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FEATURE: Don’t roll back

Meet one of the chief architects of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that is responsible for so much regulatory change impacting private real estate investing. Barney Frank, former US congressman from the state of Massachusetts is now retired after a 30-year career, but became a household name in the aftermath of the global financial crisis as he and Chris Dodd set about rectifying many of the ills that US politicians and others identified as contributing to systemic collapse in the financial industry.

The direct output of the legislation that followed included of course the Volcker Rule designed to limit banking entity investments in hedge funds, private equity funds and private equity real estate funds, and also minimum liquidity requirements for banks, and new stiffer appraisal requirements for higher-risk mortgages to name but a few.

As such, Frank may not be the most popular man in the room at a private equity conference. Nevertheless, in January he took to the stage and encouraged questions in New York during the major annual CFO & COOs Forum in New York run by PERE’s sister title, Private Equity International. Attendees may not have thrown rotten fruit, but they certainly needed little encouragement to stand up and ask questions on a range of topics from risk transfer to whether he thought House of Cards was an accurate representation of Washington life. When asked after if he thought the audience was receptive to his views, he said “my guess is there was a lot of disagreement that people didn’t want to articulate.”

In a post-Q&A interview away from the spotlight, Frank spoke of the market today some eight years since those heady days following the collapse of Lehman Brothers. Many of the oldest names in banking have changed, either forced into being absorbed by other banks, or bankrupted outright.

Frank knows of course that while popular on Main Street, his bill is less of a hit on Wall Street. Dodd-Frank has meant that the financial services industry is now faced with myriad reporting requirements and a significant compliance cost overhead.

Politically, there is resistance, too. In the 2014 mid-term elections, Republicans swept to victory in both the Senate and the House of Representatives. And already, three months into the new Congress, those pushing to rework some if not all of Dodd-Frank’s provisions have seen some success, advancing their agenda by authoring small and highly technical changes, and attaching them to opposition-proof bills like the omnibus budget bill last December.

Needless to say Frank thinks this a mistake. As far as he is concerned, the job of safeguarding America’s financial system has not been completed, and while Dodd-Frank needs further improvement, any knee-jerk approach would be ill-advised.
He says: “There are changes to be made, but they need to happen within the context of conversations about objectives. You can’t say we want to repeal the whole thing and then say ‘work with us on whatever change’. There are places where we could roll back, but there are also places where we need to do more.”

“I believe that the [Republican Party] thought they could do this piece by piece, but the reaction to the piece that was in the omnibus was I think stronger than they expected. And I believe you now have a very unified Democratic party that’s going to fight the changes, and the President is going to veto if it makes it past them. On the Republicans – if I were they, I would reconsider. I would not want this to be a major issue in the upcoming election of 2016. I guarantee you that the financial reform bill is very popular. People who don’t understand the Volcker rule like it. The GOP doesn’t want to go to the country as the advocates for the banks and against reform.”

The bill’s a success
According to Frank, current Republican efforts to rethink registration requirements for private equity firms are a case in point. President Obama has already threatened a veto on the issue, and while Frank doesn’t think private equity firms should be considered systemically important financial institutions, he does stand by the market results so far, and urges strong disclosure for financial firms of all stripes and colours.

He says: “I met someone here at the conference last night who was with the private equity fund of Bank of America, and Bank of America has already spun them off and they’re working fine. I think two sets of arguments make the case: friends on the left that said Dodd-Frank didn’t do anything, and are now defending it; and then the people on the right who said it was going to destroy the economy. The market of course has almost tripled since we said ‘this is what we are going to do’, it’s up about 280 percent. So, I think it has worked out the way we had hoped. Now, you don’t know what happens in the future, but I think in general the results are pretty good.”

When it comes to disclosure – a hot topic for private equity – Frank stands on the side of transparency. “Any concealment of risk is a problem,” he asserts.

And as for investors, a big part of his message is caveat emptor. Dodd-Frank has strengthened the fiduciary duty requirements for pension funds as trustees of other people’s money, in part because of Frank’s conviction that pension plans helped bring about the financial crisis by letting the rating agencies lull them into a false sense of security, rather than forming and defending their own views about the risks facing them.

