In the wake of the financial crisis, the federal government has implemented a sprawling piece of legislation known as Dodd-Frank. This legislation consists of over 400 new rules that will change the framework of the entire banking industry and will ultimately hurt you – the consumer.
Most people feel that the financial crisis was caused by Wall Street greed. Fat cats striving for excess by creating risky financial products, while over-leveraging in order to capture exponential gains.
While I do agree that enormous profits blinded Wall Street management to the potential risks and even prevented the exercise of proper risk protocols, I will not agree that Wall Street created these products with ill-intent. The initial objectives of these financial products provided benefit to the consumer by lowering the cost lending for the aggregate economy.
I can best explain this by comparing a bank’s balance to a glass of water. Imagine that each loan made adds water to the glass. When the glass is completely full, the bank can no longer lend. Through a process called securitization, the bank can bundle its loans and sell them to other banks and investors. This frees up a bank’s balance sheet so they can continue to lend.
Securitization is probably one of the most important financial innovations that occurred in the latter part of the previous century. But securitization also birthed the main product culprit of the financial crisis, the CDO (Collateralized Debt Obligation). Again, the intent of the CDO was for the greater good, but the product ultimately became so complex that few truly understood how to properly manage its inherent risk.
Wall Street has been impugned by its role in the financial crisis thus creating a consensus for more government oversight. We will now start to see the impacts of this oversight with the implementation of Dodd-Frank. The intent of this regulation is to eliminate systemic risk, promote transparency and protect the American public. But instead it will strangle the flow of capital, stifle innovation and make the cost of banking products more expensive for small American businesses, consumers and home buyers.
We have all been spoiled through the years as lending criteria relaxed and the creditworthiness of a borrower was overlooked through products such as no-doc mortgages. Products like this now cease to exist and banks are under regulatory scrutiny to ensure greater credit quality of their borrowers. This means that people with a credit score of 710 or below will find it difficult to qualify, while the cost to borrow will become increasingly more expensive.