Reforming the financial services industry: Dodd-Frank would bring back commonsense lending rules

The financial reform bill — formally, the Dodd-Frank Wall Street Reform and Consumer Protection Act — marks a sea change in how our nation views and implements oversight of financial providers. In many ways, it’s a return to the commonsense lending rules that built a thriving financial system respected throughout the world. That would be a welcome change from the economic turmoil of the last three years.

The deregulation of the last three decades was supposed to make financial services more efficient, not riskier and with taxpayers on the hook. But that’s what happened. Rules limiting the gambling lenders could do using taxpayer-insured deposits were abolished. Traditional consumer protections, such as limits on mortgage fees and prepayment penalties, were preempted and repealed. Lenders and Wall Street dealers with little accountability paid themselves handsomely for reckless behavior.

The resulting proliferation of bad financial policies and products was inevitable: credit cards rife with tricks and traps; payday storefronts that outnumber McDonald's; sky-high overdraft fees; and bad subprime mortgages that sparked the current recession. Consumers, who account for every $7 of every $10 spent in the economy, were crippled, as were the overall economy and all its other non-financial businesses. But so too were the lenders themselves, who discovered being allowed to drive drunk without fear of reprisal was in no one’s best interest, least of all their own.

This legislation provides an opportunity to restore safety and fair rules. It applies to nearly all financial products and services, from derivatives to investment advisers and hedge funds; and it establishes a new Consumer Financial Protection Bureau. A common theme throughout the bill is that transparency is essential for a healthy, free market. Another is that incentives must be aligned so that financial firms compete by providing value to customers rather than by catching them with deceptions and tricks.

The bill re-establishes basic rules for consumer mortgages, the financial product that triggered the crisis. It would require lenders to determine that a borrower can afford a mortgage, including any payment increases. It would limit upfront fees that strip home equity from home buyers and curb prepayment penalties that lock homeowners into bad loans. It would bar lenders from paying mortgage brokers and loan officers to steer consumers to loans more expensive than what they qualify for. And when lenders sell a riskier loan to an investor, they would have keep what economists call “skin in the game” by retaining some financial liability if the loan fails. Lenders, in short, would have incentives to make money by providing sustainable home loans that perform well.

These reforms also would benefit responsible lenders, who no longer would have to compete against those who push unscrupulous products. And, it benefits the economy as a whole as consumers build wealth that increases their personal financial stability.

Reckless home mortgage triggered the financial downturn, but derivatives amplified it. Operating in unregulated, secret markets, derivatives have exploded over the last two decades, both in complexity and volume. Even today, after these devices brought down AIG and led to the biggest bailout in U.S. history, no one has an overall picture of who holds the estimated $600 trillion in derivatives now outstanding. Such obscurity enriches the handful of big Wall Street banks who arrange these deals, while those who purchase them, including manufacturers, farmers and municipalities, too often end up on the losing end of a rigged game. The new legislation would require most derivatives to be traded and cleared on open exchanges, ensuring both price transparency and that the industry itself back up its bets instead of relying on taxpayers. These changes would once again make derivatives a valuable tool for managing volatility and other risks.

Another cornerstone of the legislation would be the creation of the Consumer Financial Protection Bureau and of a systemic risk council. The bureau would have the authority to prevent credit card companies and other lenders from inventing new ways to skirt rules of fairness. The council would be charged with watching out for the stability of the overall financial system, not just banks.

Taken together, the bill’s provisions mark a milestone in the search for the right balance of oversight and deregulation in our financial markets. Like most laws, it reflects the compromises and limitations endemic to the legislative process in a democracy. And it will require vigilance to ensure regulators use their newly granted authorities wisely. Even so, it still would provide the critical structure and tools needed to redirect the financial industry so that it once again supports, rather than hinders, the growth of our individual and national wealth.

Michael Calhoun is the president of the Center for Responsible Lending, a nonprofit, nonpartisan research and policy organization focused on financial services.