The former Fed chairman’s memoir helps explain why this economic recovery has been so disappointing.
News that the U.S. economy grew only 1.5% in the third quarter again raises the question: Why has the recovery from the recession been so historically weak?
Former Federal Reserve Chairman Ben Bernanke’s new book, “The Courage to Act,” amply illustrates how the failure to understand what caused the 2007-08 financial crisis ushered in policies that have slowed growth.
By the time he became Fed chairman in February 2006, Mr. Bernanke was aware that a large housing bubble was developing—by 2007 it had inflated to the largest in U.S. history—and that underwriting standards across the housing market were declining. Yet he apparently never tried to determine why these major shifts were occurring.
Because he didn’t investigate this issue, in March 2007 Mr. Bernanke famously told Congress that “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” When the crisis developed later that year, the only changes he could imagine that would prevent another crisis were, as he says in his book, “improved monitoring of the financial system and stronger financial regulation.”
Nowhere in the book does he mention or show any grasp of the true causes of the decline in underwriting standards: the federal government’s affordable-housing goals, which required Fannie Mae and Freddie Mac to meet annual quotas for mortgages made to borrowers at or below the median income. Nor does he mention that these goals had increased from 30% of all mortgages they acquired in 1992 to 56% of all they acquired in 2008, forcing Fannie and Freddie to loosen their standards further to reach the targets. Because they were the dominant players in the market, all underwriting standards deteriorated.
What little he knew about Fannie and Freddie appears to come straight from the left’s history of the financial crisis. He writes that from 2004-06, “anxious about competition posed by private-label [mortgage-backed securities], and eager for the high returns that lower quality mortgages seemed to promise, they bought and held private label MBS that included subprime and other low-quality mortgages.”
Yet by 2002 Fannie and Freddie had acquired $1.2 trillion in subprime and other weak mortgages. By the time he became Fed chairman, they’d racked up $3.4 trillion. By 2008, apparently unknown to the Fed or Mr. Bernanke, 31 million loans—more than half of all U.S. mortgages—were subprime or otherwise weak, and 76% of those sat on the books of government agencies, principally Fannie and Freddie. This shows, beyond question, where the demand for these subprime and risky loans originated.
So it came as no surprise, given his limited knowledge, that he and Hank Paulson, then-Treasury secretary, were, as Mr. Bernanke put it, “eager to focus Congress on the gaps in financial regulation” when they testified before the House Financial Services Committee in July 2008. After that, the Democratic-controlled Congress, working with the Obama administration, produced the overreaching Dodd-Frank Act, signed into law in 2010 and named after the two strongest congressional proponents of affordable-housing goals, former Rep. Barney Frank and Sen. Chris Dodd.
It is thanks to Dodd-Frank that the five-year growth rate has averaged about 2.2%. Dodd-Frank has had this effect primarily because of the new regulatory costs and lending standards it imposed on financial firms, particularly small banks. New regulations from the Consumer Financial Protection Bureau and other Dodd-Frank inventions have forced many small banks out of business, forced others to merge with larger competitors, and reduced the rate of new bank formation from an average of 100 a year before 2010 to only three afterward.
The regulations and restrictions on small banks have most acutely affected small businesses, particularly startups. Though most new employment in the U.S. economy comes from small business, entrepreneurial startups provide most small-business employment growth. A 2013 study published in the Review of Economics and Statistics shows that over time firms aged 0-5 years account for 20% of total job creation in the U.S.
This part of the economy has been hit hardest by Dodd-Frank rules that have driven up costs for small banks, reduced their number and applied large bank lending standards to the small outfits that have always met their communities’ needs with the flexible standards startups require.
A 2015 Goldman Sachsstudy shows that large firms—500 employees or more—have grown at a pace consistent with past recoveries, but small businesses have remained stagnant. The study concludes that, since Dodd-Frank, small businesses—which rely largely on small banks—have been unable to find the credit necessary for growth, while large firms have access to credit through the capital markets.
If Mr. Bernanke had used his academic skills and the Fed’s data to determine what actually caused the crisis, he might not have pushed Congress to fill “the gaps in financial regulation.” Had he advocated instead changing destructive housing policies, Dodd-Frank might never have happened and the economic recovery would have been far more robust.
The views expressed in this testimony are those of the author alone and do not necessarily represent those of the American Enterprise Institute.
