Dodd-Frank, Operation Twist & Wall Street

It’s been a year since the Dodd-Frank bill was signed into law, putting a whole new perspective on the term “too big to fail” and putting the brakes on taxpayer bailouts for failing financial institutions. With the downgrading of the credit ratings of three major banks – Bank of America, Wells Fargo and Citigroup – on Wednesday, it appears that the time has come to test the effectiveness of the Dodd-Frank bill. Commenting on the downgrade of Wells Fargo’s stock, Moody’s noted that, because the risks of contagion have become less acute, allowing a financially troubled large bank to fail is more likely to happen now than would have been the case during the financial crisis. This is seen as a vindication of the stance lawmakers took in passing the bill. Instead of propping up failing financial institutions with taxpayers’ money, the federal government has the option of unwinding these banks in a controlled and orderly manner. Each of the three banks in question is required to present a plan by July next year outlining steps for distribution of assets in the event of becoming insolvent.

Wall Street indexes dropped yesterday on the news that the so-called “Operation Twist”- a stimulus plan based on a policy used in the 1960s – has been approved. Set to start in October and continue through to June 2012, the policy is based on selling $400 billion in short-term Treasuries and buying longer-term bonds to the same value, with the objective of lowering yields on long-term bonds and keeping short-term rates stable. This is intended to push interest rates down on all types of loans, thereby incentivizing companies and consumers to borrow and spend. The Dow Jones dropped by 284 points (2.5%), with Hewlett-Packard being the only Dow component to trade higher, likely spurred on by rumors of CEO Leo Apotheker being replaced amid a shuffle of key personnel.

Operation Twist has both its supporters and critics, with presidents of three of the regional Feds voicing their dissent – Philadelphia’s Charles Plosser, Narayana Kocherlakota of Minneapolis, and Richard Fisher of Dallas. Many are of the opinion that lower interest rates may not be enough to encourage borrowing and spending, as the problem is not so much the interest rate, which has been low for some time now, it is more likely a case of a lack of disposable income for consumers.