Impact of the Dodd Financial Reform Act

My friends, it’s difficult if not impossible to judge the total impact of a piece of legislation that is over 2,000 pages long. In fact, I think it’s fair to say that no one fully understands the both intended and unintended consequences of legislation that is so enormous. I have read many parts of the bill and therefore have some semblance of an understanding of what it means, but I, by no means, would claim to have a full and complete understanding of all that is in there.

This much can be said I think, the direct outcomes of the bill have four major impacts:

1. Additional charges will be put upon issuers of credit
2. Additional regulations will be put upon issuers of credit
3. Additional regulations will be put upon Broker Dealers and Registered Investment Advisors
4. Large financial institutions will be more politically sensitive in their business dealings

Let me try to explain each one of these as directly as I can. Again, please try to keep in mind, that I do try to stay non-political, but economics are economics,

First, additional charges will be put upon issuers of credit. This is being done to finance the bill and is in the form of surcharges and fees placed on credit issuers. These fees are used to pay for several new Federal Agencies including: the Bureau of Consumer Financial Protection (CFPB), and a powerful Financial Stability Oversight Council (FSOC), made up of nine existing agencies, with power to “draft” financial institutions into a regulatory structure. Let me be crystal clear on this fundamental point, and it is a point I hope all Steve Beaman Community members will learn, and take to heart. Corporations do NOT pay income tax, fees or surcharges. In an accounting world where things don’t always appear as they are, it looks like they do. But let me explain. All corporations who rely on private capital to grow, share this economic reality. They must earn a profit or they won’t exist. Period!

Now, with that fundamental and basic understanding, do you as a rational and intelligent person think that a corporation, formed and funded by shareholders out to make a competitive profit, will cut their earnings to pay for the fees associated with this legislation? The answer is no. Those fee’s, like all costs involved in creating and sustaining a corporation, are ultimately passed on to the customers in the form of higher prices. And this legislation, I will bet, is no different. Look for fees to go up on all things financial.

In this legislation, a large loophole is that the Community Banks are exempted from this legislation I believe and therefore, will have a slight cost advantage over the national and larger banks. I’m not sure at this time about Credit Unions, but I’ll keep checking

The second thing that will occur is that more stringent lending guidelines will be in place. First out the door, the No Documentation loans that became so prevalent in the 2000’s. Now most of us will say to that “Good, they shouldn’t exist anyway”. But let’s remember why these were created. In order to incentivize lenders to offer loans to “all Americans” under the Community Reinvestment Act and other Fair Housing Initiatives, Congress procedurally mandated that lenders come up with a way to loan otherwise non-credit worthy customers money to buy houses. Part of this arrangement was that those loans could be guaranteed by Fannie Mae and Freddie Mac, the two huge government sponsored enterprises (or GSE’s). It is important to note that both Fannie Mae and Freddie Mac are EXEMPTED from this legislation. The bottom line, look for it to continue being difficult to secure a home mortgage, especially if that loan falls out of the guidelines of the Federal Government Fannie Mae and Freddie Mac organizations.

The third thing is that this creates government oversight bureaus and additional regulation for broker-dealers and Registered Investment Advisors. Look, like you, I disdain the Bernie Maddoff’s of the world, and I agree that advisors and brokers who cheat their clients should be put behind bars for a long time. But, I believe the unintended consequence of this portion of the legislation is that it won’t offer additional protection for investors, but it will increase the cost and complexity of owning a financial services firm. Therefore, fewer small investment advisors will be able to survive, and fewer will be formed. This will create additional marketing power within the major brokers (see Goldman Sachs, Morgan Stanley and Merrill Lynch). The Consumer Protections offered by this legislation are very difficult to specify at this time as the bill gives 30 months for the development of the consumer protection boards.

The fourth and final impact of the bill is that large financial institutions will become much more politically savvy (as if they’re not already, duh). The reason is that this bill give the pre-emptive ability to the federal government to shut down a large organization before it enters bankruptcy. This sounds good, and frankly, might serve to mitigate some of the problems like we had in 2008 with Lehman. However, the contra side of this is we just made the Federal Government the arbiter of which firms are preemptively worked out, and which enter bankruptcy. The problem with this was displayed in 2008. The Feds bailed out Bear Stearns and arranged a shotgun marriage with JP Morgan. The feds then didn’t bail out Lehman much to their surprise. This arbitrary decision process could then do two things, first incent more risk because large institutions can be assured they’re bailed out, but that ties to the second, only if they’re very politically connected. This part is a mixed bag. None of us wants to see the type of melt-down we saw in 2008. But honestly, I believe a much better way to have protected against that was simply to re-install the Glass-Steagel act that had been in place since the Depression until the late 1990’s. This act separated investment banking activities like trading from the commercial banking activities like taking deposits. In short, banks that took your money and were guaranteed by the FDIC weren’t allowed to participate in the much more risky business of financial trading. And trading firms weren’t allowed to participate in banking. As a result, the Trading firms wouldn’t have had access to the capital and thus the leverage that they had in the 2000’s which led in part, to the meltdown.

I’ll keep an eye on this and report to you as things become clearer. But for today, I’m Steve Beaman and thanks for listening.