Chairman Jeb Hensarling, Ranking Member Waters and members of the Committee:
I am grateful for the opportunity to testify before this committee on the question: “The Dodd-Frank Act Five Years Later: Are We More Prosperous?” My name is Peter Wallison. I am the Arthur F. Burns Fellow in Financial Market Studies at the American Enterprise Institute. My testimony is my own and does not necessarily represent the views of AEI.
I am particularly delighted to be seated here with Phil Gramm, not only the teacher of the chairman of this committee but to my mind the greatest political economist ever to sit in the US Senate. He is sorely missed by everyone who recognizes the need today for pro-growth economic and financial policies. To be sure, there are great advocates for these policies in Congress today, but the knowledge and clarity of expression of Senator Gramm was and is unique. Although I like to have the opportunity to speak once in a while when I testify before congressional committees, I would happily cede all of my time to Phil Gramm. In that way, not only will the members of this committee be educated, but so will I.
Dodd-Frank became a law on July 21, 2010, and this testimony will use that date as the reference point for determining the economic effects of the act. On whether we are more prosperous since July 21, 2010, it is important to understand that the question of prosperity or economic growth is relative. There has certainly been economic growth since July 21, 2010. In that sense, we are more prosperous, but as Senator Gramm said in his written testimony: “Had this recovery simply matched the strength of the average of the other ten recoveries since World War II, 14.4 million more Americans would be working today and the average income of every man, woman and child in the country would be $6,042 higher.”
Below is a chart, prepared by the Federal Reserve Bank of Dallas that encapsulates the point that Senator Gramm is making.
As the chart shows, through the first quarter of 2013, there had been some economic growth, but far less than in a normal recovery. Since then, as we know, things have not improved substantially. A recent op-ed in the Wall Street Journal by Glenn Hubbard (former chair of the Council of Economic Advisers under George W. Bush) and Kevin Warsh (a former Governor of the Federal Reserve) in effect updates this chart: “Economic growth in real terms is averaging a meager 2.2% annual rate in the 23 quarters since the recession’s trough in June 2009. The consensus forecast of about 1% growth for the first half of this year offers little solace.”
What’s the problem?
I believe that all the new regulation added by the Dodd-Frank Act in 2010 is the primary reason for the slow growth this country has experienced since 2010. Later in this testimony, I will show that the new regulations imposed on banks—particularly small banks—has created a bifurcated economy. Large firms in the real economy, which can access the capital markets for financing, have been growing roughly in line with previous recoveries, but smaller firms that rely on banks for financing are growing far more slowly. Since most of the growth in the US economy, and especially in employment, comes from small firms, the economy is underperforming and will continue to underperform until the treatment of banks under Dodd-Frank Act is substantially modified or repealed.
A Cost-Benefit Analysis of Dodd-Frank’s Additional Regulations on Banks
The relevant question about the efficacy of any new regulation such as the Dodd-Frank Act is always one of balancing costs and benefits. Regulation inevitably imposes costs, and placing additional costs on any business will virtually always reduce the system’s productivity and growth by diverting expenditures to regulatory compliance instead of greater production. In banking and finance, which rely heavily on human capital, it may be easier to measure at least one element of cost—the effect on hiring practices. If, in order to comply with a regulation, a bank has to hire a compliance officer rather than a loan officer, the bank will inevitably be less productive—it will make fewer loans for the same amount of revenue.
Looking simply at employment practices instead of other effects of regulation is a very simple idea, and it doesn’t fully reflect all the costs of additional regulation. As Greg Ip recently wrote in the Wall Street Journal, “[N]o one knows the true costs or benefits of the blizzard of laws, rules and penalties imposed since the financial crisis…Unlike the rules governing pollution and automobile safety, the costs and benefits of big new financial rules are seldom rigorously quantified… The costs of financial regulation go beyond what banks and their shareholders must pay for more compliance personnel. By making credit more expensive and restricting supply, new regulation can ding growth, especially at times like the recent past when the Fed can’t compensate by lowering interest rates, which are already near zero.”
Nevertheless, although we can’t put a number on all the costs of more regulation, at least for the banking industry we can say that hiring practices shaped by additional regulation may be one way to measure some of the costs of the new regulation that came with the Dodd-Frank Act. I will assume in the discussion that follows that all the new regulations that have been imposed on banks have required them to add compliance officers instead of loan officers, and that this was one major cost of the Dodd-Frank Act. It added costs, but reduced the amount of lending. The next question is measuring the benefit.
