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February 15, 2013

GAO Examines Fallout of Financial Crisis, Impact of Dodd-Frank

By Lene Powell, J.D.

A report published Thursday by the Government Accountability Office found that the 2007-2009 financial crisis was associated with domestic output losses ranging from several trillion to over $10 trillion, and resulted in a decline of nearly 39% in median household net worth. The report, which examined the economic impact of the financial crisis and the costs and benefits of the Dodd-Frank Act, was prepared in response to a request from Sen. Tim Johnson (D-SD), chairman of the Senate Banking Committee, and Rep. Michael Capuano (D-MA), ranking member of the Subcommittee on Oversight and Investigations, House Committee on Financial Services.

The financial crisis. The 2007-2009 financial crisis was the most severe economic downturn since the Great Depression of the 1930s, the report said. Between December 2007 and the end of the recession in June 2009, U.S. real gross domestic product (GDP) fell from $13.3 trillion to $12.7 trillion (in 2005 dollars), or by nearly 5%. U.S. output losses associated with the crisis could range from several trillion to over $10 trillion.

As for the impact on individuals, households collectively lost about $9.1 trillion in national home equity between 2005 and 2011, according to the report. Median household net worth fell by $49,100 per family, or by nearly 39%, between 2007 and 2010, driven most strongly by a broad collapse in home prices. Between 2006 and 2007, the steep decline in home values left homeowners collectively holding home mortgage debt in excess of the equity in their homes. The report noted that this marked the first time that aggregate home mortgage debt exceeded home equity since data were kept in 1945.

The review attributed the financial crisis to losses in the mortgage market in mid-2007, followed by a reassessment of financial risk in other debt instruments and a liquidity and credit crunch, leading to the failure of financial institutions. Factors that played a role included innovations in asset securitization that reduced mortgage originators' incentives to be prudent and made exposure difficult to understand; faulty assumptions in the models used by credit rating agencies to rate mortgage-related securities; gaps and weaknesses in regulatory oversight; and government policies to increase homeownership, including the role of Fannie Mae and Freddie Mac in supporting lending to higher-risk borrowers.

Potential benefits of the Dodd-Frank Act. While there was no clear consensus among experts on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future financial crisis, experts did generally agree that certain provisions would help enhance stability.

Many stakeholders viewed the creation of FSOC as a positive step to identify or mitigate a future crisis, the report stated. Before the Dodd-Frank Act's passage, federal financial regulators focused their oversight more on individual financial firms and less on market stability and systemic risk. The Dodd-Frank Act established FSOC to create an entity charged with the responsibility for monitoring and addressing sources of systemic risk, and also created OFR to support FSOC and Congress by providing financial research and data. Among other powers, FSOC is authorized to designate certain financial market utilities and nonbank financial companies as systemically important and subject them to increased regulatory oversight.

In addition, heightened standards for systemically important financial institutions (SIFIs) are generally perceived as a positive development, according to the review. The Dodd-Frank Act requires the Federal Reserve to supervise and develop enhanced capital and other prudential standards SIFIs, which include bank holding companies with $50 billion or more in consolidated assets and any nonbank financial company that FSOC designates. Provisions related to increased standards for SIFIs include risk-based capital requirements and leverage limits, liquidity requirements, single-counterparty credit limits, and other measures. In January 2012, the Federal Reserve proposed rules to implement the enhanced prudential standards, but has not yet finalized all of these rules.

According to the report, credit default swaps (CDS) were most central to the system-wide problems encountered during the crisis, but other OTC derivatives were also a factor in the propagation of risks during the recent crisis because of their complexity and opacity, which contributed to excessive risk taking, a lack of clarity about the ultimate distribution of risks, and a loss in market confidence. In response, Title VII of the Dodd-Frank Act established a new regulatory framework for swaps to reduce risk, increase transparency, and promote market integrity in swaps markets. Generally, the act provided for the registration and regulation of swap dealers and major swap participants, imposed mandatory clearing, required cleared swaps to be executed on an organized exchange, and requires swap reporting. The report stated that a broad range of financial market regulators, participants, and observers expect various provisions under Title VII to help promote financial stability, but also identified potential obstacles, including margin requirements and certain reporting issues.

Costs of Dodd-Frank implementation. For federal entities, a large portion of the federal entities' resources devoted to the act's implementation are funded by fees paid by regulated institutions or other sources outside the congressional appropriations process, which limits the impact of these activities on the federal budget deficit, said the report.

Due to the act's focus on enhancing financial stability, large, complex financial institutions will likely bear the greatest costs, but smaller financial institutions and other financial market participants also will incur costs, according to the report. However, the costs are difficult to measure. Representatives from financial institutions and industry associations told GAO that firms generally do not track their incremental costs for complying with the act. Moreover, the piecemeal way that the act is being implemented makes it difficult to measure their regulatory costs. Likewise, none of the industry associations GAO met with are tracking the incremental costs that their members are incurring to comply with the act.

Finally, the report said that some observers expressed concerns about potential unintended consequences of the act, such as reducing the competiveness of U.S. financial institutions in the global financial marketplace.

RegulatoryActivity: DoddFrankAct: ExchangesMarketRegulation

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