The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences

by David A. Skeel Jr., Harvey R. Miller (Foreword), William D. Cohan (Introduction)

After watching the government bail out Bear Stearns and AIG in 2008, and pump well over one hundred billion dollars into Citigroup, Bank of America, and the other largest banks the same year, Americans realized that the existing regulatory framework did not work. The Dodd-Frank Act, which President Obama signed into law in July 2010, was Washington's answer. The legislation created an entirely new set of rules for both the instruments and the institutions of contemporary finance. Although the reforms were desperately needed, they were drafted by the same people who designed the bailouts of 2008, and it shows.

In The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences, David Skeel explains where the legislation came from, tracing its assumptions back to the 2008 crisis and offering an inside account of the key moments in the legislative process. He analyzes each of the main components of the Dodd-Frank Act, explaining how they will work and showing that the new regulatory framework depends on precisely the qualities that Americans found so offensive about the bailouts of 2008: special treatment of the largest financial institutions and ad hoc intervention in the event of trouble. Skeel's assessment is not entirely pessimistic, however. He argues that a few features of the Dodd-Frank Act are genuine improvements, such as its regulation of financial derivatives, and he outlines several simple bankruptcy reforms that would curb the worst excesses of the new partnership between the government and the largest financial institutions.

Genres: Politics, Finance, Economics, Business

240 pages, Hardcover

First published January 1, 2010

About the author

David Arthur Skeel Jr. is the S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania, and the author of Icarus in the Boardroom (Oxford, 2005) and Debt’s Dominion: A History of Bankruptcy Law in America (Princeton, 2001), as well as numerous articles and other publications. He has been interviewed on The News Hour, Nightline, Chris Matthews’ Hardball (MSNBC), National Public Radio, and Marketplace, among others, and has been quoted in the New York Times, Wall Street Journal, Washington Post and other newspapers and magazines. Skeel has twice received the Harvey Levin award for outstanding teaching, as selected by a vote of the graduating class, and has also received the University’s Lindback Award for distinguished teaching. In addition to bankruptcy and corporate law, Skeel also writes on sovereign debt, Christianity and law, and poetry and the law, and is an elder at Tenth Presbyterian Church in Philadelphia.

Reviews

[Arjun Narayan · Rating 5 out of 5]

This book is a very well written summary of the Dodd-Frank bill. David Skeel has strong opinions, but they are clearly separated from the factual descriptions, which makes it easy to ready and comprehend even
if you disagree with the author. The prose flows easily, and the
explanations and citations are clear - so you can quickly catch up on
things that are unfamiliar to you. Any explanation of the Dodd-Frank
bill necessitates a good summary of the financial crisis, so that is
where the book begins. I also think that that is one of the best parts
of the book. Chapter 2, "The Lehman Myth" is one of the best
chapters. I am a believer of the Gary Gorton story that the crisis was
a shadow bank run, and that also necessitates an explanation of why
the focus on Lehman is a red herring, so this ties together well with
that narrative as well.

The book segues into a clear explanation of the actions that Paulson,
Geithner, and Bernanke took, although it was brief. I managed to get
by since that is usually the focus of other narratives, but you might
be lost if this was the first book. I can sense that Skeel does not
quite agree with those actions, but he is neutral and does not inject
any opinions at that point (I happen to believe that the trio made the
best of a bad situation given their limited agency even if they did
overstep their legal authority). I do, however, agree with Skeel's
conclusions that the Dodd-Frank bill is designed to "retroactively
legalize" their actions (not in the sense that there was any
prosecution risk, but such that for the next crisis, those actions
would be legal).

Chapter 2 is a much needed summary of "the Lehman myth", with
supporting factual evidence (mostly in the form of market reactions to
events and statements). While it is clear that many experts believe
the narrative that Skeel presents (and to me it seems the right one),
this is not summarized elsewhere, so this is a valuable contribution.