Giving Congress its due, in enacting Dodd-Frank Congress was trying to achieve financial stability in the future through stricter regulation of the financial system. In doing so, I believe Congress misdiagnosed the financial crisis as the result of lax regulation of the private financial sector. In effect, it treated the symptoms rather than the disease. The symptoms were the weakness of private financial institutions as unprecedented numbers of mortgages defaulted in 2007 and 2008, but the disease was the government’s housing policies, which—between 1992 and 2008—caused a drastic deterioration in residential mortgage underwriting standards. A single fact demonstrates the government’s role in weakening the financial system: in 2008 more than half of all mortgages in the US—31 million loans—were subprime or otherwise weak and risky. And of these 31 million mortgages, 76 percent were on the books of government agencies. This shows, without question, that the government created the demand for these low quality mortgages.
For purposes of this testimony, however, whether Congress was right or wrong in its diagnosis of the financial crisis is immaterial. Even if Congress was correct in its assessment of the causes of the crisis, we can evaluate whether the balance it struck between costs and benefits in the regulation of banks was correct. Here we can be reasonably sure that we know what benefit Congress was seeking. Because of its diagnosis of the crisis, Congress was seeking to create future stability in the financial system by imposing greater regulation on private sector financial firms, particularly banks. So the question is whether the stability Congress was hoping to achieve through additional regulation in Dodd-Frank outweighs the costs.
Before beginning this analysis, it is important to note that we cannot weigh all the costs of Dodd-Frank. We don’t have the capacity to do that at this point. When Jamie Dimon, the chair of JPMorgan Chase, asked Ben Bernanke in 2011 whether “anyone bothered to study the cumulative effect of all these things,” Bernanke replied, “I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.”
Nevertheless, the fact that we can’t quantify all the costs of Dodd-Frank does not mean that we can’t assess at least one of them, and that is the cost of hiring compliance officers instead of loan officers. Compliance officers are necessary to meet the regulatory demands of the government; loan officers are necessary to increase lending or to sustain it at previous levels. To the extent that banks have to hire compliance officers instead of loan officers, they are inevitably reducing the amount of lending they will do.
A good place to assess the cost-benefit question underlying Dodd-Frank is the act’s requirement that all bank holding companies with $50 billion in assets or more be considered systemically important financial institutions (SIFIs) and subjected to “stringent” regulation by the Fed. Among many other requirements, these banking organizations must also prepare living wills—detailing how they would be broken up if they fail—and participate in annual Fed-designed stress tests. These and other requirements add substantial additional costs to whatever “stringent” regulation entails. These substantial additional costs, even if only in the form of more compliance officers than loan officers, will mean that these banks will supply less credit to the real economy. If banks did not have to hire any compliance officers, all their new hires—if any—would be loan officers, which would generate more loans and hence more revenue and more economic growth for the real economy.
Do the benefits that Congress sought in imposing substantial new regulation on banking organizations with assets of $50 billion or more outweigh the costs? The benefit is added stability. With “stringent” regulation, stress tests and living wills, it is fair to assume that these banks will be less likely to fail in the future, and if they fail their failure will not be as disorderly as failures in the 2008 financial crisis. The cost is that these banking organizations will, through their subsidiary banks, be making less credit available to the real economy because they have been required to hire more compliance officers instead of loan officers.
The Federal Reserve’s Flow of Funds accounts tells us that as of the end of the first quarter of 2015 the total financial assets in the US were $86 trillion, and total assets of private depository institutions were $17 trillion. $50 billion is .3% of 17 trillion. So the drafters of the Dodd-Frank Act believed that a banking organization with .3% of the assets of the entire banking business would cause the financial system to become unstable if it failed. A bank with $200 billion in assets would have 1.2% of total bank assets. Even a bank with $500 billion in assets has only a little over 3% of all bank assets. It seems completely implausible that in an economy with $85 trillion in financial assets and a banking system with $17 trillion in assets the failure of a $50 billion banking organization—or even a $200 billion or $500 billion bank—would cause any significant instability. Losses, yes. Instability in the whole financial system, no.
So it seems that Congress struck the wrong cost-benefit balance between economic growth and stability when it decided that any banking organization with assets of $50 billion or more ought to be subjected to costly new regulations in the interest of assuring the future stability of the financial system. This new regulatory burden imposes a high cost in the form of much slower growth—especially, as we will see, for businesses dependent on banks—with very little benefit in the form of additional stability. Senator Gramm described the high cost relative to benefits in the statement from his testimony that I quoted above. In that case, which assumed that Dodd-Frank had not been adopted at all, the cost came in the form of a slower economic recovery since the end of the 2009 recession than the average recoveries of the past.
