Dodd-Frank Is Hurting the Recovery!

 

The Federal Reserve Bank plays an important role in our economy by trying to keep inflation low and stable but also by trying to make recessions less severe by increasing the money supply when the unemployment rate is high. My last post, “What the Federal Reserve Can and Can’t Do” emphasizes that, as Ben Bernanke says, “the Fed has little or no control over long term fundamentals,” such as economic growth which depends on increases in productivity which, in turn, are heavily influenced by fiscal and regulatory policy.
Capture8The American Enterprise Institute’s Peter Wallison explains very clearly in “The slow economic recovery explained,” why, for example, the Dodd-Frank Act of 2010 is having a harmful effect on economic growth:

  • Regulatory burdens imposed by Dodd-Frank have been particularly harsh for community banks, with $10 billion or less in assets; 98.5 % of U.S. banks fall into this category. Since Dodd-Frank was enacted in 2010, community banks’ share of banking assets has shrunk by 12%.
  • According to the Small Business Administration, there were approximately 23 million small businesses (with fewer than 500 employees) in 2012, compared to 18,500 firms with more than 500 employees. Large businesses have access to capital markets whereas small businesses rely on local banks for their credit needs.
  • Regulatory costs affect small banks more than large banks because the costs are fixed, independent of size of the institution. When the Consumer Financial Protection Bureau sends out voluminous regulations on mortgage lending, for example, then extensive legal fees, compliance officers and technology retooling must be paid for up front.
    Capture
  • A recent report from Goldman Sachs, “The Two-Speed Economy,” shows that large firms have grown faster than usual after 2010 while small firms have grown much slower than usual (see chart above).

Conclusion. Monetary policy alone, as conducted by the Federal Reserve, cannot return our economy to good health. This can only be accomplished by increasing productivity which is aided by smart fiscal and regulatory policy. Dodd-Frank is an example of regulatory policy which is hurting economic growth by having a harmful effect on main street banks.                                 

The Financial Crisis IV. Where Do We Go From Here?

 

“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.                                                                    former Congressman Barney Frank, 2010

“Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.”
                                                   former Federal Reserve Chair, Ben Bernanke, 2010

As I explained in my last post, my views on the financial crisis are most heavily influenced by John Allison, President of the CATO Institute; Sheila Bair, former Chair of the FDIC; and Peter Wallison, a financial policy analyst at the AEI, as follows:

  • The primary cause of the crisis was the affordable housing policy, created by Congress and administered by HUD, under which higher and higher percentages of mortgages acquired by the GSEs Fannie Mae and Freddie Mac had to be made to low and moderate income borrowers. This policy, aided by the very low interest rates maintained by the FED from 2002-2004, created the housing bubble which burst in 2007 leading to an unprecedented number of delinquencies and defaults.
  • Subprime lending abuses could have been avoided if the FED had used the authority it had under the Home Ownership Equity Protection Act of 1994 to require appropriate mortgage lending standards. In other words, lax regulation, but not deregulation, was a major contributor to the crisis.
  • Investment Banks, such as Bear Stearns and Lehman Brothers, magnified the misallocation of credit to the housing market with financial products such as CDOs and derivatives.

Clearly congressional action was needed to address the financial abuses leading up to the crisis.  But the Dodd-Frank Act is an overreaction.  It requires 398 new regulations which are taking a big toll on the economy as shown by the chart below from the American Action Forum.
CaptureDodd-Frank should be scaled back so that its provisions apply only to the very largest financial institutions where the abuses were the greatest.  This can be accomplished with capital requirements which increase proportionally with the size of the institution so that smaller banks are better able to compete with the giants.
Faster economic growth is critical for our future.  It will not only create more jobs and higher paying jobs but will also alleviate our deficit problem by bringing in more tax revenue.  Paring back and streamlining Dodd-Frank would be a big step in the right direction.

The Financial Crisis III. How Do We Sort Out What Happened?

 

The Financial Crisis in 2008 was one of the most disruptive events in U.S. history.  It is crucial that we understand what caused it so that we can recover from it more fully and avoid a recurrence.  My favorite books about the crisis are: The Financial Crisis and the Free Market Cure by John Allison, President of the CATO Institute and former CEO of the large financial services company, BB&T;  Bull By the Horns by Sheila Bair, Chair of the FDIC from 2006-2011; and Hidden in Plain Sight by Peter Wallison, an economics policy scholar at AEI and former member of the FCIC.
CaptureNot surprisingly, these three very well informed individuals have somewhat different points of view.
Mr. Wallison says that the government’s affordable housing policies caused the financial crisis by essentially requiring the GSEs Fannie Mae and Freddie Mac to acquire increasingly large numbers of subprime mortgages.  The financial power of the GSEs forced private lenders to lower their own lending standards in order to compete (this last assertion is in dispute). When the resulting housing bubble burst, large numbers of subprime mortgages defaulted causing huge losses for both GSEs and private financial institutions alike.
Ms. Bair says that “the subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act to promulgate mortgage lending standards across the board.”  In March 2007 she testified strongly in favor of the Fed issuing an anti-predatory lending regulation under HOEPA and was rebuffed by the Fed.  As FDIC Chair she constantly urged, largely without success, that other federal agencies use their regulatory powers to curtail the abuses of private lenders.
Mr. Allison agrees with Mr. Wallison that “the whole origination market relaxed its standards to compete with Freddie and Fannie.”  However he goes on to say that “the investment banks (including Bear Stearns and Lehman Brothers) magnified the misallocation of credit to the housing market.  They created a series of financial innovations (CDOs, derivatives, etc.) that leveraged an already overleveraged product. … Investment bankers unquestionably made irrational decisions based on pragmatic, short-term thinking. … Those who made these mistakes should have been fired and their companies allowed to fail.”
Can these disparate points of view be melded into a coherent framework for the financial crisis which suggests a way forward from where we are today?  I will attempt to do this in my next post.

