Chipping Away at Dodd-Frank: Coming Full Circle

In 2008, the U.S. economy, and in fact, the world economy, was on the edge of a precipice. Hastened in large measure by loose lending standards, subprime mortgages and declining residential real estate values, IndyMac, the largest savings and loan in the Los Angeles market and one of the largest mortgage originators in the country, failed in July 2008. About two months later, Lehman Brothers, a major player in securitized subprime mortgage pools, followed suit. Then, like dominos, came the failures of Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual and other giants of the banking industry, and “too big to fail” became a media catch phrase. The concern that the prospect of collapse of the U.S. banking industry would crash the rest of the economy resulted in the Emergency Economic Stabilization Act of 2008, which allowed the secretary of the Treasury and the Federal Reserve to bail out financial institutions and other critical industries.

According to a report from the U.S. Senate’s Homeland Security Permanent Subcommittee on Investigations, released on April 13, 2011, the principal causes of the 2008 financial collapse were high-risk mortgage lending, regulators’ failure to stop such practices, inflated financial institution credit ratings, and investment banks’ abuse of the system through the creation and marketing of complicated, high-risk synthetic and derivative securities.

Once the dust had settled on the Great Recession and the fear of a systemic collapse of the banking system had passed, Congress and the Obama administration began to look for ways to avoid future bailouts. Proposals ranged from breaking up international financial institutions (thus eliminating “too big to fail” bailout pressure) to reinstituting the Glass-Steagall prohibitions on commercial banks engaging in investment banking activities.

Ultimately, in 2010, Congress passed, and President Obama signed into law, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Among its provisions, Dodd-Frank:

  • Creates the Consumer Financial Protection Bureau to oversee financial institutions’ consumer lending activities, including credit reporting agencies, credit and debit card issuers, and payday and consumer lenders;
  • Establishes the Financial Stability Oversight Council to monitor financial institutions, including entities that had previously been subject to little regulation such as hedge funds, and to prevent entities from becoming too big to fail;
  • Implements the Volcker Rule, which prohibits banks from using depositor funds to finance hedge fund investments;
  • Increases federal regulation of derivative security transactions and hedge funds;
  • Mandates registration and SEC oversight of credit rating agencies; and
  • Establishes the Federal Insurance Office to coordinate the largely state-based regulation of insurance companies.

The Democratic Party controlled the 111th Congress with majorities in both houses, and Dodd-Frank, like much of the 111th Congress’s other legislation, passed along party lines. Throughout the debate, and ever since, the legislation has been a target for opponents on both the left, which asserts the law does not go far enough, and the right, which has expressed concern that the legislation would reduce the competitiveness of American financial institutions and markets, driving financial firms overseas.

Even after passage, industry groups and other opponents of the legislation attempted actively to limit the law’s provisions. For example, Dodd-Frank created the Consumer Financial Protection Bureau (CFPB), which was intended to consolidate the haphazard regulatory structure of consumer finance transactions, which at the time involved the Federal Reserve, the Federal Trade Commission, the Federal Deposit Insurance Corporation, the National Credit Union Administration and the Department of Housing and Urban Development. Elizabeth Warren, who quarterbacked the CFPB provisions of the legislation, was initially considered to direct the CFPB, but Senate Republican opposition made her nomination untenable. Ultimately, the Obama administration nominated Richard Shelby, but Senate Republicans held up his confirmation for two years.

The CFPB continues to draw the ire of some opponents. At least two lawsuits have challenged the constitutionality of the CFPB. In June 2012, the Competitive Enterprise Institute, an anti-regulation think tank, a Texas bank and eleven states’ attorneys general filed a suit against the CFPB. Judge Ellen Segal Huvelle of the U.S. District Court for the District of Columbia ultimately dismissed that case for lack of standing (State Nat’l Bank of Big Spring v. Lew, 958 F.Supp.2d 127 (D.D.C. 2013)). The second lawsuit came from Morgan Drexen, Inc., a provider of outsourced paralegal-type services to attorneys collecting debts for their clients, and Kimberly Pisinski, an attorney-customer of Morgan Drexen. While under investigation by the CFPB, Morgan Drexen filed a lawsuit claiming that Dodd-Frank violated the separation of powers provisions of the U.S. Constitution. Judge Colleen Kollar-Kotelly ruled that Morgan Drexen’s arguments would be better handled in the then-pending enforcement action and that Pisinski lacked standing to pursue the claim (Morgan Drexen, Inc. v. CFPB, 979 F.Supp.2d 104 (D.D.C. 2013)).

In November 2014, Republicans effectively swept congressional elections, increasing their majority in the House of Representatives (from 54 percent to 57 percent) and wresting control of the Senate, albeit with a non-filibuster-proof 54 percent majority. Newly emboldened from their successful electoral results, the Republican leadership hammered out a joint spending bill that has begun to chip away at Dodd-Frank.

One key element in the legislative debate on Dodd-Frank was the desire to reduce U.S. taxpayers’ exposure to banks’ losses on derivatives and other risky security transactions. As initially proposed, the legislation required banks to “push out” derivative trading activities to separate entities that would not be covered by federal deposit insurance. The theory was that if banks wanted to engage in these kinds of risky investment activities, they would do so on their own dime, without the safety net of taxpayer guarantees. Ultimately, Congress tamed this “push-out rule,” concerned that such an overly restrictive constraint on U.S. banks would place them at a competitive disadvantage to overseas banks, encouraging large multinational corporations to seek banking services from non-U.S. banks.