We don’t know how much additional growth we would have had if Dodd-Frank had drawn the SIFI line for banking organizations at the different place—say, at $500 billion or $1 trillion. Although we know that regulation has some cost, there is insufficient data available to draw any connection between a certain amount of new regulatory cost and a certain amount of reduced economic growth. But what we do know in the case of the special regulations imposed on banks with more than $50 billion in assets up to as much as $500 billion is that we have bought more stability than we need at the cost of reduced economic growth.
The same is true for small banks, which have also been required to address many new regulations coming out of Dodd-Frank, especially in mortgage lending, debit and credit card activity and consumer lending. There has actually been some solid academic work on how regulation affects the employment practices and profitability of community banks—those with assets of less than $50 million. In 2013, three economists at the Federal Reserve Bank of Minneapolis actually looked at the effect of new regulations on these small institutions. They chose to model only the effects on bank hiring, although many other factors—risk-taking, legal liability, product costs—are affected by additional regulation. “[W]e find,” they write, “that the median reduction in profitability for banks with less than $50 million is 14 basis points if they have to increase staff by one half of a person; the reduction is 45 basis points if they increase staffing by two employees. The former increase in staff leads an additional 6 percent of banks this size to become unprofitable, while the latter increase leads an additional 33 percent to become unprofitable.”
Although community banks with less than $50 million in assets are of course much smaller and simpler than banks with $50 billion in assets, the point is the same if we are talking about the effect of regulations on hiring practices. If a banking organization larger than $50 billion has to hire additional compliance officers in order to meet its new stringent regulation, living will and stress test requirements, its profitability will also be reduced, a certain number of those banking organizations will then become vulnerable to failure, and all of them will reduce the amount of credit they provide because relatively more of their human capital is engaged in compliance rather than sales.
In March, 2014, for example, JPMorgan Chase, the largest US banking organization, cut back its projections for the coming year, saying that its trading profits and return on equity would be down. It noted that it would also add 3000 new compliance employees, on top of the 7000 it added the year before. But the total number of employees of the banking organization were expected to fall by 5000 in the coming year. Absent the regulatory imperative, the bank might have cut 8000 employees instead of 5000, thus cutting its costs somewhat further, or it might have added 3000 new loan officers instead of compliance officers to increase its revenues. But with the regulatory imperative it faced, even a large banking organization that is experiencing a decline in profitability had to increase its hiring of compliance officials and cut employees from its profit-making activities. What we are seeing, then, is a clear case—even at the level of the largest banking organizations—of compliance costs substituted for the personnel that are normally the sources of revenue and profit.
Are There Other Explanations for the Slow Recovery?
Defenders of Dodd-Frank sometimes argue that a slow recovery is typical after financial crises, but recent scholarship casts doubt on this explanation. Michael Bordo and Joseph Haubrich studied 27 recession-recovery cycles since 1882 and concluded: “Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis.” [emphasis added]
Bordo and Haubrich find only three exceptions to this pattern; in these cycles, the recoveries did not match the speed of the downturns. The three were the Depression of the 1930s, the 1990 recession that ended in March 1991, and the most recent recession, which ended in June 2009. What do these three exceptions have in common?
In each case, the government’s intervention in the financial system was unusual and extensive. During the Depression Era the Hoover and Roosevelt administrations tried many ways to arrest the slide in the economy, all without success. Hoover was an inveterate activist in all things, and Franklin Roosevelt believed in constant experimentation until something worked. Neither of them seemed to have a consistent theory about what brought on the economic downturn or how to address it. Under President Hoover, Congress passed the Smoot-Hawley Tariff Act, and the Emergency Relief and Reconstruction Act, and established the Reconstruction Finance Corporation. Under Roosevelt, the US went off the gold standard, established a deposit insurance system and a federal regulatory system for state-chartered banks; Congress adopted the National Recovery Act, the Emergency Banking Act, Emergency Farm Mortgage Act, the Securities Act, the Securities & Exchange Act and the Farm Credit Act. Other major laws with financial implications were the National Industrial Recovery Act and the Agriculture Adjustment Act (both of which were eventually declared unconstitutional by the Supreme Court). This enormous flurry of activity, however, while popular with the American people, did not produce a recovery until the nation geared up for war at the end of the 1930s.
