Dodd-Frank: Regulation as necessary evil.

Commentary about business and finance.
July 22 2011 11:21 AM

Happy Birthday, Dodd-Frank

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

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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."

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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.

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