On July 21, 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank for short) was signed into law by President Barack Obama following an economic crisis that required a $700 billion bailout of the financial services industry. The 848-page legislation put forward sweeping regulatory reforms for the financial services industry that affected everything from mortgages to securities to how the government handles insolvent banks or insurance companies. Not only that, it also directed new and existing federal agencies to write thousands of pages of new regulations for the financial sector.
Why was it needed?
With banks closing and the economy plummeting in the wake of the 2008 financial crisis, Congress wanted to do something to not just fix the problem, but prevent it from happening again.
The story of the financial crisis that triggered what’s become known as the Great Recession begins with subprime mortgages. Subprime mortgages are made to borrowers who may have a poor credit score or can’t make a 20 percent down payment on their home, and as economic conditions worsened more of these borrowers couldn’t pay and started to default. This not only negatively impacted the banks that made the loans initially, but it also hurt the banks that invested in mortgage-backed securities (basically a bundle of mortgages, some of which were subprime), which lost value as defaults mounted.
While banks were losing money due to subprime mortgages and mortgage-backed securities, insurance companies were losing money due to what are known as credit default swaps.A credit default swap is essentially insurance for banks that buy securities; it protects them in case the security they’re buying isn’t stable and its issuer goes into default. Banks had invested in these to hedge against the declining value of mortgage-backed securities, so insurance companies were also destabilized by the crisis.
The insolvency of several banks and insurance companies (plus General Motors and several federal housing agencies) prompted a $700 billion federal bailout, which advocates claimed was needed to prevent a catastrophic failure of the financial system. The thinking was that those institutions were “too big to fail” and if they did, it would ripple through the financial sector and the U.S. economy as a whole. As a result, there was outcry for increased regulations on the financial sector to prevent this kind of madness from happening again.
What did it do?
Initially proposed by President Obama in June 2009, Congress considered several similar bills before settling on the version that became the Dodd-Frank Act (named after then-Rep. Barney Frank (D-MA) and then-Sen. Chris Dodd (D-CT)). While Dodd-Frank ultimately passed both chambers of Congress, it did so on party line votes — 237-192 in the House and 60-39 in the Senate, with only three Republicans in each chamber voting in favor.
As mentioned previously, Dodd-Frank was a huge piece of legislation that covered nearly every aspect of the financial sector. But it did focus in particular on several areas, including:
- Addressing financial instability and liquidating failed banks and insurance companies;
- Regulatory protections for investors;
- Mortgage reforms aimed at reducing abusive lending practices.
In order to reduce the threat “too big to fail” institutions posed to the economy, Dodd-Frank created a Financial Stability Oversight Council that could vote to designate financial services companies as being “systemically important” and subject them to additional oversight. It also clarified that the Federal Deposit Insurance Corporation (FDIC) would be responsible for liquidating failed banks, but that the Securities and Exchange Commission (SEC) would assist in handling investment banks, while the Federal Insurance Office would handle the insurance companies. The Federal Reserve could also put any qualified financial institution through liquidation.
Also included in the legislation was the Volcker Rule, which prohibits commercial banks (like those where you’d open a checking or savings account) from engaging in speculative, and potentially risky, investments that aren’t beneficial to their customers.
Dodd-Frank increased regulations on asset-backed securities (which are backed by mortgages, receivables from credit cards, etc.) like those that triggered the financial crisis. The law required banks to shoulder five percent of their credit risk and also established risk retention requirements for mortgage lenders. These provisions were aimed at deterring lenders from lowering their lending standards and signing off on risky loans that may not be repaid. It also created the Consumer Financial Protection Bureau (CFPB), which regulates consumer financial products and services and offers advice and assistance to consumers.
It also included provisions requiring mortgage lenders to abide by minimum standards for “qualified mortgages” — which are defined as loans that don’t increase the principal balance of the loan or involve points and fees exceeding 3 percent of the loan amount. Dodd-Frank also placed restrictions on how bankers are compensated for originating loans and requires them to verify a borrower’s ability to repay. If a lender fails to check on that, or the mortgage has more than 3 percent fees or other exploitative terms, a borrower can use that as a defense in foreclosure proceedings.
Dodd-Frank called on federal agencies to write some regulations on their own, in addition to the provisions of the legislation passed by Congress. As a result, those agencies have issued 631 regulatory releases according to the law firm DavisPolk, and those agencies have also published nearly 22,300 pages of rules in the Federal Register (over 13,000 of which were final rules) and none of which were approved by Congress.
Did it work?
That depends on who you ask. Dodd-Frank has remained controversial since its passage, as evidenced by Republicans trying to roll it back and Democrats offering a spirited defense of the law’s efforts to punish financial services companies for their wrongs.
Among the critiques levelled at Dodd-Frank are that its regulations have prevented banks from lending as much as they would have otherwise, which has impeded economic growth. Opponents of the law also cite rules aimed at larger firms that are instead making compliance difficult for smaller community banks.
Others insist that Dodd-Frank didn’t go far enough, believing that it should have broken up “too big to fail” banks. Critics also point to the fact that Dodd-Frank did nothing to deal with Fannie Mae and Freddie Mac — two government-sponsored entities that create and sell mortgage-backed securities. They received $116 and $71.3 billion, respectively, in a bailout of their own which hasn’t yet been repaid.
Advocates for Dodd-Frank believe that, while imperfect, the safeguards put in place by the legislation have helped to stabilize financial markets and prevent the sort of excessive risk taking that caused the financial crisis. They claim that it allowed trading in asset-backed securities and other derivatives to be brought under control while ensuring that borrowers are able to repay their mortgage loans.
Whatever your opinion about Dodd-Frank, it will likely remain a political flashpoint for the foreseeable future. A bipartisan overhaul of its community bank rules was signed into law in May 2018 by President Donald Trump — and further reforms may be in store.
― Eric Revell
(Photo Credit: Leader Nancy Pelosi via Flickr / Public Domain)
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