In addition, the Pecora hearings of the early Roosevelt administration, propagated the idea that banks’ securities activities had caused the crisis; this is uncannily similar to the narrative that produced the Dodd-Frank Act, which blamed the financial crisis on insufficient regulation of the financial system and greed and recklessness on Wall Street. The Pecora hearings resulted in the Glass-Stegall Act, which separated securities and banking activities. Whether or not that was harmful can be debated, but the wholesale revision of financial structures it entailed probably constricted credit and market confidence in the years that followed.
The recession in 1990 and early 1991 came after the collapse of the S&L industry in the late 1980s and the failure of almost 1600 banks during the same period. Both were blamed on insufficient regulatory authority or lax enforcement—again like the narrative that supported the Dodd-Frank Act—and produced the Financial Institutions Recovery, Reform and Enforcement Act (FIRREA) in 1989 and the FDIC Improvement Act (FDICIA) in 1991.
These laws increased the regulatory authority of federal bank regulators, and under pressure from Congress and the public they cracked down on depository institutions, causing a credit crunch and what was called a “jobless recovery” in 1991. As one observer put it, the Comptroller of the Currency “had softened regulatory policies on banks early in his tenure, helping fuel excessive real estate lending by banks. By mid-1990 and early 1991, the regulatory attitudes had apparently changed: “Bank examiners became too restrictive, helping to create a near credit crunch.” In addition, the first set of Basel risk-based capital rules were adopted in 1988 and were gradually phased in at this time, requiring banks to re-compute their capital positions and in many cases required them to increase their capital.
Thus, there is historical evidence that the slow recovery from the 2008 financial crisis is due in part—maybe primarily—to the fact that the Dodd-Frank Act was adopted shortly after the crisis. Instead of allowing the economy and the financial system to heal naturally, it introduced constraints, costs and uncertainties that have interfered with the natural course of the recovery. Moreover, like the Pecora hearings, Dodd-Frank was based on the idea that the private sector was to blame for the crisis and thus sought to punish the very entities that were necessary to finance a recovery.
The idea that a post-recession series of actions can in fact slow an economic recovery receives added weight from a recent book by James Grant called The Forgotten Depression. Grant traces the sharp downturn and the following sharp recovery in 1920 and 1921. The downturn in 1920 was severe. “Just how severe,” writes Grant, “is a question yet to be settled…Official data as well as contemporary comment paint a grim picture. Thus, the nation’s output in 1920-21 suffered a decline of 23.9 percent in nominal terms, 8.7 percent in inflation-(or deflation)-adjusted terms. From cyclical peak to trough, producer prices fell by 40.8 percent. Maximum unemployment ranged between two million and six million persons…out of a nonagricultural labor force of 31.5 million. At the high end of six million, this would imply a rate of joblessness of 19 percent.”
But the government did nothing. President Wilson had suffered a second severe stroke in October 1919, and was partially paralyzed, although this fact was withheld by the White House. What little energy Wilson had through the election year of 1920 was reserved for the fight over the League of Nations. The Republican Harding administration, which followed, did nothing either, says Grant. “The successive administrations of Woodrow Wilson and Warren G. Harding met the downturn by seeming to ignore it—or by implementing policies that an average 21st century economist would judge disastrous. Confronted with plunging prices, incomes and employment, the government balanced the budget and, through the newly instituted Federal Reserve, raised interest rates…Yet by late 1921, a powerful, job-filled recovery was under way. This is the story of America’s last governmentally unmedicated depression.” Needless to say, there was no new regulation, and the economy recovered quickly.
This is not to say that a laissez-faire policy is always best, but simply that adding new regulatory activity after a severe recession seems to slow a rapid return of economic growth, and that certainly seems to be borne out by the examples cited above.
It is of course possible that the 2008 financial crisis and the ensuing recession were such shocks to the economic system that they have caused a secular change in the performance of the US economy—a “new normal” of slow growth and declining living standards for the middle class. However, it is far more likely that government policies are responsible for these conditions, and if we look for the policies that could have had the greatest effect on the economy since the financial crisis, there have been only three—the Affordable Care Act, the Fed’s historically low interest rates, and the Dodd-Frank Act. Neither the ACA nor low interest rates should have had a repressive effect on new business formation; quite the contrary. Nor should either of them significantly suppress capital investment—again, it’s more likely that they’ve both had stimulative effects. So that leaves Dodd-Frank as the most likely cause of the slow-growth economy we have been experiencing.
