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What is Dodd-Frank, and Why Should SoCal Real Estate Investors Care?

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Nov 23, 2016

What is Dodd-Frank, and Why Should SoCal Real Estate Investors Care?

We would like to begin this article with a simple fact; we are not in the business of politics, we are in the business of real estate. This article is an objective examination of what the Dodd-Frank regulations are, and seeks to further explain both positive and negative effects these regulations can have on SoCal Business; especially as they pertain to Real Estate, Real Estate Investment, and Property Management. We will not input political leaning, nor any judgement as to whether or not the bank regulations are good or bad. We will simply attempt to give a clearer understanding of these regulations so that you can draw your own conclusions.

 

History of the Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of financial reform legislation passed in 2010 as a response to the financial crisis of 2008. Named after sponsors U.S. Senator Christopher J. Dodd and U.S. Representative Barney Frank, the legislation was intended to increase regulations on lending, credit, and other areas of the financial landscape.  The Dodd-Frank Act implements changes that, among other things, affect the oversight and supervision of financial institutions, provide for a new resolution procedure for large financial companies, create a new agency responsible for implementing and enforcing compliance with consumer financial laws, introduce more stringent regulatory capital requirements, effect significant changes in the regulation of over the counter derivatives, reform the regulation of credit rating agencies, implement changes to corporate governance and executive compensation practices, incorporate the Volcker Rule, require registration of advisers to certain private funds, and effect significant changes in the securitization market.

In simplest terms: The Dodd-Frank Act seeks to eliminate the need for future taxpayer-funded bailouts.

Dodd-Frank's Component Pieces

The scope of this legislation is almost unfathomable, and would be impossible to describe in complete detail without a nearly unlimited time-frame and perhaps a law degree or 5. However, we can examine the main bullet points of the legislation in order to better understand the positions of both supporters and opponents of the Dodd-Frank Legislation.

New Agencies and Councils Created by Dodd-Frank:

  1. Financial Stability Oversighte Council(FSOC)-
    Committee of 10 voting, and 5 non-voting members composed of US Treasury officials, Federal Reserve Board Members, and Insurance experts charged with monitoring the financial system, including identifying potential threats to the country's financial stability

  2. Consumer Financial Protection Bureau (CFPB)-
    Their main function is to monitor and prevent predatory mortgage lending and help to make the terms of a mortgages, and other loans easier for consumers to understand. The CFPB accomplishes this by:
    -Preventing brokers from earning higher commission fees for loans with higher interest rates
    -Preventing mortgage originators from steering consumers towards loans with the highest payout to originators,
    -Requiring credit lending companies to provide terms and conditions for their loans to consumers in a way that is easy to understand, before finalizing paperwork for the loan.

  3. SEC Office of Credit Ratings-
    Established to make sure that credit reporting agencies were reporting accurately instead of reporting misleadingly favorable investment ratings

Volcker Rule:

Volcker Rule disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks’ own accounts under the premise that these activities do not benefit banks’ customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits.

(For a more detailed break-down of the Dodd-Frank Legistlation, dodd-frank quick refference guide is a great tool created by Morrison & Foerster)

Mixed Reviews

As with any legislation, and especially in regards to the Dodd-Frank Act, the legislation was met with fierce support - and equally fierce opposition. Some of the most heated debates directly relate to the Volcker Rule, and its ban on proprietary trading, in addition to the limitation on the size of banks. Both sides of the argument raise valid points. It seems as though the "right" answer is depends on which side of the fence you are standing.

The Advocates:

According to many experts, this legislations' benefits far outweight the potential pitfalls. Some of the most notable ideas in favor of the Dodd-Frank Act include:

  • Banks will be required to keep a share of mortgages the underwrite. In other words, they have a financial stake in making sure they give out sound loans.
  • There will also be greater separation between the consumer-oriented banking and the high-flying investment banking. The collapse of a mega investment bank may be less likely to either require a bailout or cause a systemic default. 
  • A Consumer Financial Protection Agency will help every day consumers–the kind who aren’t particularly financially sophisticated and shouldn’t need to be. The CFPA will be empowered to crack down on the people conning consumers out of what they’ve earned. This means a healthier and more stable middle-class. It means people have money left to spend on things they actually want. And it means fewer products that are designed to fail in a profitable manner.

The Opponents:

Not everyone was excited to see this legislation come to pass. Many criticisms of the act exist, and many of them offer valid points. Some of the more notable points in opposition include:

As you can imagine, the majority of the opposition  cite the enormous cost and scope of the new legislation - namely the cost. 

  •  According to recent studies, the legislation has imposed more than $36 billion in costs
  •  73 million paperwork burden hours.
  •  Limiting the risks that a financial firm is able to take simultaneously decreases its profit-making ability.
  •  The need to maintain regulatory compliance unduly burdens community banks and smaller financial institutions 

But How Does This Relate to SoCal Real Estate Investing in 2017?

As the nation transitions between presidents, ideas regarding the validity of the Dodd-Frank Act become more apparent. The President Elect, Donald Trump has made it clear via his website that his intention is to push for a full reppeal of the Dodd-Frank Act in its entirety. Although a full repeal of the massive, complicated legislation is unrealistic to accomplish in a 100 day scope, it is very likely that the Republican Majority in Senate and Congress  will want to make amendments to the legislation, especially pertaining to the Volcker Rule.

Residential and Owner Occupied Only – First and foremost, the law only applies to homebuyers who intend to occupy the home.  If you sell strictly to other investors, the loan requirements have no affect on you in the first place.  Similarly, the new law does not apply to commercial real estate

Loan Requirements Currently In Place Under Dodd-Frank

  1. No Negative Amortization
  2. No Balloon Payments
  3. Cannot Exceed 30 Years
  4. No Prepayment Penalties
  5. Variable Interest Rate—can be included but underwriting must be based on the highest rate that will occur in the first five years. This point also implies that credit and Debt to Income ratio must be verified (43% DTI limit)
  6. Must Verify Income
  7. “Non-Qualified Loan” Exemptions—If you offer a loan that is non-qualified, the burden of proof for exemption rests with the lender. (Recommendation: For any loan that falls under the exemptions below, disclose to the borrower in the actual loan agreement in large print: “NOTICE—THIS LOAN FALLS UNDER A DODD/FRANK EXCLUSION AND PENALTIES WILL NOT APPLY.”

If the litigation is repealed, then regulations such as these loan qualifications may no longer be a part of the home buying process, allowing more people access to purchase homes or get mortgage loans.

In the short-term, it appears as though the repeal of the Dodd-Frank Litigation will almost certainly mean a huge rise in home sales, and in the price of those homes. In California  the cost to purchase a home already far exceeds the national average, aided in part by the housing shortage which is rampant in the cramped metropolitan area. A sharp incline in lending by banks, and thus, increase in the number of people who can (and will) buy a home, points to the already elevated home prices in California growing that much higher. 

Closing Thoughts

What are the long-term effects? That depends staunchly on your view of the financial crisis of 2008. Will the economy be fated to repeat itself if regulations are rolled back, allowing banks to lend money as they had before? The short-term benefits are obvious: less regulation means more home loans will be written, and thus a higher profit for real estate investors as the market adjusts to the changing financial landscape. Will that benefit us in the long-term, or are we facing another situation in which lending leads to potential financial problems? Only time will tell.