On the campaign trail, candidate Donald Trump frequently discussed the need to scrap the Dodd-Frank Act (the “Act”).  Following the election, the President-elect’s transition team signaled that reform will most likely come incrementally. The area most likely to be tackled first encompasses the portions of the Act that have hampered lending by small lenders and community banks. Whether these provisions will be repealed or replaced remains to be seen. But either way, changes could represent a double-edged sword for private lenders to the housing and construction industries.

On the one hand, private lenders may benefit from easier lending requirements from community banks and other bank sources of capital—opening up more liquidity to do deals. On the other hand, the possible loosening of restrictions may create conditions where small lenders and community banks start competing more directly for the non-standard deals that are currently the domain of private lenders. To get a handle on what the future may hold, it’s valuable to look more closely at the Act to understand what its impact and legacy on bank lending has been up to now.

IS DODD-FRANK ON THE CHOPPING BLOCK?

The President-elect’s argument to get rid of the controversial banking regulations was a populist message: that Dodd-Frank made the large Wall Street banks an even bigger threat to the nation’s economy and working families, the opposite of what it was intended to do as the government’s response to the 2008 financial crisis. According to a statement posted on the Trump official transition website, “Big banks got bigger while community financial institutions have disappeared at a rate of one per day, and taxpayers remain on the hook for bailing out financial firms deemed ‘too big to fail.’ The Financial Services Policy Implementation team will be working to dismantle the Dodd-Frank Act and replace it with new policies to encourage economic growth and job creation.”

The facts line up with the first part of the President-elect’s argument. Big banks have only gotten bigger since the law’s implementation, with the Big Four—JPMorgan Chase, Citigroup, Bank of America and Wells Fargo—now controlling about 45 percent of total bank assets. Meanwhile, smaller lenders struggle to compete as their compliance costs have gone through the roof, and, as a result, their growth rate for small business loans and individual mortgages has been significantly lower than for the larger banks.

However, repealing Dodd-Frank in its entirety would be an uphill battle since the vast majority of its provisions are now engrained in the banking system. Further, the political impetus to do so probably takes a back seat to other items on the Trump team’s to-do list, like replacing the Affordable Care Act and renegotiating trade agreements. Few on Capitol Hill actually understand the arcane labyrinth of provisions the Act contains, so the appetite of Congressional Republicans to take a hammer to Dodd-Frank is fairly limited. Furthermore, on the other side of the aisle voluble legislators including Senators Chuck Schumer and Elizabeth Warren have pledged a bare-knuckle, no-holds-barred fight if President-elect Trump tries to make good on that campaign promise.

GUESS WHO’S CALLING MOST LOUDLY FOR REPEAL?

The reality is that the loudest drumbeat to completely repeal Dodd Frank is mostly coming from the large banks themselves. Given the uphill political battle, it’s likely that the new administration may choose instead to deal with portions of the law that have restricted lending across the broader system, and particularly for small community banks, which played little role, if any, in the 2008 crisis.

The Trump administration will most likely rely on a proposal from Rep. Jeb Hensarling, R-Texas, who leads the House Financial Services Committee and serves as an adviser to the President-elect. His bill—called the Choice Act—doesn’t call for abolishing Dodd-Frank altogether, but rather for eliminating several of its core parts, including a provision that lets the government dismantle failed banks. He also wants to do away with the Volcker Rule, which imposes restrictions on banks’ trading and investments, and to weaken the reach of the Consumer Financial Protection Bureau. The lowest-hanging fruit would be to tackle the portions of the Act that have restricted lending, particularly for those small lenders and community banks.

Although President-elect Trump’s nominee for Treasury Secretary comes from the big banks, even he has voiced support for reforming portions of Dodd-Frank along the lines of Hensarling’s proposal, rather than scrapping it completely. Nominee Steven Mnunchin is a Goldman Sachs alum who has voiced skepticism about Dodd-Frank. Mnunchin spent more than two decades at Goldman, and later became a movie producer and hedge fund manager. In a recent CNBC interview, the Treasury Secretary nominee said that Dodd-Frank was “way too complicated” and indicated that his agenda was to strip back portions of the law that prevent banks from lending.

Even one of the original authors of the bill, former Sen. Barney Frank, admits the Act has aspects that need to be reformed. Frank told a reporter from the Washington journal The Hill that he believes the law set too low a threshold—$50 billion in assets—for banks to face increased regulatory burdens.

“That was a mistake,” Frank told The Hill. “We should have made it much higher—$125 billion or more—and we should have indexed it.”

Other Democrats have signaled a willingness to work in a bipartisan way on modest reforms to alleviate the burden on smaller lenders, including Senators Sherrod Brown of Ohio and Jon Tester of Montana, according to a recent Morning Consult report. Even Fed Chairwoman Janet Yellen has signaled concern that the smaller lenders struggle to compete, due to the provisions of the Act.