Finally, quite apart from the fact that Dodd-Frank has probably slowed the recovery from the financial crisis and the ensuing recession through adding excessive regulatory costs, it is important to note that it has also added regulations that impose major costs but which have little or no relationship with the financial crisis. In a 2014 study, the American Action Forum showed that three requirements in the Dodd-Frank Act, the pay ratio rule, the Conflict Minerals provisions and the Volcker Rule totaled more than $10 billion in costs for financial firms, but none has been shown to be a cause of the crisis. For the reasons outlined earlier, these costs are reducing the availability of credit and slowing economic growth for reasons of social justice or the placation of a special interests, not because they were deemed necessary to address the financial crisis. In the case of the Volcker Rule, as discussed later, it may be the eventual cause of another financial crisis by reducing liquidity in the financial markets. In this case, the eagerness of Congress to impose more restrictions on the financial system than were warranted by its own misdiagnosis of what happened in 2008 may have planted the seeds for a future crisis.
How Dodd-Frank has Slowed Economic Growth
If excessive regulatory costs have slowed the recovery from the financial crisis, they will continue to slow economic growth until they are reduced or eliminated. In the balance of this testimony, I will focus on the additional regulatory costs imposed on banking organizations, especially small banks, because I think there is a strong case that reducing credit availability from banks is having a particularly adverse effect on small business, which in turn is the principal source of growth and employment in the US economy.
The most important factor in this analysis is the dependence of small and medium sized businesses on bank lending. Larger businesses have access to other sources of credit, primarily through the capital markets. Firms that have registered their securities with the SEC are able to sell bonds, notes and short-term paper in the capital markets—normally a less expensive and easier process than borrowing from a bank. The chart below shows that since the mid-1980s the capital markets have outcompeted the banking industry as a source of credit for business corporations. This popular alternative means of financing, however, is not available to small or medium sized businesses, because they are not generally owned by public shareholders and do not report their financial results to the SEC. Accordingly, they are more dependent on bank financing than larger firms. Greater and more costly regulation of banks, then, would inevitably cause either an increase in the cost of bank credit, a reduction in its availability, or both, to these smaller firms.
Source: Fed Flow of Funds
A second factor causing difficulties for small banks in particular is the narrative underlying the Dodd-Frank Act—that the financial crisis was caused by insufficient regulation of banks and other financial firms. Solid academic work by my AEI colleague Paul Kupiec and two others has shown that when the regulators were said to have been lax, that is followed by more intrusive activity by bank examiners, and this reduces the amount of lending. “[S]upervisory restrictions,” they report, “have a negative impact on bank loan growth after controlling for the impact of monetary policy, bank capital and liquidity conditions and any voluntary reduction in lending triggered by weak legacy loan portfolio performance or other bank losses.” This analysis received confirmation from Fed Governor Duke in testimony to Congress in February 2010, “Some banks may be overly conservative in their small business lending because of concerns that they will be subject to criticism from their examiners…some potentially profitable loans to creditworthy small businesses may have been lost because of these concerns, particularly on the part of small banks.”
Finally, the new and more costly regulation imposed by Dodd-Frank appears to have stalled the formation of new banks, which in turn has also affected the availability of credit for the small and medium-sized businesses that are dependent on bank lending. A Federal Reserve Bank of Richmond report in March 2015 notes that “The rate of new-bank formation has fallen from an average of about 100 per year since 1990 to an average of about three per year since 2010.” Trying to assess the reasons for this sharp decline, the report continued, “Banking scholars …have found that new entries are more likely when there are fewer regulatory restrictions. After the financial crisis, the number of new banking regulations increased with the passage of legislation such as the Dodd-Frank Act. Such regulations may be particularly burdensome for small banks that are just getting started.”
The authors suggest other possible causes, but the fact that the decline became so severe in 2010, the year of the enactment of Dodd-Frank, is strong evidence that the new requirements in the act—which have been cited again and again by small banks since 2010—are responsible. In any event, the decline in new banks caused an overall decline of 800 in the total number of small independent banks between 2007 and 2013. This would have had a disproportionate effect on small business and account in part for the failure of the economy to gain any momentum since the enactment of Dodd-Frank.
