Why Dodd-Frank won’t prevent another financial crisis

Too Convoluted to Succeed

by Nicole Gelinas

Five years ago this September, the Lehman Brothers investment bank collapsed. Markets around the world froze until Western governments devised a massive bailout plan that kept investors from pulling trillions out of the global financial system and precipitating a worldwide depression.

The financial crisis helped propel Barack Obama to the presidency. In his inaugural address, Obama said that the crisis was a reminder that “without a watchful eye, the market can spin out of control.” 

After the February 2009 stimulus law and the March 2010 “Obamacare” health-insurance overhaul, the Dodd-Frank financial-reform act of July 2010—meant to sharpen the vision of that “watchful eye”—became Obama’s third signature legislative victory. 

“The American people will never again be asked to foot the bill for Wall Street’s mistakes,” Obama said as he signed the bill into law. “There will be no more tax-funded bailouts—period.” 

To applause, he added that “there will be new rules to make clear that no firm is somehow protected because it is ‘too big to fail.’ ”
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Piles of books have tried to explain why Wall Street collapsed in 2008 (see “Surveying the Wreckage,” Summer 2010), but most agree on a few fundamental causes. 

• First, American policy encouraged borrowers and lenders to pump too much money into housing—distorting the economy, inflating a bubble, and leaving borrowers (small homeowners) as well as lenders (large financial institutions and investors) vulnerable to a sudden downturn. 
• Second, banks and other financial firms borrowed far too much money relative to capital—that is, to the non-borrowed money that they had on hand to help absorb any unexpected losses. And they could do this partly because they used structured financing. Through securitization, for example, financial firms could take lots of loans and structure them into bonds, which they maintained were safer than the individual loans because some bond investors agreed to take losses before other bond investors would. Because the banks had supposedly transformed risky bets into safe ventures, they didn’t need to hold much capital, regulators believed—after all, the chance of incurring losses was minimal to nonexistent.
• Third, and relatedly, financial firms could circumvent open, transparent markets by using new types of financial instruments to take enormous bets with little or no capital down. They could do this largely because a 2000 law had prohibited regulators from imposing capital and transparency requirements on new derivatives, or “swaps,” markets—a dangerous gap, especially since regulators limited borrowing in nearly all other securities and derivatives markets.
• Last, and perhaps most important, financial institutions and their investors assumed—correctly—that the government would save them in any crisis. 

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