Dodd Frank Act Essay

INTRODUCTION

The Dodd-Frank Wall Street Reform and Consumer Protection Act was a direct response to the global financial crisis of 2008 and was put into effect on July 21st, 2010. The main purpose of the act was to reduce risk in the financial system to prevent a future financial crisis. In order to understand the Dodd-Frank Act and its effects, it is important to identify some of the key components behind the financial crisis. As such, a brief synopsis of the crisis will be given before delving into the implementation and effects of the Dodd-Frank Act. The key provisions to be focused on will be systemic risk regulation, the Volcker rule, and regulation of financial instruments.

BRIEF SYNOPSIS OF THE FINANCIAL CRISIS

Prior to the financial

crisis, the housing market was growing rapidly and home prices were rising constantly. As seen to the right in the information sourced from the National Association of Realtors, the sales of existing homes were strong and the overall market sentiment was that there would always be an increase in housing demand. (Lombra, 3) At the root of this phenomena was pressure from the government, as seen under the Clinton administration, “to increase lending to minorities and low-income home buyers–a policy that necessarily entailed higher risks.” (Wallison) This led to an overall decrease in underwriting and lending standards setting the stage for the crisis that ensued.
The cycle towards the crisis begins with homeowners who are buying homes and therefore obtaining a mortgage on their home from lenders. From here investment bankers will purchase these mortgages and securitize them into MBS products (Mortgage-Back Securities) as a CDO (Collateralized Debt Obligations). These CDOs are made of different tranches based on risk levels, which are respectively rated by the Credit Rating Agencies, Moody’s, S&P, and Fitch. After this process is done these banks will then sell these CDO’s to a wide array of investors.
As this process continued and demand grew, banks began to increase their leverage and exposure to this market and began securitizing sub-prime mortgages. These sub-prime mortgages were supplied through predatory lending practices targeting homeowners with little credit history and little to no down payment. A major issue was that many of these CDO’s were rated with misleading risk assessments. Many people referred to the continued growth in the housing market and thought they were safe investment grade products when in reality they were non-investment grade speculative products. While many investors assumed that a few defaults would occur they felt confident that with a strong housing market one could simply foreclose and sell the homes that were defaulted on.
As the housing market continued to grow in this fashion with sub-prime mortgages a bubble in the market began to form. As this bubble grew more of these CDO’s were made up of extremely risky mortgages and finally the bubble popped. As seen below, home sales began to fall and the overall housing markets declined. (Lombra, 6) Mass defaults followed and many investors, pension funds, and other institutions were left holding toxic assets.
This decline was further exacerbated through the use of OTC derivatives more specifically CDSs (Credit-Default Swaps).

These financial instruments were originally used as products to insure the CDO’s they were based off of, however over time they were also used to speculate and bet against the health of the CDO’s. One of the largest suppliers of these products was AIG who faced severe issues as homeowners began to default. As many banks were left with these potentially worthless CDO’s backed by homes whose prices were collapsing, it was not long before these financial institutions were no longer at liberty of supplying credit to the public. Credit markets froze up, the financial system began to decline, and given the financial systems integration into the rest of the economy both domestically and abroad, much of the world economy began to

falter.
While this is an overly simplified version of the crash it serves as a backdrop to the reasoning and implementation of the Dodd-Frank Act by the regulators to mitigate risk in the financial system.

IMPLEMENTATION & EFFECTS

The Dodd-Frank Act contains numerous items that have continued to affect the finance industry since it was put into effect.

That said the overarching objective of the act continues to be to reduce risk in the financial industry, and subsequently reduce the risk posed by “too big to fail” institutions to the rest of the economy. This focus will be the key provisions of the Act, the reasoning behind said provisions, their implementation, and the subsequent impact on the industry. In order to analyze the direct effects Dodd-Frank had on the industry, Goldman Sachs will be used as an illustration of the industry before and after Dodd-Frank. The key provisions in focus are: Systemic risk regulation, The Volcker Rule, Regulation of financial instruments (Securitization and

Derivatives)

SYSTEMIC RISK REGULATION

In regards to systemic risk regulation, the Financial Stability Oversight Council was formed in order “to serve as an early warning system identifying risks in firms and market activities.” The FSOC was further empowered to identify “systemically important companies.” (Guynn, Randall, Davis Polk, and Wardwell LLP) This power was granted to the FSOC following the threat certain financial firms posed to the overall economy, in that their collapse would lead to a ripple effect strong enough to trigger an industry or economic collapse. These companies as stated in the Dodd-Frank Act can include both bank and non-bank financial institutions commonly deemed as “too big to fail” by the media.
These systemically important non-bank and bank holding companies with assets greater than or equal to $50 billion are subject to certain standards ranging from capital requirements, leverage limits, and liquidity requirements. (Morrison & Foerster, 24) These capital requirements ensure that a firm has the necessary financial capital to deal with adverse conditions in the market. Additionally, the leverage limits and the need for these companies to maintain a debt-to-equity ratio less than x15 ensures that a firm does not possess too much debt and is not so far leveraged as to be exposed to the volatile market conditions that can occur during an economic collapse. (Morrison & Foerster, 24)
In order to incentivize firms to maintain strong financial positions, they are required to carry out annual stress tests as well as internal stress tests and submit them to the Federal Reserve. The results of these tests not only give the public confidence once they are published, but are also important to shareholders as a failure of these tests does not allow the firm to increase the money they will return to their investors through dividends. (Tracy) These stress tests align regulator and firm incentives to maintain safe levels of risk. This effect was seen in mid-June of 2016 when many of the large banks “dialed up buyback plans and dividends” following a successful run of stress tests. (Marino)

The effects of systemic risk regulation can be seen through several factors including the decrease in overall leverage ratios and debt-to-equity ratios in the industry from before to after the crisis. This is exemplified from financial ratios obtained from Goldman Sachs’ 10K’s and Annual Reports. (Goldman Sachs, 2007 & 2017)