Another 2015 study ties the decline of community banks even more closely to the Dodd-Frank Act: “[C]ommunity banks’ share of U.S. banking assets and lending markets has fallen from over 40 percent in 1994 to around 20 percent today. Interestingly, we find that community banks emerged from the financial crisis with a market share 6 percent lower, but since the second quarter of 2010—around the time of the passage of the Dodd-Frank Act—their share of commercial banking assets has declined at a rate almost double that between the second quarter of 2006 and 2010. Particularly troubling is community banks’ declining market share in several key lending markets, their decline in small business lending volume and the disproportionate losses being realized by particularly small community banks.”
If these factors are indeed adversely affecting banks and thus small business, we should see a difference in growth rates between small business and larger businesses since 2010, when the Dodd-Frank Act was adopted. A recent paper shows exactly that kind of disproportionate effect on small and medium size businesses.
In a Goldman Sachs report published in April 2015, and titled “The Two-Speed Economy,” the authors posit that new banking regulations have made bank credit both more expensive and less available. “This affects small firms disproportionately because they largely lack alternative sources of finance, whereas large firms have been able to shift to less-expensive public market financing.” But banking regulation was not the only regulation that had an effect on small business: “While banking regulation has played a key role, regulation outside of banking has also raised the fixed costs of doing business.” These costs fall most heavily on small firms because larger firms can more easily cope with the fixed costs imposed by regulation.
Using IRS data, the Goldman study finds that large firms—those with $50 million or more in revenue annually, have been growing revenue at a compounded annual rate of 8 percent, while firms with less than $50 million in revenue have been growing revenue at an average of only 2 percent compounded annually. Using Census data, Goldman found that “firms with more than 500 employees grew by roughly 42,000 per month between 2010 and 2012, exceeding the best historical performance over the prior four recoveries. In contrast, jobs at firms with fewer than 500 employees declined by nearly 700 per month over the same timeframe, whereas this figure had grown by roughly 54,000 per month on average over the prior four recoveries.”
This accounts for the dearth of new business formations. Small firms are simply unable to get the credit that used to be available to small business and small business start-ups, and the credit that they can get is more expensive. This would also have a disproportionate effect on employment in the recovery, because small business is the principal source of new employment growth in the US economy.
The Goldman paper then turns to the lack of capital investment, and also finds the source of that in financial regulation. “Even as large firms experience a relatively robust recovery, they appear to be investing less than we would expect given their historically high profit margins, and investing with a bias toward shorter term projects; this dynamic may be playing out because large firms are facing less competition from smaller firms. Investments in intellectual property, for example, are tracking nearly five percentage points below even the low end of the historical experience and more than 20 percentage points below the historical average.”
Finally, the Goldman paper expresses concern that this is not necessarily a temporary phenomenon: “Taken together, the reduced competitiveness of small firms and the changing investment decisions of larger ones are reshaping the competitive structure of the US economy in ways that are likely to reverberate well into the future, and in ways that any future evaluation of the aggregate effects of post-crisis regulations should consider.”
It would be hard to find a better way to express the dangers of leaving the Dodd-Frank Act in place without serious reforms.
Dodd-Frank, the Volcker Rule and the Danger of another Financial Crisis
Any policy that reduces market liquidity should be worrisome for this country, given the experience of the financial crisis. More than anything else, the crisis was a liquidity crisis, not a solvency crisis. When Lehman Brothers was allowed to fail, liquidity in the market dried up, meaning that firms that wanted to sell securities to raise cash were not able to do so. We don’t know what lies before us, and what event or events could cause many investors to seek to liquidate their holdings of fixed income securities, but what is clear is that if the market does not have the liquid resources to buy these securities their prices will drop precipitously. The securities “fire sales” that regulators say they are worried about will become a reality. The irony is that it is the laws and regulations that Congress has put in place through the Dodd-Frank Act that will cause the crisis.
Chief among these is The Volcker Rule, which forbids banks or their affiliates to engage in proprietary trading of debt securities. Although it was justified by the claim that banks were taking risks with insured deposits, this was truly an absurd idea. The riskiest thing that banks do with their insured deposits is make loans. Trading securities in a liquid market is far less risky than giving a borrower a substantial amount of money in the hope of eventual repayment. Before the Volcker rule, banks were active in making markets in debt securities by standing ready to buy or sell these securities . It is very difficult to tell the difference between making a market—that is, buying and selling for your own account—and proprietary trading. As a result, banks have begun to reduce their market-making activities, leaving the market for all securities with far less liquidity than it had before the Volcker rule was adopted. Some large banks have simply disbanded their bond-trading groups.
