Chris Dodd's Toothless Reform

If you thought the financial crisis marked a turning point in American history, and that Democrats and Republicans were committed to making TARP the bailout to end all bailouts, you'd be sadly mistaken. As Senator Chris Dodd's financial reform bill makes its way through the Senate, there is a broad conviction among experts that it will do little to prevent yet another financial crisis.

So the whole ordeal that has played out over the miserable months since the collapse of Lehman will hit us again within the next decade, only this time the banks will be bigger and more systemically important than ever. Indeed, as Neil Barofsky, the Treasury's TARP watchdog, has put it, "These banks that were too big to fail are now bigger. Government has sponsored and supported several mergers that made them larger. And that guarantee—that implicit guarantee of moral hazard, the idea that the government is not going to let these banks fail—which was implicit a year ago, it's now explicit."

The regulators and policymakers who are supposed to prevent the next crisis are on auto-pilot.

Given the intense popular anger over the fecklessness of the financial industry, you'd think the stars would be aligned for a truly aggressive reform plan, one that established stronger margin and capital requirements. Instead, we have a bill that essentially says, "trust us, we'll sort this one out." That is, trust the infinite wisdom of Congress and the regulatory agencies to steer us through the rocky shoals of the inevitable next crisis. The hope is that the Dodd bill might make it slightly easier to sort out the mess by creating an Orderly Liquidation Authority that will allow the FDIC to take effective control of and dismantle a financial firm heading off a cliff. And if the authorities do their job well and anticipate danger and react to it swiftly and fairly, all will be well.

The trouble is that, as Eric Lichtblau's reporting in The New York Times reminds us, the revolving door between Congress and the financial industry is very much intact. There is no question that Wall Street's interests will be protected in closed-door meetings. If key government decision-makers are effectively on retainer with the big financial firms, who exactly is going to represent the interests of taxpayers?

It's not obvious that congressional Democrats or Republicans are up to the job. Republicans have been waging a scorched-earth campaign against fairly modest regulation of derivatives, a vitally important piece of the puzzle. One of the main reasons Lehman's collapse proved so destructive is that hardly anyone understood the value of its derivatives book, a collection of impenetrably complex and often highly opaque financial instruments. The White House has called for more transparency in how derivatives are traded, a step that could go a long way toward easing if not preventing the next crisis. And to her great credit, Senator Blanche Lincoln of Arkansas, a widely despised moderate Democrat set for an all-but-certain defeat in this year's midterm elections, has put together a fairly tough derivatives proposal that goes further than the Obama administration in tightening the rules.

Unfortunately, a large number of Republicans, and more than a few moderate Democrats, believe that requiring that derivatives are traded on exchanges and subjecting them to tough margin and capital requirements—tools designed to give investors and regulators a sense of how much money is really changing hands—would harm U.S. industry. They are almost certainly wrong. As long as they stick to this view, they will have a tough time improving other aspects of the bill.

And that's a problem. Republicans were right to oppose the Democratic health bill because it endangered the country's fiscal future, and there was little to be gained from giving it bipartisan cover. Financial reform, in contrast, is the issue that will determine the future shape of the American economy. In the wake of the crisis, the federal government has sharply expanded its reach in the financial sector, pressuring Fannie and Freddie into originating decidedly problematic mortgages, super-sizing rickety banks, creating a mortgage modification program that does more to pump money into the banks than into struggling homeowners, and much else besides. This isn't happening because the Obama White House has launched some secret plot to destroy the American economy. Rather, it is happening because the regulators and policymakers who are supposed to prevent the next crisis are on auto-pilot. The only thing they know how to do is pump money into their friends in the financial sector.

Sheila Bair, the Bush appointee in charge of the FDIC who has become a hero to financial reformers, has forcefully argued that the Dodd bill ends bailouts. She has also claimed that the extraordinary discretion the bill gives the FDIC is no problem at all; she is perfectly capable of deciding which creditors will be made whole and which will not, and much else besides. Her confidence is admirable. But what happens when a straight-shooting populist crusader like Sheila Bair is no longer in charge?

In itself, the Dodd bill isn't going to wreck the financial system. That damage has been done over the last three decades, under Republican and Democratic presidents, as Nicole Gelinas explains in her excellent book After the Fall. What it might do, however, is create a new complacency about the difficult steps we need to take next. And that's a serious problem.

Reihan Salam is a policy advisor at e21 and a fellow at the New America Foundation.