by John F. McDonaldRoosevelt University Professor
One year has passed since the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Implementation of the law has proceeded slowly, but that is OK, because financial institutions are operating under a yellow caution flag, particularly when it comes to real estate lending.
Recently, Thomas Hoenig, president of the Kansas City Federal Reserve Bank, has been making news by proposing some regulations that are more stringent than those in Dodd-Frank because he does not think the law effectively addresses the issue of financial institutions deemed "too big to fail."
He proposes a return to the strict separation of commercial banking and investment banking that existed under the Glass-Steagall Act from 1933 until 1999 and further reforms of the conditions under which investment banks operate. Commercial banks, those whose depositors are protected by federal deposit insurance, would be prohibited from trading in financial assets. The Volcker Rule adopted in Dodd-Frank permits trading for bank customers, but Hoenig argues that rule is too easy to "game," and allows risky proprietary trading on the bank's own account.
Investment banks are not covered by government deposit guarantees, but Hoenig recognizes that the instability of these institutions (Bear Stearns, Lehman, et al.) was caused by their use of very short-term funding, even overnight loans, to undertake long-term investments. An investment bank that relies on overnight loans to buy mortgage-backed securities, for example, can find itself insolvent very quickly if a lender gets worried and refuses to "roll over" such short-term loans.
One change Hoenig recommends is elimination of the special status of repurchase agreement lenders under the bankruptcy law — they get paid back before other creditors — to reduce this type of short-term borrowing by investment banks.
Dodd-Frank includes many provisions, from the creation of a Financial Stability Oversight Council and an Orderly Liquidation Authority to regulated trading of complex instruments such as credit default swaps, detailed regulations for home mortgages and consumer protection.
But neither Dodd-Frank nor Hoenig addresses the future status of mortgage giants Fannie Mae and Freddie Mac. These government-sponsored enterprises were placed in conservatorship by the Treasury in 2008, and since then they have provided the insurance backing for the vast majority of new home mortgages. Nearly all experts agree that the roles of these agencies should be reduced significantly and the home mortgage market turned over to the private sector.
And some new set of financial regulations will be needed for the next boom and bust.
As the late economist Hyman Minksy argued, credit expands with an upswing in the economy, and lenders and borrowers will figure out how to evade financial regulations to increase leverage — and risk — in the process. Financial actors were especially creative from 2001 to 2007. The report of the Financial Crisis Inquiry Commission, established in May 2009 to examine the cause of the global financial crisis, does a good job of telling the story, but it was criticized for failing to determine which of the many possible causes were the biggest factors.
Dodd-Frank, and Hoenig's suggested revisions, on the other hand, have been formulated without solid research, which is under way.
Meanwhile, the economic slump continues. The unemployment rate is 9.2 percent. Does anyone know how to create jobs? It seems that no one inside the Washington Beltway knows, nor does the current crop of presidential candidates.
Many economists argue that preconditions for job growth include, along with effective financial regulations, stimulation of aggregate demand (fixing the nation's infrastructure) in the short run and putting the federal budget on a sound footing in the long run by reforming the federal tax system and revising entitlement programs — Social Security and Medicare.
Will that happen?
John F. McDonald is the Gerald W. Fogelson Distinguished Chair in Real Estate at Roosevelt University. He teaches a course in real estate and the financial crisis.
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Copyright © 2011, Chicago Tribune
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