How The Dodd-Frank Act Has Failed To Keep Us Safe

©ValueWalk

Banks haven’t learned their lesson. Dodd-Frank act has failed to keep the system in check.

Q2 2020 hedge fund letters, conferences and more

Ten years ago last month, Congress took a step toward reining in pieces of a troubled financial system when it passed the Dodd-Frank Act. The move was touted as the end of an era when banks could get away with betting on complicated financial instruments that threatened the global economy. New evidence indicates that Dodd-Frank has failed to keep us safe.

The Dodd-Frank Act May Not Be Enough To Prevent The Next Crisis

A Pew poll in April found that just 23 percent of Americans rate the country's economic conditions as excellent or good. No doubt the Covid-19 pandemic has laid bare this insecurity and stoked fear. We've all seen the damage coronavirus has caused to supply chains, unemployment, and small businesses. The Dodd-Frank Wall Street Reform and Consumer Protection Act was likely the last thing on respondents' minds as they took the survey. But a combination of Covid-19 and weak provisions within the legislation could now create an even bigger crisis than the one we saw in 2008.

Here's how.

Almost everyone remembers that high-risk loans, speculation and leverage fueled the run-up to the Global Financial Crisis. As the financial sector began to collapse in mid-September 2008, the aggregate default and the trading of sub-prime mortgages in the form of collateralized debt obligations (CDOs) was a major liability. Banks bought and sold CDOs of all types and even made speculative bets on their value. It all fell apart when the housing crisis triggered a wave of defaults. Many CDOs turned out to be worthless. Credit markets froze and the financial system shuddered under the weight of the calamity.

Dodd-Frank Act Fails To Prevent Next Crash

Congress passed the Dodd-Frank Act two years later in order to prevent the next crisis. Under the new rules, banks were forced to undergo stress tests, keep more capital on hand and make fewer risky bets. CDOs lost their luster. In their wake, a new financial product, the collateralized loan obligation, or CLO, became the new must-have investment for the banking sector. CLOs are made up of loans to troubled businesses, so-called leveraged loans.

As Frank Partnoy puts it, leveraged loans are "the subprime mortgages of the corporate world." They are made to companies that have "maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan." Of the more than $1 trillion worth of leveraged loans currently outstanding, the majority are held in CLOs. (“The Looming Bank Collapse,” The Atlantic, July/August 2020)

Will CLOs Trigger The Next Market Crisis?

Enter Covid-19. As small businesses face a looming apocalypse from a drop-off in demand, it could be simply a matter of time before those leveraged loans that make up CLOs start to default. Some estimates show the CLO market to be larger than the sub-prime market in its heyday. It's easy to picture a scenario like, or worse than, 2008, especially considering changes the Dodd-Frank Act put into place.

What kind of changes? Although the Federal Reserve has announced that CLOs can receive bailout money as part of its response to the pandemic, Dodd-Frank explicitly limits the Fed's ability to help specific companies as outlined under Section 13(3) of the Federal Reserve Act. Imagine a bank with a large portfolio of CLOs needs a bailout. It could collapse. Others could start to fall like dominoes without some sort of emergency suspension of the Dodd-Frank rules. It's anybody's guess how likely that is in today's dysfunctional Washington.

CLO warning signs?

Dodd-Frank was an attempt to move us closer to correcting the excesses of a banking sector still desperately in need of reform. Clearly, we're not there yet. We may be even closer to a reckoning that dwarfs the one we saw in 2008, triggered by a pandemic-driven wave of corporate defaults.

One of the biggest reasons we still sit on the precipice of crisis a decade after Dodd-Frank is that risks aren't properly assessed. Policymakers and regulators seem to be asleep at the wheel. Risk-sharing is an alien idea in a reckless industry that seems more at home in Las Vegas than on Wall Street. The notion of big banks getting their comeuppance is inconceivable to a society that grants immunity to a financial sector that has not learned the lessons of the last crisis.

We ignore this at our economy's peril.


About the Author

Joshua Brockwell is the director of investment communications at Azzad Asset Management, a registered investment advisor in Falls Church, Virginia.