3 Reasons Dodd-Frank Is Doomed

As the Dow reaches levels it hasn't seen since the spring of 2008, it may seem that the market has finally recovered from the nightmarish financial crisis. Unemployment remains high and housing is stuck in neutral, but overall the economy is looking up.

Unfortunately, little has changed underneath the surface. The too-big-to-fail banks have only consolidated and become bigger. The Securities and Exchange Commission is hopelessly playing catch-up, and the banks continue to resist regulation, as we've seen from their comments on the Volcker Rule.

The Dodd-Frank Act was supposed to fix this, but, I'm afraid, it's doomed. Here's why:

Toothless enforcement
By granting big banks exemptions to the laws it's supposed to be enforcing, the SEC has made a habit of encouraging bad behavior. According to a report by The New York Times, the commission gave waivers allowing banks to fast-track securities sales and protect them from certain types of lawsuits nearly 350 times in the last decade.

JP Morgan Chase (NYS: JPM) , for example, settled six fraud cases over the last 13 years, but has received at least 22 waivers. Bank of America (NYS: BAC) along with its crisis acquisition, Merrill Lynch, settled 15 fraud cases and got at least 39 waivers. Even Goldman Sachs (NYS: GS) maintained those privileges despite paying a $550 million settlement for misleading subprime mortgage investors. Of the major banks only Citigroup (NYS: C) has had significant privileges revoked.

Former SEC Chairman David Ruder said that without the waivers, those firms would have trouble staying in business. Equally confounding is the SEC's habit of granting waivers to repeat offenders that had settled previous charges by agreeing not to break the very laws that the government agency was now accusing them of breaking once again.

Lack of funding
Despite appearing to have ceded whatever power it had to enforce securities laws, the SEC has complained of being underfunded and understaffed. That's part of the reason, it claims, it chooses to settle cases rather than take them to court. The agency's cries are not unwarranted: In this year's budget, the Republican-controlled appropriations committee attempted to lop $222.5 million off its request, trimming the total to its 2011 allotment of $1.19 billion. The final budget passed at a compromise figure of $1.32 billion, which supports 1,299 full-time equivalent positions in its enforcement division. For comparison, the New York Police Department has an annual budget of $3.9 billion and employs 36,000 full-time officers.

Though the Republicans cited cost control as one of their reasons for slashing the commission's budget, the SEC actually acts as a profit center for the government, generating income from transaction fees and fines, which goes back to the Treasury after the agency's budget has been met. In 2011, the SEC wrested more than $2.8 billion in fines from lawbreakers.

Endless complexity
While it's still unclear if Dodd-Frank will actually benefit investors, there's one group that's already seeing a payday: Lawyers. Some hedge funds have estimated they will need to spend $100,000-$150,000, much of which will go to legal guidance, to adequately fill out forms required by the Financial Reform Act. Even Sheila Bair, the former head of the FDIC, said, "I fear that the recently proposed regulation to implement the Volcker rule is extraordinarily complex and tries too hard." A final version of the Dodd-Frank bill still seems a long way away; one banker predicted ten years of legal wrangling still to unfold.

Like many other laws, the Financial Reform Act is prone to loopholes. In response to the Volcker rule, banks have dropped the word 'proprietary' from their trading departments. Similarly, some banks' fees on debit cards are being cut, but other competitors have received a waiver from this rule.

Finally, the lobbying effort has begun in full force as financial industry trade association SIFMA claims an army of 5,490 lobbyists working to tailor Dodd-Frank to their interests.

Foolish takeaway
If the recent MF Global meltdown taught us anything, it's that vertigo-inducing leverage and opacity hasn't gone away. The Wall Street investment banks have become an oligopoly, and the very notion of "too big to fail" would seem to indicate that the solution is to break them up. Yet Dodd-Frank didn't break them up. Ironically, the financial crisis only served to further concentrate the industry, and the five largest banks now hold more than half of the industry's assets. Richard Fisher, the president of Federal Reserve Bank of Dallas, said recently that "[d]ownsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Then 'creative destruction' can work its wonders in the financial sector, just as it does elsewhere in our economy."

That would seem to be the great irony with our banking system. Though they are supposed to be the stewards of capitalism, they are not in fact subject to the rules of free markets. Breaking them up would increase competition, bring sky-high compensation back down to earth, and ensure that the system functions as it's intended to.

Though the future of the Wall Street banks may still be hanging in the balance, fortunately our experts at the Fool have found some more-conventional lending institutions that look like steals at today's prices. Even Warren Buffett said, "Well, it doesn't clearly make sense. If I had a choice of buying or selling certain banks in the United States today, I'd be buying." Find out what these bargains are in the Fool's new report: "The Stocks Only the Smartest Investors are Buying." It's free! All you have to do is click right here.

At the time thisarticle was published Fool ContributorJeremy Bowmanholds no positions in the companies above. The Motley Fool owns shares of JPMorgan Chase, Citigroup, and Bank of America.Motley Fool newsletter serviceshave recommended buying shares of The Goldman Sachs Group. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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