Chapter 4 is a good summary of the new clearinghouses and how they
would centralize counterparty risk for the benefit of then
system. Skeel summarizes the various possible future outcomes (a
single dominant clearinghouse versus a fractured system of multiple
clearinghouses) and their effects. Going in, this was the part of the
Dodd-Frank bill that I was most interested in. I intend to read "The
Risk Controllers" by Peter Norman next for more details.

One great insight towards the latter part of the book (I believe it is
in Chapter 8, or 9) is that the term systemic risk really packs
in three distinct risks that are often confused: correlated asset
price depression, confidence crisis, and counterparty contagion.

Correlated asset price depression is when an institution with
significant asset holdings fails, and those assets are sold off in
distress. This firesale depresses the price at which those holdings
sell. Since most banking institutions have highly correlated asset
holdings, their mark-to-market value drops, causing other banks to be
in trouble as well. Laws and regulations on leverage limits might
force them into sales as well, causing a spiral of legally mandated
firesales. (This also explains why the TARP buy by the Fed was the
only logical way to halt this process through shoring up the asset
prices).

A confidence crisis is when a bank failure causes investors and
creditors to be spooked. If this is a surprise event, it causes them
to reevaluate their entire beliefs about that sector of banks, and
they pull their money from other institutions, even if they are
solid. This precipitates a bank run in the classic Diamond-Dybvig
sense, albeit on the ``shadow banking'' system. This narrative is
particularly important to understand because it is the core of the
Lehman myth: that when Lehman was allowed to fail, this spooked all
participants. Skeel shows that this is not the case by looking at CDS
prices for various bank participants before and after the crisis.

The third mechanism (and the one I am most interested in) is
counterparty contagion. This is when banks have complex derivative
exposures to each other, and thus the failure of a single institution
affects every other participant in a very difficult-to-determine
fashion. Thus, if a confidence crisis is the pathway through which a
shadow banking run is initiated, counterparty contagion explains why
such a crisis develops in the first place: the system of complex
interconnected counterparty exposure is such that investors
cannot reason about individual institutions in a sane way. The
new clearinghouses may, or may not deal with the current system (by
forcing derivatives to be cleared through a central clearinghouse,
allowing for some risk reduction through netting of exposures, and the
fact that the clearinghouse has a "global view" to all party's
exposures).

A final point: Skeel is right to diagnose and worry about the
corporatist leanings of the Dodd-Frank bill. He shows how the bill's
main elements will (and already have) cemented the big banks as an
oligopoly that now receive preferential treatment at the hands of the
government. I think he is right. I, personally, have lost all
confidence that this will ever be fixed in the United States (and
Europe is already lost, with banks being explicitly politicized and
firmly part of the bureaucratic extension of the nation states), but
now we are veering onto explicitly political territory.

Some miscellaneous notes:

David Skeel is a bankruptcy expert, and thus this book is narrated
through that lens. I think that viewpoint is very much necessary, and
a good counterpoint to the handwavey economic nonsense that seems to
occupy much of the other experts pontificating on this crisis (Anat
Admati is a notable exception to that rule, more on Admati later).

Skeel seems to believe that higher capitalization requirements
wouldn't really help, which is counter to the Anat Admati
narrative. He doesn't discuss this in much detail, so I would be
curious to see more of a debate between their viewpoints.

This book gels very closely to the Darrell Duffie viewpoint. From the
heavy citations to Duffie (including to "personal communication"
between Skeel and Duffie) it is clear that they have both strongly
influenced each other. I gave up earlier on Duffie's book "How Big
Banks Fail and What To Do About It" as it was technically very
dense. I will give it another shot after finishing up on Admati, and
dealing with a few other books (including Peter Norman and Gary
Gorton's "Misunderstanding Financial Crises").

[B · Rating 4 out of 5]

A timely book I have read with the intention that it would help me with an article on financial regulations I was working on while at Thomson Reuters as senior banking editor.

