Happy Birthday, Dodd-Frank

In the absence of smarter bankers, regulation will have to do.

Obama signing the Dodd-Frank financial reform legislation in 2010

Poor Dodd-Frank. How would you like to celebrate your first birthday like this? A year after the financial reform legislation was signed into law, Republicans are inveighing against it, introducing bills to abolish or weaken it, and trying to starve the regulators that are supposed to implement it. Wall Street is pouring money into lobbying against it. Liberals worry that Dodd-Frank is already dead, and while that might be overstating the facts, the argument that too much regulation might stifle the weak recovery is gaining ground.

Right now, the only thing you can be sure of about Dodd-Frank is that it will have unintended consequences. But the status quo was not an option. The subprime crisis laid bare some ugly truths about the banks and showed that some of our fundamental assumptions about the way the world worked were wrong.

One reason we had a crisis in the first place was because modern bankers were willing to sell any product, no matter how shoddy, to anyone who would buy it.  Whether it was Countrywide selling terribly flawed mortgages to people who could never pay the money back, or Goldman Sachs creating money-losing securities to sell to clients in order to decrease its own risk, almost every financial institution performed some variation of the same bait and switch.

There’s little reason to believe that this mindset has changed. (At least Rupert Murdoch said he’s sorry!) Banks still take a cavalier approach to foreclosures, one that shows little respect for their customers. The bankers say that homeowners and investors should take their lumps for purchasing shoddy products. And in an ideal world, people would better understand the financial products they buy. But they can’t or don’t, and the bankers don’t want to assume any responsibility for the quality of the products they sell. I believe that government regulations like those that the controversial new Consumer Financial Protection Bureau may hand down are a poor substitute for bankers choosing on their own to behave ethically and responsibly, and for consumers digging into the details on products that sound too good to be true. But let’s get serious. Bankers aren’t going to change their behavior, and consumers aren’t all of a sudden going to become educated and savvy. (Especially in the face of a deluge of advertising, like that we saw at the height of the mortgage boom, which urged consumers to cash out the equity in their homes.) Unfortunately, regulation is the only tool left.

It isn’t just that bankers don’t know how to treat customers responsibly; they don’t know how to manage their own firms responsibly. Until 2008 bankers and regulators—chief among them, former Federal Reserve chairman Alan Greenspan—thought that bankers wouldn’t behave recklessly because it wasn’t in their interest to do so. We know now that wasn’t true. All the big banks would have blown themselves up, along with their customers, had the government not intervened. Even Greenspan had a brief moment of contrition, telling Congress in 2008 that “those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” Donald Kohn, a former Fed vice chairman, recently told British lawmakers that he no longer believed bankers’ self-interest would keep markets safe: “I placed too much confidence in the ability of the private market participants to police themselves.”

One part of the problem is that in these days of publicly-traded banks and brokerages, the interest of the bankers and the interests of the banks’ stockholders aren’t always the same. If an executive can pocket tens of millions in cash compensation in the short term, he will fret a bit less about the future of his firm, or even the money he might still have tied up in it. Dodd-Frank contains some provisions that attempt to better align compensation with a bank’s long- term performance, such as the ability to “clawback” executive compensation that’s based on improper financial statements. These reforms may not work, but they’re well worth trying.

Another, more intractable problem is that financiers, though paid as if their brilliance rivalled Einstein’s, often aren’t, um, terribly bright. If I had to choose between malevolence and foolishness as a chief cause of the crisis, I’d probably pick foolishness. (The great title of Kurt Eichenwald’s book about Enron, Conspiracy of Fools, could apply to the financial crisis as well.) Case in point: Chuck Prince, the former CEO of Citigroup, almost destroyed Citigroup by piling bad mortgage-backed securities onto the balance sheet. That wasn’t a very Einsteinian thing to do. And all it takes is one prominent banker to jump off the cliff while chasing profits to get the others to jump off too. Dodd-Frank relies on regulators to be smarter than the banks—the new Financial Stability Oversight Council is supposed to sleuth out systemic risk before it becomes apparent. Historically, most bank regulators have taken their cues from bankers. That’s going to be hard to change. But again, we have to try.

Today’s loudest argument against Dodd-Frank is that it will make banks less competitive, and that customers will pay the price for that. This is an old argument. Through the last few decades it has been used to fend off oversight of derivatives and tightening of mortgage standards, and it has been used to argue for weaker capital requirements. Maybe this time government’s heavy hand really will stifle competition. But when competition seems so often to mean a race to the bottom, maybe the only option is for the government to stifle it a bit. In the fall of 2009 John Mack, the former CEO of Morgan Stanley, made an offhand stop-me-before-I-kill-again-type remark at a panel discussion hosted by Vanity Fair. (I was there.) I can’t recall the particulars, but he talked about almost doing a ridiculous deal, only to have someone else swoop in and offer an even more ridiculous deal. “We cannot control ourselves,” Dealbreaker reported Mack saying. “You have to step in and control the Street.”

Despite the return to big profits and big bonuses at the largest banks—and their repayment of the funds from the Troubled Asset Relief Program, which is now projected to produce a profit—it isn’t clear the banks’ crisis is over. Recently, Treasury Secretary Tim Geithner said that the financial sector was “on more solid ground” than at any time before 2008. That isn’t saying much. There’s a lot of worry about what a financial conflagration in Europe would mean for U.S. banks. There’s also worry about the banks’ immense books of home-equity loans. These should be worthless if the first mortgages on those homes are in trouble. The banks haven’t taken big writedowns, and the New York Times recently reported that the Securities and Exchange Commission is questioning how banks are valuing these loans.

The banks say that they’ve got Europe under control, and that they’ve valued their books of second-lien mortgages appropriately. I’d like to believe them, but I remember when they said their exposure to subprime mortgages was perfectly manageable. Bank stocks certainly aren’t trading like everything is under control. Bank of America, for instance, sells for a huge discount to book value, a signal that investors don’t trust its accounts.

So if you happen to hear some banker or congressman ranting that Dodd-Frank will destroy capitalism as we know it, ask what exactly he or she proposes to do instead. Maybe you’ll hear a better idea. But I sure haven’t.