPA) which will operate from within the Federal Reserve. With the goal of reducing the ‘predatory’ lending practices – “liar’s loans”, unclear interest rate structures and specious fees, it’s largely unclear what specific role the CFPA will play or how broadly it will exert its power. But, it’s reasonable to expect that a new force has emerged in the financial regulatory landscape with broad influence and great impact.

Detractors think the CFPA and its regulations will cause businesses and individuals to have a tougher time getting credit. We agree, but don’t think this is incompatible with the overall agenda of Dodd-Frank – which is to reduce volatility in the credit markets. Obviously, all financial innovation hasn’t been a good thing and any legislation that seeks to address the problems in the current financial system will stifle innovation, both good and bad. Under any circumstances, we don’t expect this will have meaningful impact on our clients direct borrowing needs for mortgages or business financing. (We do, however, expect this will affect certain clients who own businesses dependent on innovative consumer credit for sales…)

Where we expect the most substantial impact on our clients will be in the form of increased standards for home equity lines of credit. Specifically we expect lower allowed loan to value ratios, greater verification of income and more conservative income assumptions from existing investments. Consequently, it’s reasonable to expect that the availability and terms for all loans greater than $1 million will worsen, but otherwise we think this will have a minimal effect on most clients’ banking experiences, other than to enhance the attractiveness of working with smaller depository institutions and to make the underwriting process for mortgages generally more document intensive and onerous (things the Bradley & Company Wealth Management System seeks to substantially ameliorate).

We expect the impact of Dodd-Frank to impact the fixed income markets. The failure of the rating agencies to predict the risks associated with various securities has had the effect of making broad investments (ETFs and mutual funds) in the fixed income markets more attractive for individual investors of all types. The failure of ratings agencies (S&P, Moody’s and Fitch) to accurately predict default risks been addressed in Dodd-Frank by the creation of an Office of Credit Ratings (OCR) in the Securities & Exchange Commission. The OCR will monitor the big Wall Street credit ratings firms and watch out for possible conflicts of interest. This should generally have a good effect on the rating agencies competence and independence, eventually bolstering confidence in the accuracy of their assessments and increasing the price of corporate bonds. Going forward, it’s reasonable to expect that ratings changes will be more frequent – leading to greater volatility in the corporate fixed income markets, but he net result will be to make individual bond investments more attractive and appropriate for individual investors.

Dodd-Frank will increase transparency in the derivatives markets. Most of the trading in the derivatives “market” is ‘over-the-counter’ and effectively happens out of the public and regulators eyesight. No more, according to this reform bill: it will take place on public exchanges, with the goal of identifying systemic risks.

For certain clients, this will initially limit their ability to hedge certain concentrated stock positions, but the impact should be minimal, as these transactions migrate over to exchanges. Clients in resource-intensive businesses are more likely to be impacted. The most legitimate objections to the bill relate to the impact Dodd-Frank will exert on certain commodity prices and increases it will drive for economies of scale on the agricultural sector, in particular. However, in the end (whenever that is) we feel that this will greatly benefit all players in the financial markets and reduce overall volatility, and thus eventually improving pricing for hedgers of all stripes. In sum, sunlight equals disinfectant.

Dodd-Frank’s impact is probably going to be less than either its detractors or proponents contend, but its passage is an important milestone and an important part of the recovery process for the US (and global) economy. Comprehensive change is “normal” after a financial crisis of this magnitude and the changes made by Dodd-Frank strike us as generally appropriate.

But, it’s also unrealistic to expect the result of the bill’s passage to exert a great influence positive or negative in the coming months; It remains unclear how the reforms passed will be implemented and with what degree of intensity. Also, at 2,300 pages of legislation – there is much that we will learn, much to be adjudicated and some components, like the health care bill, will possibly be repealed by future governments. Financial regulations are like ice cream – they melt easily once the heat is turned up.

“Because of this reform, the American people will never again be asked to foot the bill for Wall Street’s mistakes,” the President said in mid-July. “There will be no more taxpayer-funded bailouts, period.” We largely disagree – one of the most striking characteristics of the bill is that it doesn’t address one of the primary drivers of the problem – the inherent unprofitability and unfunded liabilities of both Fannie Mae and Freddie Mac, which could be as high as US$1 trillion. The question of how to address these two government institutions’ unfunded liabilities continue to weigh on the markets and will not easily be resolved. It’s reasonable to expect that at some point, there will be a need to end the life support being paid into Fannie and Freddie, but at present, the future for continued bailouts of these institutions seems bright.

So, in the short term, passage of the bill will likely pull some money off the sidelines and likely calm things down a bit, but until the question of Fannie and Freddie is resolved, this chapter in the financial crisis remains unfinished.