The author analyzes various parts of the newly minted Dodd-Frank Act including resolution powers, derivatives regulation, consumer protection, corporate governance, among others, with a generally supportive attitude. He also discusses controversial topics such as the shift of emergency powers from the Fed to the FDIC, and FDIC’s unlimited borrowing capacity.
On the derivates reform, Skeel argues for bringing the “intent of delivery” back into the regulatory fold.

I think the best chapters are on the topics of resolution and bankruptcy, where he examines concepts such as the “automatic stay,” seniority of claims, “qualified bidding”, minimal judicial review, and conflict of interest in having resolution road plans.

Skeel also goes especially in depth with regards to the new clearing of derivatives, explaining the pros and cons of collateral management, netting, and the systemic importance of CCP/FCMs.

He also points out new problematic areas that arise in the new regulatory environment, such as the “retention rule” and its application to residential mortgages.

[Peter S · Rating 4 out of 5]

Great overview and critique of Dodd Frank. Basically Skeel believes first that Dodd Frank should have been more trusting of the bankruptcy process. Second, he believes that it should have taken a more Brandeisian/Jeffersonian approach whereby the power and riskiness of the system is reduced via greater competition and smaller companies. He dislikes that Dodd Frank created a class of companies that work with regulators to create the regulation and cannot ever go out of business because of their systemic importance (size).

If you're really interest in FinReg or bankruptcy post '08 you'll like, otherwise it's likely too in the weeds.

[Frank Stein · Rating 4 out of 5]

I know I just said I wouldn't read any more books on the financial crisis, but this is a book about what happened AFTER the crisis, so its technically not the same thing. My statement stands.

This is a book on the Dodd-Frank Act of 2010 written by a bankruptcy lawyer, David Skeel, and Skeel clearly shows his training by focusing overwhelmingly on the bankruptcy aspects the law (so much so that he does not even discuss the Durbin Amendment limiting bank interchange fees). That could give one a distorted view of the act, but it actually highlights how the whole regulatory structure set up by Dodd-Frank is essentially a way to avert and possibly subvert typical bankruptcy procedures. Even the Consumer Financial Protection Bureau, written by another bankruptcy lawyer, Elizabeth Warren, is predominately concerned with avoiding consumer bankruptcy.

Despite his suspicions about the act as a whole, Skeel is favorable to changes like the CFPB, the new clearinghouses and exchanges required for derivative trades, and the securitization rules that force banks to hold at least 5% of securitized assets on their books when selling off mortgage bonds or other debt instruments. The crucial flaw in the law, as he sees it, is that its new "resolution" authority, which allows the FDIC to capture "systematically important" banks when they are in danger of defaulting, also allows the FDIC and the Treasury to exercise almost complete discretion as to which creditors to pay off and how to unwind the captured company. The potential for political machinations is rampant, and the designation of at least 36 of these financial firms (those with more than $50 billion in assets) as "systematically important," means they will officially be marked as "too big to fail" and thus creditors will act appropriately, confident that they will get bailed out by the FDIC or government when push comes to shove, just like in 2008.

As Skeel shows, this part of the act is basically an attempt to enshrine the 2008 bailouts into law. Timothy Geithner, current head of the Treasury and the former head of the New York Federal Reserve, was both the premier instigator of the AIG bailout and the Obama administration's point person on writing the law. He used his draft to grant the Secretary of the Treasury (namely, himself) unprecedented power, including the position of "first among equals" on the new Financial Stability Oversight Council, and to guarantee the Treasury's ability to select firms to bailout and unwind. He even hired the law firm he previously hired to run the AIG bailout, Davis, Polk, & Wardwell, which also represented the financial industry's lobbying arm, to write much of the law. When Treasury submitted its draft bill to Congress, it still had the law firm's watermark on the pages, which they had neglected to delete.

As Skeel says, the law shuns a Brandeis-ian break-up of the banks for a "corporatist" association of big banks and big government that would seem to guarantee more bailouts and handouts. He's ultimately hopeful that a few simple new laws and new bankruptcy procedures could avoid the worse consequences of the act. I'm less so.