So if you invest on behalf of a pension scheme, you’ll likely be hearing this from Frank: “‘[B]e careful – don’t get into something that’s [too] complicated. Don’t make a deal with someone who knows a lot more than you do and is making money off the deal.’ Some municipal officials complained […] saying, ‘if I can’t go to the ratings agencies how can I judge a deal?’, and I said, ‘if you can’t judge a deal on your own then stay the hell away from it.’ The head of Pepsi [Indra Nooyi, CEO of PepsiCo] told me that herself: ‘If they bring me a deal that takes more than 15 minutes to explain to me, I don’t want to do it.’ Buffet says the same thing.”

He also warns against paying big-ticket fees. “Don’t pay them if you don’t like them. I think there have been some excess fees. I think people need to look carefully at the post-fee return and walk away from a lot of this if it’s too expensive. I do think fairly unsophisticated trustees of other people’s money got persuaded into making deals they shouldn’t have made.”

One part of the bill where Frank sees room for improvement is on the capital adequacy and risk retention front. Many of the bill’s original risk retention rules for mortgage lending, which required mortgage lenders to assume the risk if they kept the loan in their portfolios, or for sellers of securitised loan baskets to do so, were ultimately relaxed in the final version of the bill.

Still, a recent Harvard study showed that community banks are having a hard time underwriting mortgage loans and other lines of credit due to the capital requirements put on them under Dodd-Frank. As it stands, the cash-on-hand requirements and reporting overhead for small banks make it uneconomic to do the small loans these types of lender are meant to provide.

Frank accepts that this is sub-optimal and believes it can be bettered: “I think the $50 billion threshold for systemically important institutions can probably be raised. I also think we can do more on risk retention.”

The ‘hi, how are you’ guys

The old adage that all politics is local is also true for the politics of Dodd-Frank. Therefore, where things are likely to get interesting when it comes to reforming the reform bill is on the local level.

Frank explains that over the course of the bill’s construction, more lobbying pressure was coming from estate agents and auto dealers than regulators may have anticipated.

“Every member of Congress has those guys in their district. They are the ‘hi, how are you?’ guys. Their corporate culture is to go out and be friendly to people. The bankers just sit there and say no to people, but the realtors go out and sponsor the Kiwanis Club and Little League, and the auto dealers have those jokey ads on television and everyone likes them. So when they go out they have real force in Congress. Very few members of Congress outside of Manhattan were coming up to me and saying, ‘we can’t do this, JP Morgan is all over my back,’ they were coming up and saying, ‘the realtors are all over me! How are we going to deal with this?’ The auto dealers got themselves exempted from the Consumer Financial Protection Bureau [CFPB].”

And guess what? Americans today would be better off had this not happened, at least as far as Frank is concerned: “The main thing getting people in trouble now are predatory auto loans, which I take as some confirmation that we were headed in the right direction.”

Tough choices ahead
Frank would also like to see more structural changes to the regulators themselves. “I think the SEC and CFTC [Commodity Futures Trading Commission] should be combined but there’s no political will to do that.”

The other problem he sees is that the regulators are not given sufficient funding to function as well as they need to: “If you’re the SEC, and you are underfunded the way the SEC has been underfunded under Republican leadership, and particularly if you’re the CFTC – you have a serious problem because you go to court with one of these major firms and your budget is very quickly constrained.

In an ideal world, according to Frank, industry players would take on full responsibility for the risk they are taking by having enough capital on their books to cover it, and retaining the risk for the loans they make. Without that, the lack of discipline that created the 2008 disaster is likely to come creeping back.

One positive development, he notes, is the growing co-operation between the US and international governments in terms of doing their part to prevent the type of behaviour that led to 2008.

“I think you’ve seen the British, the EU and the US realise their common interest here more than people would have expected. I was in constant communication with regulators in the EU and in Canada when we were crafting the bill. […] It’s important governments work together to keep the private sector from gaming us against each other. I’ve been encouraged by that so far.”

Looking ahead, he says the next big hurdle will be dealing with rising inequality, and inadequate public resources.

“It’s not just a social problem, it’s an economic problem. If people don’t have enough money to spend, then consumption suffers, and consumption is a big part of the economy. The second thing is that there is a rightwing refusal to fund government adequately and there are things that the economy needs that can only be done if we pool our resources. Transportation, research and development, education, etc. It is this rightwing increasing hostility to any public sector activity to the point where Dwight Eisenhower is now [seen as] a dangerous radical because he wanted to do interstate highways.”

The same instincts are also threatening Frank’s legacy. Five years after its introduction, Dodd-Frank is facing an uncertain future.