Fear in today’s markets shows failure of Dodd-Frank

If the financial crisis in 2007-2008 was fundamentally about mortgages, as many believe, why are we facing a similar financial crisis today?

Here’s the answer: The fundamental problem three years ago was not mortgages. It was the repurchase market and credit default swaps.

Mortgages were simply the collateral on the repurchase market and the instruments being insured by the swaps. Any other collateral, any other instrument, could have caused the same problem. Today it’s Greek and U.S. debt.

The Dodd-Frank Act tried to deal with credit default swaps. It did almost nothing to fix the repurchase market. The act’s failure to stop runs on the shadow banking system, where repos are the main financing, leaves us as vulnerable to a credit panic as we were in 2007.

Mark Thoma, professor of economics at the University of Oregon and blogger at Economist’s View, made this point July 22 at America Public Media:

… when it comes to the most important problem we need to fix, runs on the shadow banking system – i.e. runs on investment banks, hedge funds, etc. that were at the heart of the financial crisis – the legislation is largely silent.

The financial crisis can be viewed as a traditional bank run on the shadow banking system. The shadow banking system does not have the equivalent of the deposit insurance that exists in the traditional system to stop bank runs, and as the crisis unfolded and depositors in the shadow banking system became worried that their deposits might not be safe, they rushed en masse to withdraw their funds.

This caused widespread problems as funds needed to finance daily activities dried up. As the New York Fed noted recently, this vulnerability still exists and that’s a big worry.

With the debt ceiling debate and the troubles in Europe looming over us, the failure to fix this problem could be quite costly. If a run on shadow banks begins due to concerns over either issue it will be difficult to stop, a fact that highlights the bottom line: Despite all the good things Dodd-Frank has accomplished, there is still much more that needs to be done.