The Financial Crisis II. Is Peter Wallison Credible?

 

“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.
 
                                                             former Congressman Barney Frank, 2010

“The ferocity of the left in defending Fannie Mae, Freddie Mac, and the government’s housing policies before 2008 is sometimes shocking, especially when even Barney Frank has given up.  It makes you wonder why this is so important to them.  They have no data, no policy arguments, just a virulent denial that anything other than the private financial sector could possibly be responsible for the financial crisis.”
                                                  “Hidden in Plain Sight,” p 42, by Peter Wallison, 2015

My last post, “The Financial Crisis I. The Cause” reported on a new book “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” by Peter Wallison, a financial policy analyst at the American Enterprise Institute.  He makes a very strong case, with voluminous documentation, that the basic cause of the financial crisis was the HUD policy requiring government agencies like Fannie Mae, Freddie Mac and the FHA to gradually acquire an increasing percentage of subprime mortgages.  When the housing bubble finally burst in 2007, the enormous number of delinquencies and defaults among these nontraditional mortgages, aggregate value over $5 trillion, drove down housing prices and caused the financial crisis.
CaptureAs noted above by Mr. Wallison himself, such an explanation is simply unacceptable to people who insist on blaming the private sector for the crisis.  Rather than dealing with public records and data available, they instead try to discredit Mr. Wallison.  My purpose today is to give two vivid examples of the types of documents which Mr. Wallison uses to make his case:

  • (Fannie Mae 10-K report, 2006). “We have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased hosing goals and new subgoals.  These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions.  We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.
  • (statement by Daniel Mudd, former Fannie Mae CEO, April 2010). “Fannie Mae’s mission regulator, HUD, imposed ever-higher housing goals that were very difficult to meet during my tenure as CEO.  The HUD goals greatly impacted Fannie Mae’s business, as a great deal of time, resources, energy and personnel were dedicated to finding ways to meet these goals.  HUD increased the goals aggressively over time to the point where they exceeded the 50% mark, requiring Fannie Mae to place greater emphasis on purchasing loans in underserved areas.  This became particularly problematic when goal requirements grew to far exceed the proportion of eligible mortgages originated in the primary market.”

Mr. Wallison’s book is filled with this type of detailed documentation for the case he is making.  It should be persuasive to anyone with an open mind.  It certainly is to me.  Now that Mr. Wallison’s credibility is established, it is time to discuss the implications of his thesis.  Stay tuned!

The Financial Crisis I. The Cause

 

Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.                                                                                                         Ben Bernanke, September 2, 2010

An outstanding new book by Peter Wallison, ”Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” gives a voluminous and highly compelling explanation of the main cause of the financial crisis of 2008.  Mr. Wallison worked at the Treasury Department in the 1980s, was a member of the Financial Crisis Inquiry Commission (2009 – 2011) and is currently a scholar at the American Enterprise Institute.
CaptureHere is the outline of Mr. Wallison’s story:

  • The Department of Housing and Urban Development gradually increased the requirement that loans acquired by Fannie Mae and Freddie Mac be made to low- and moderate-income borrowers from 30% in 1992 to 56% in 2008.
  • As a result of these policies, by the middle of 2008 there were 31 million Nontraditional (low down payment and/or poor credit) Mortgages (NTMs) in the U.S. Financial system, more than half of all mortgages outstanding, with an aggregate value of more than $5 trillion. At least 76% of these were on the books of government agencies such as Fannie, Freddie and the FHA or banks and S&L institutions, holding loans which they were required to make by the Community Reinvestment Act.
  • The 24 million NTMs acquired or guaranteed by government agencies were major contributors to the growth of the housing bubble and its lengthy extension in time.
  • The growth of the bubble suppressed the losses that would ordinarily have brought NTM type Private Mortgage-Backed Securities (PMBS) to a halt but rather made these instruments look like good investments.
  • When the bubble finally burst, the unprecedented number of delinquencies and defaults among NTMs drove down housing prices.
  • Falling home prices produced losses on mortgages, whether they were government backed or PMBS.
  • Losses on mortgages caused investors to flee the PMBS market, reducing the liquidity of the financial institutions that held the PMBS.
  • Once the housing bubble burst, four major errors were made by our top government financial officials: The first and major error was the rescue of Bear Stearns. The moral hazard created by this action reduced the incentive for other firms to restore their capital positions. Once Bear had been rescued it was essential to rescue Lehman Brothers. Treasury Secretary Paulson and Fed Chairman Bernanke’s arguing that they did not have legal authority to rescue Lehman provided an excuse for Congress to pass the destructive Dodd-Frank Act. Finally, TARP accomplished little but caused much popular resentment against the banks which supposedly got bailed out.

Conclusion: as long as the American people don’t understand that government housing policies were the main cause of the financial crisis, we are likely to repeat the same mistakes over again.