Nonetheless, Dodd-Frank opponents and industry lobbyists continue to view the enacted provisions as too restrictive. The 2014 spending bill included a provision that rolls back some restrictions on bank transactions in derivatives. Senator Warren and others lambasted the provision as watering down the protections of Dodd-Frank. Proponents of the provision, including Representative Jim Himes of Connecticut, argue that the change only affects “plain vanilla” interest rate swaps. According to Himes, loss exposure on more exotic derivatives that may have led to the 2008 financial collapse would still be insulated from federally insured accounts.

Ultimately the tactic of including the Dodd-Frank amendment in critical, “must pass” legislation, like a spending bill, was successful. On January 17, 2015, President Obama signed the legislation. Congress followed this with another “must pass” bill, this one reauthorizing the Terrorism Risk Insurance Act, with additional provisions relaxing the derivatives restrictions. On January 12, 2015, President Obama signed the extension into law.

With these successes under their proverbial belts, Dodd-Frank opponents are eying other tweaks to the legislation. Among the proposals that some legislators and lobbyists are considering:

“Qualified” mortgage status

As previously mentioned, the 2008 financial crisis came about, in part, due to exotic, derivative security transactions. Some of the most problematic securities involved bundles of residential mortgage loans that were divided into segments called “tranches.” For example, one tranche might include the interest payments. Another tranche might include the principal payments for the first three years of the mortgages in the pool. Another tranche might include the principal payments for the next three years, and so on. With the high volume of mortgage securitizations, the mortgage originators assumed little risk of loss before transferring the debt to a pool. This structure provided an incentive for mortgage originators to focus on quantity (of loans or fees or borrowers) and not quality.

Dodd Frank’s “Ability-to-Repay” (ATR) rule requires lenders to consider a borrower’s ability to repay the loan as part of the lending approval process. In general, certain loan features that were popular before the 2008 financial crisis, such as interest-only loans, negative amortization and “no-doc” loans, are prohibited under the rule. “Qualified loans” presumptively meet the ATR rule.

The banking industry is seeking a modification of Dodd-Frank to confer “qualified mortgage” status on loans that they issue for their own portfolios (as opposed to those sold to investors). Senator Mary Landrieu initially proposed this modification in August 2014. Proponents of the change argue that if the issuer is retaining ownership of the loan, then it has presumably considered the risks associated with collection, and the mortgage should be assumed safe.

Indirect automobile financing

In September 2014, the CFPB announced an initiative that could lead to federal regulation of indirect automobile financing transactions. Automobiles can represent one of the largest purchases consumers make. While some automobile sales are made for cash, they are often financed. Some automobile financing transactions are handled “directly” with the financing entity, but most occur through an intermediary, typically the car dealer.

These “indirect automobile financing” transactions can create an opportunity for consumer manipulation. In an indirect financing transaction, the intermediary sends information about the customer to one or more financing sources. Assuming it is an acceptable credit risk, the financing source quotes a rate to the dealer. The dealer is then in a position to “mark-up” the rate in negotiating with the customer. The indirect financing transaction also creates additional sales opportunities for the intermediary: extended warranties, protection packages covering specific automobile components (such as tire replacement or rustproofing packages) and monitoring services (such as OnStar™).

With the Internet providing consumers with greater access to information about vehicle prices and dealer costs, car dealers’ margins on vehicle sales have declined. As a result, dealers are relying more and more on the profits derived from ancillary services and financing. Between 1990 and 2000, financing and insurance activities generated between 25 percent and 40 percent of dealers’ overall profits. By 2011, the profit contribution from these ancillary services was closer to 60 percent of total profits.

The CFPB issued Bulletin 2013-02 with the intention to encourage fair lending practices in the indirect automobile financing market. Representatives Martin Stutzman and Ed Perlmutter have introduced legislation that would nullify CFPB Bulletin 2013-02 and restrict its regulatory powers with regard to indirect automobile financing.

Balloon payment lending legislation

One of the predatory lending practices that Dodd-Frank sought to curtail was the use of balloon payments to artificially reduce initial monthly mortgage payments. Balloon payments were a tool that the mortgage industry used to entice customers to borrow by offering seemingly more affordable monthly payments. There are certain faults in this logic: the underwriting of the loans did not contemplate someone failing to pay it back, and it failed to address the effect of falling house prices. The loan would schedule payments, often with little or none of the payment reducing loan principal. After a relatively short period of time, usually three to seven years, the borrower faced a significantly increased monthly payment or a required refinancing of the loan. These transactions essentially relied on an expanding residential real estate market that would allow the borrower to either “flip” the property or refinance using the unrealized gain in market value to support a new loan. There are legitimate business reasons to enter into these types of loans, and if used for the right reasons, they can often be helpful.

In general, Dodd-Frank limits these kinds of lending transactions but makes an exception for certain rural communities where such loans are a necessary tool for financing agricultural properties. Senators King and Warner introduced legislation to clarify ambiguities in the rural exemption to the prohibition on balloon loans.

President Obama has vowed to protect Dodd-Frank’s essential provisions through the final two years of his administration. Despite this commitment, the Obama administration has clearly acknowledged that, like most complicated legislative endeavors, Dodd-Frank can be tweaked to improve the protections it provides for consumers and the U.S. economy while reducing the compliance burdens it places on financial institutions. Which “tweaks” will improve the statute are in the eye of the beholder.

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