Dodd-Frank makes future taxpayer bailouts more likely

Peter Wallison Arthur F. Burns Fellow in Financial Policy Studies, American Enterprise Institute
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If there is one thing the American people disliked about how their government reacted to the financial crisis, it was the bailouts of large financial firms. Obama administration officials saw this clearly, so in structuring and describing the Dodd-Frank Act — the financial reform law Congress passed in 2010 — they were careful to leave room for the claim that the act would make bailouts a thing of the past. The one thing the government couldn’t do, administration officials said, was use taxpayers’ funds to keep large financial institutions from failing.

So it must have been a surprise to Mr. Obama and his staff that on the Sunday before the election, an article by Gretchen Morgenson in The New York Times should say that the Obama claim was “wrong.” As Morgenson explains, “Dodd-Frank actually widened the federal safety net for big institutions.” What a disappointment. Obama and his team had almost made it through the election before the cat was out of the bag — and from The New York Times of all places.

The act gives a new, mandatory role to clearinghouses for derivatives and other trades. Trillions of dollars in interest rate, currency and credit default swaps — which were once cleared primarily by hundreds of banks — are now required under Dodd-Frank to be cleared through eight clearinghouses. These institutions will act, in a sense, as guarantors of the performance of the parties in hundreds of thousands of derivatives contracts. In effect, they step into the shoes of the two parties that have agreed to swap a series of payments based on changing market prices.

The Morgenson article highlights the fact that in assuming this central role in the financial markets, clearinghouses will now become central to the health of the financial system. If a clearinghouse fails, the U.S. and global economy could grind to a halt as counterparties do not receive expected payments. In other words, Dodd-Frank has added to the list of financial institutions that are too big to fail and then created a procedure for bailing them out with taxpayer funds if they fail.

The Obama administration has been saying that Dodd-Frank eliminated too-big-to-fail. If that were true, there would be no need to provide for bailouts of clearinghouses with taxpayer funds. But it was never true; that’s why the administration and the Democrats in Congress provided authority for the Financial Stability Oversight Council (FSOC) — an über-regulator consisting of all the federal financial supervisors and chaired by the treasury secretary — to designate these clearinghouses as systemically important institutions, allowing them to have access to Federal Reserve funding if they ever got into financial trouble. The FSOC obliged, making the designation in July to little public notice. In other words, eight clearinghouses are now anointed as Financial Market Utilities and made eligible for a bailout from the Fed just like Bear Stearns and AIG.

Not only is this another example of the Obama administration saying one thing and doing another, but it also makes the failure of a clearinghouse — and its use of taxpayer funds — more likely. When banks did the clearing for derivatives, traders had to look to the financial strength of the clearing bank to be confident that they would receive the payments they expected. When clearinghouses act between traders in a fully private setting, the same thing is true; they compete with one another in part by demonstrating their financial strength. Now that clearinghouses have government backing, their financial strength is less important; they will be encouraged to compete on fee levels or willingness to take risks. In the end, one or more of them will fail, and the taxpayers — once again — will have to come to the rescue.

But it gets worse. One of Dodd-Frank’s key provisions prohibits the Federal Reserve from using its funds to bail out individual financial firms, as it did in rescuing AIG. Most members of Congress have probably been telling voters during the current campaign that Dodd-Frank put a stop to that. Not so. The act permits the FSOC to designate any financial institution that is engaged in clearing, settlement or payments activities — that is, almost every bank of any size — as eligible for a Federal Reserve bailout if its financial condition might prevent it from performing these functions. So with one hand the act took away bailout authority, but quietly, elsewhere in the act, this authority was fully restored.

In the first debate, Mitt Romney remarked that the Dodd-Frank Act is a “big kiss” for the big Wall Street banks, because it designates all of them as too big to fail. That is bad enough, because it provides them with lower cost funding than their smaller competitors. But by providing specific authority for Federal Reserve bailouts in the future, Dodd-Frank reneges on its most basic promise to American taxpayers.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. His book on Dodd-Frank, “Bad History, Worse Policy: How a False Narrative About the Financial Crisis Gave us the Dodd-Frank Act,” is forthcoming in January.