Introduction

12 Years Later, Dodd-Frank Tested

12 Years Later, Dodd-Frank Tested

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No one could have predicted that a decade of expansion and employment growth would be wiped out in a matter of weeks. Yet, based on the record number of unemployment filings last week (3.28 million), that is exactly what's happened.

To put the new number in perspective: 3.28 million is 3 million higher than the previous week and 5 times higher than the previous record high (695,000 in October 1982) 38 years ago. There is something else in desperate need of some perspective. The situation we are currently in is not like what we experienced 12 years ago, although they do have some things in common.

As was the case in 2008, we are almost certainly going to discover that we are in the first quarter of a recession. By definition, a recession is a decline in the country's GDP for two or more consecutive quarters. Even with all the tools the U.S. government and the Federal Reserve have at their disposal, we don't see any way of avoiding another.

The other similarity is that during both crises, the Federal Reserve and the Treasury flooded the economy with liquid assets to help keep things running, maybe not as smoothly as they would like, but running nonetheless.

After a short twelve years, those commonalities are putting fear into the minds of some, that we are doomed to repeat 2008. But, for better or worse, this is a very different situation.

For one thing, our nation's bank and credit union industries are in the best shape most of us have seen in our lifetimes. Over 90% of banks and 80% of credit unions are currently rated either 5 or 4-Stars by Bauer. Fewer than 2% are rated 2-Stars or below. That's a sharp contrast to the numbers in 2008, but that's not all.

Twelve years ago, there were some unscrupulous bankers and mortgage brokers (most of which no longer exist i.e. Countrywide) trying to game the system. Home buyers were led to believe they could afford more home than they actually could. The mortgage brokers involved didn't care as long as they got their commission. Perhaps they believed it was a victimless crime. It was anything but.

The banks involved should have known better but as long as they could bundle the mortgages into securities and sell them, they were not risking anything, so they thought. But where is Countrywide today?

The mortgage loans artificially inflated real estate prices and created a bubble. When that bubble popped, we all paid a price. Thousands of people lost their homes and hundreds of banks, Countrywide included, failed.

The Dodd-Frank Act (a/k/a the Financial Stability Act of 2010) changed all of that. Certainly one of, if not the most, important pieces of legislation passed during the Obama Administration, Dodd-Frank made two major changes to how loans were made.

The first seems obvious, but in this age, common sense has to be legislated. That is the lender must make sure that the borrower has the means to repay a loan, a change of circumstances notwithstanding. At the time the loan is granted, the lender must determine that the borrower is a good risk.

We believe this to be self-evident, yet it needed to be legislated. Why? The banks were not risking anything. Once they bundled up the mortgages and sold them, they became someone else's problem. That was the second piece of the lending process that Dodd-Frank fixed. The lender is now required to keep skin in the game. That means they can still sell Mortgage Backed Securities, but not all of them. The lenders must keep at least 5% on their own books. That makes them care.

There was a third item that made a huge difference, but it didn't pertain to loans. Dodd -Frank required higher capital ratios to provide a buffer. This additional capital will be the cushion that will help financial institutions weather this crisis today.

Of course, this is the first real test we've had of the efficacy of Dodd-Frank, so we could be wrong. But from where we sit, our nation's banks, (with the exception of those listed on page 7) are as prepared as they possibly can be for what lies ahead.

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