DODD-FRANK AND COMMUNITY BANKS

Despite the many worrisome headlines issued by Dodd-Frank skeptics, most community banks and small lenders with under $1 billion assets are actually in fairly good shape today. An easing of their regulatory burden would be a boon for them that would likely result in somewhat more opportunistic lending.

Dodd-Frank critics usually point to the reduced number of community banks in operation today as proof that the new regulations are strangling them. However, more objective analysis, including from the Brookings Institution, suggests the reduction in the sheer numbers of community banks is more a result of consolidation, driven by macro factors like regional population shifts and implementation of new technologies. Due mostly to industry consolidation, the number of community lenders with less than $100 million in assets has shrunk by nearly a third since 2003, while the number of institutions with greater than $300 million in assets has grown.

                                                                                                                                                                                                                              Source: Brookings Institute

These community lenders already account for nearly half of all small business loans, particularly for the SBA program. However, they have been clearly held back with mortgage loans, where they represent only about 15 percent of all residential lending. Dodd-Frank dramatically reduced the willingness and ability of community banks to make mortgage loans due to the broad risk retention requirements that it imposes on everything sold into the secondary market. The Act requires lenders to show that borrowers met an “ability to repay” test—which can be challenged in court for the entire life of the loan, tremendously raising the risk of litigation for the lenders.

To understand how reforming or eliminating parts of Dodd-Frank will help those community lenders, it’s valuable to understand exactly how restrictive the Dodd-Frank rules have been for them. The Act provides only narrow exceptions to the risk retention requirements. It provides for a designation called the Qualified Mortgage (“QM”) definition for loans with pre-established characteristics that are deemed to meet the ability-to-repay test. Even with just QM loans on their balance sheet, lenders face risk of litigation or sanctions because it is unclear if the QM designation provides a “safe harbor” against legal challenges, or if it’s only a “rebuttable presumption,” meaning they could still be challenged in court.

Worse, the QM designation is a cookie-cutter approach that limits the lenders’ flexibility to accept borrowers that don’t meet the strict conditions. Most lenders do not want the financial or reputational risk associated with loans outside the QM designation and simply don’t make loans other than Qualified Mortgages. Other community banks have simply stopped providing mortgages altogether, as the requirements and compliance cost made it unreasonable without considerable volume.

MORE COMPETITION FOR PRIVATE LENDERS?

While much of the controversy about Dodd Frank focuses on the notion that it has harmed these smaller lenders, in fact community banks and other lenders in the asset classes of $300 million to $1 billion have stronger balance sheets now than prior to 2008 due to all of the onerous FDIC and OCC capital requirement regulations. As a result, successful efforts to get rid of the Dodd-Frank restrictions on smaller traditional and community banks may well open a spigot of new lending.

When considering whether competition from banks could put a squeeze on private lender origination, it’s valuable to consider the size difference. Current estimates of the private lending industry range from $65 billion in annual mortgages to as high as $100 billion. While that’s an impressive range, it’s dwarfed by the conventional lending industry that totals about $1.6 trillion, according to the Mortgage Bankers Association. (Consider that Wells Fargo & Co. alone issued $43 billion in residential-mortgage loans just during the first quarter of 2016.)

Over the past few years private lenders have enjoyed a more robust growth rate than banks: in 2015, private lenders originated 68 percent more volume than in 2014, according to Mortgage Bankers Association’s Commercial/Multifamily Annual Volume Origination Summation. That annual growth rate is nearly double the 35 percent increase that commercial banks and savings institutions saw over the same time period.

However, with deregulation, banks’ growth rate will pick up speed. The loosening of the Dodd-Frank regulations may well increase origination and leverage for both commercial banks and independent mortgage lenders, causing a rise in the mortgage credit availability index that has been mostly flat for the last several years.

It remains to be seen how fully credit restrictions will be eased for the traditional banking industry, including for the small lenders and community banks. If the Act and its regulations, as well as other regulations like the Basel III standards, are eliminated or relaxed, private lenders will need to remain vigilant about increased competition from banks on mortgages and other loans.

To compete with banks, private lenders will have to rely on their speed of origination, ability to find deals and overall market expertise. Even if Dodd-Frank reform gets held up by political backlash—don’t forget that many on both the right and left will interpret its repeal as a free pass for “too big to fail” lenders that played a big role in the 2008 crash—the industry will continue to reward those private lenders who are at the top of their game.

The most likely scenario is a repeal of portions of the Act that will help smaller lenders and community banks increase their balance sheet leverage and lend more. Rather than just more competition for deals, the flip side of deregulation may be that that the easing of credit restrictions on banks becomes a boon for the private lenders that rely on them for liquidity.

Rather than expand into direct loans that don’t meet the QM designation, it’s quite possible that community banks and other lenders will prefer to make individual or warehouse loans to private lenders, letting them perform essentially as the banks’ intermediaries for non-QM mortgages and even the subprime parts of the construction sector. In that scenario, look for lower cost of capital and greater liquidity to prime the private lending industry for even more robust growth in the years ahead.

Jeffrey Levin’s article originally appeared in Private Lender magazine: January/February 2017