By Nabi Menai
Perhaps one of the most cataclysmic events of the 21st century was the financial crisis that began in 2008. Not only did it send the United States into a historic recession, its effects reverberated around the world and the ramifications of the crisis can still be felt today. Banks and law firms have drastically altered their hiring practices; mortgage companies have become subject to copious regulation; and Washington D.C. has kept an observant eye on Wall Street ever since. Most notably, however, in the wake of the financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in July 2010. Along with the passage of Dodd-Frank came some of the most stringent regulation of financial institutions within the United States. Congress’s objective with respect to Dodd-Frank was to ensure that key financial institutions, such as investment banks, would not be able to operate in the same unfettered way as they had in the years leading up to the 2008 crisis. Dodd-Frank is an extremely complex and nuanced piece of legislation, but its importance cannot be overstated. Thus, the fervor with which the Trump administration has loosened some of the seminal provisions of Dodd-Frank deserves attention.
Causes of 2008 and the Dodd-Frank Response
In order to understand the significance of Dodd-Frank it is worth detailing some of the key factors that contributed to the 2008 financial crisis. One main cause pertains to the housing market and specifically, how banks were distributing and selling mortgages to millions of people across the country. For example, with the expansion of the Private Label Securities (PLS) market, mortgage lending dramatically expanded. A large portion of these mortgages were subprime loans with predatory features and “there was a dramatic expansion of mortgage lending, a large portion of which was in subprime loans with predatory features.”[1] In addition, because banks handed out a great deal of mortgages to people who were refinancing their loans, “they often were exposed to complex and risky products that quickly became unaffordable when economic conditions changed.”[2] Moreover, because many people were sold adjustable-rate mortgages (ARMSs) they were unable to afford their homes when the interest rate on their mortgage changed. Simply put, an ARM is a “loan with an interest rate that will change throughout the life of the loan.”[3] In the build-up to the 2008 crisis, many Americans bought ARMs which had “low initial ‘teaser’ rates that lasted for the first two or three years and then increased afterward . . . [and] many of these mortgages were structured to require borrowers to refinance or take out another loan in the future in order to service their debt, thus trapping them.”[4] As more Americans signed ARMs, the market for PLSs grew. For instance, “PLS volumes increased from $148 billion in 1999 to $1.2 trillion by 2006, increasing the PLS market’s share of total mortgage securitizations from 18 percent to 56 percent.”[5]
To make matters worse, many of these subprime mortgages were packaged and sold as securities which were then sold to a myriad of investors. The financial instrument which facilitated this process is known as a collateralized debt obligation (CDO). CDOs played an integral role in the build-up to the financial crisis of 2008 and while they had virtually disappeared in the immediate aftermath of the crisis, it did not take long for them to emerge again and be sold on Wall Street.[6]
However, Dodd-Frank mitigated the potentially deleterious effects that selling and trading CDOs can have on the economy. For example, the Dodd-Frank Act includes a provision commonly referred to as the Volcker Rule, which essentially “forbids banks from owning any proprietary trading operations, hedge funds or private equity funds.” Preventing investment of FDIC funds for hedge funds or private equity funds “limit[s] the sort of exposure that threatened to collapse the largest banks during the crisis.”[7] Thus, Dodd-Frank established many important safeguards which limit the way in which banks make speculative trades and invest their capital. By getting rid of these safeguards, the financial sector becomes more and more capricious.
Dismantling Dodd-Frank
In May 2018, the Trump Administration began its conquest to dismantle Dodd-Frank after Congress approved the first substantial rollback.
Once the bill was signed by President Trump, “small and medium-sized banks” no longer have to pass ‘stress tests’ which test their ability to withstand a severe economic downturn. It also offers a reprieve to big banks, allowing institutions like American Express to no longer be deemed ‘systematically important.”[8] These institutions are therefore subject to less government oversight. In addition, “the bill also exempts some loan originators, including small lenders, from certain disclosure requirements under the Home Mortgage Disclosure Act.”[9] Given the symbiotic relationship between liberal lending practices and the propensity for banks to capitalize on these practices, many Democrats have said “this will open the door to discriminatory practices because the rules required collection of credit scores, loan amounts and interest rates in an effort to expose redlining and lending discrimination,”[10] based on race and various socio-economic factors. Moreover, opponents of the bill have also claimed that “the changes could open taxpayers to more liability if the financial system collapses or increase the chances of discrimination in mortgage lending.”[11] Although the bill falls far from acting as a major repeal or ‘gutting’ of Dodd-Frank, it loosens the regulatory measures that the government imposed on financial institutions to keep them from similar capricious practices in the years leading up to 2008.
Although the bill falls far from acting as a major repeal or ‘gutting’ of Dodd-Frank, it loosens the regulatory measures that the government imposed on financial institutions to keep them from similar capricious practices in the years leading up to 2008.
As stated before, predatory lending practices contributed significantly to the housing crisis; therefore, relaxing Dodd-Frank’s requirements vis-à-vis selling mortgages to the public is not the most prudent course of action considering the track record that banks have had in the past.
Additionally, “the law also exempts banks with less than $10 billion in assets from the Volcker Rule.”[12] Many experts have opined that this is a dangerous move as well, not only because it diminishes the reach of the Volker Rule, but also because it allows banks to act with less government oversight. According to Marcus Stanley, policy director at Americans for Financial Reform, “this proposal is no minor set of technical tweaks to the Volcker Rule, but an attempt to unravel fundamental elements of the response to the 2008 financial crisis, when banks financed their gambling with taxpayer-insured deposits.”[13]
Conclusion
The Trump administration has made it clear that it is not finished with watering down Dodd-Frank, as President Trump has promised to do “a big number” on Dodd-Frank regulation. Although the changes made to the landmark bill have not substantially undercut the force of Dodd-Frank, they signal a step towards a new era of financial deregulation and less oversight. With many of the residual effects of the financial crisis still being felt across the country and the world, less regulation and oversight may be the perfect recipe for another disaster.
[1] Colin McArthur & Sarah Edelman, The 2008 Housing Crisis, CTR. OF AMERICAL PROGRESS (Apr. 13, 2018), https://www.americanprogress.org/issues/economy/reports/2017/04/13/430424/2008-housing-crisis/.
[2] Id.
[3] Adjustable Rate Mortgages, FreddieMac, http://myhome.freddiemac.com/buy/adjustable-rate-mortgages.html (last visited Apr. 15, 2019).
[4] Id.
[5] Id.
[6] Id.
[7] Adam C. Uzialko, The Return of CDOs: Is Another Economic Crisis on the Horizon?, BUSINESS NEWS DAILY (Nov. 13, 2017), https://www.businessnewsdaily.com/10353-cdo-financial-derivatives-economic-crisis.html.
[8] Jeenah Moon, Congress Approves First Big Dood-Frank Rollback, N.Y. TIMES (May 22, 2018), https://www.nytimes.com/2018/05/22/business/congress-passes-dodd-frank-rollback-for-smaller-banks.html.
[9] Id.
[10] Id.
[11] Jacob Pramuk & Emma Newburger, The ‘Center of Gravity Has Shifted’: How Lehman Brothers’ Collapse Helped Fuel Democrats’ Shift Left 10 Years Later, CNBC (Sept. 10, 2018), https://www.cnbc.com/2018/09/07/lehman-brothers-collapse-financial-crisis-pushed-democrats-to-left.html.
[12] Victoria Guida, Trump’s Regulators Deliver New Victory for Banks, POLITICO (May 30, 2018), https://www.politico.com/story/2018/05/30/trump-bank-regulations-volcker-rule-577718.
[13] Id.