This has substantially reduced the amount of capital and liquidity available to the debt markets. The lack of liquidity has almost certainly increased the buy-sell spreads in the debt markets and the costs of buyers, sellers and investors who trade in fixed income securities. It is now much more difficult to sell a fixed income security and thus much more risky to buy one. As reported on May 20, 2015 in the Wall Street Journal,
Talk to almost any banker, investor or hedge-fund manager today and one topic is likely to dominate the conversation. It isn’t Greece, or the U.S. economy, or China…It is the lack of liquidity in the markets and what this might mean for the world economy—and their businesses. Market veterans say they have never experienced anything like it. Banks have become so reluctant to make markets that it has become hard to execute large trades even in the vast foreign-exchange and government bond markets without moving prices, raising fears investors will take unexpectedly large losses when they try to sell. The U.S. corporate-bond market has almost doubled to $4.5 trillion since the start of the crisis, yet banks today hold just $50 billion of bonds compared with $300 billion precrisis.
As Douglas Elliott of the Brookings Institution has pointed out, there have been several periods of extreme volatility in recent years, for which market liquidity was necessary. Nevertheless, Basel III’s capital requirements and Stable Funding Ratio, and the Fed’s new Liquidity Coverage Ratio have all increased the cost of funding a portfolio of bonds, all of which—together with the Volcker Rule—reduce the amount of liquidity in the market. This could lead to a serious liquidity crisis if one or more major financial institutions is required to sell assets to meet its cash needs: “Illiquidity in financial markets,” says Elliott, “can help trigger or exacerbate a financial crisis by creating actual or paper losses at banks or other financial institutions. If a bank needs to raise cash quickly, perhaps to meet deposit outflows in the event of a loss of confidence in that institution, they will likely need to sell securities, especially if they have an excessive mismatch between the maturities of their assets and liabilities. In illiquid markets, this would require ‘fire sales’ in which the seller accepts a significantly lower price in order to get cash quickly.”
On October 15, 2014, the Treasury market moved 40 basis points, an almost unheard of drop for the world’s most liquid market. Investigations are underway, but it is difficult to believe that this move was not related to the fact that banking organizations—the largest players in the fixed income markets—now hold only one-sixth of the amount of bonds they held before the crisis. There are fewer market makers and the fewer market makers have fewer cash resources. This is a prescription for a liquidity disaster similar to the 2008 financial crisis.
The Obama administration has denied that the Volcker Rule could be a major factor—or indeed any factor—in the decline of market liquidity, but in July 2015, Lael Brainard, Fed governor, admitted that regulation could be playing a role. Other experienced market observers have been more definitive. In a Wall Street Journal op-ed piece on June 9, 2015, Stephen Schwartzman, the CEO of Blackstone, noted that “A warning flashed last October in the U.S. Treasury market with huge intraday moves, unrelated to external events. Deutsche Bank has reported that dealer inventories of corporate bonds are down 90% since 2001, despite outstanding corporate bonds almost doubling. A liquidity drought can exacerbate, or even trigger, the next financial crisis.”
Another article in the Wall Street Journal in May 2015, reported that a board member of the European Central Bank, Benoit Coeure, saw “extreme volatility in global capital markets [as] showing signs of reduced liquidity.” The article noted that “The world’s largest banks dumped around $1 trillion in assets from government bond-trading businesses between 2010 and the end of last year.”
Still a third article, in the American Banker in June 2015, quoted Richard Berner, the director of the Office of Financial Research, a Treasury unit, to the effect that “the financial reform law could ‘be contributing to more permanent adjustments that could impair market functioning,’ including by reducing market liquidity.”
The administration’s refusal thus far to admit that the Dodd-Frank Act may be responsible for what could be a future financial catastrophe, must be seen as a wholly political effort to defend what they see as one of President Obama’s key legacies. With financial markets “flashing danger” it is time to look objectively at this problem before it causes another financial crisis. Thus, the Dodd-Frank Act is not only holding back the growth of the economy by reducing the credit available for small businesses; it is also creating the foundation for another financial crisis in the future.
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For years, Congress has been trying to determine whether the Financial Stability Oversight Council is recognizing legitimate risks to the economy when it designates large financial firms as systemically important financial institutions. Now, thanks to MetLife’s legal challenge to its designation as a SIFI, Congress has an answer: The FSOC had no credible metrics or data to support its designation of MetLife.
The sponsors of the 2010 Dodd-Frank Act created the council in the belief that the failure of Lehman Brothers in September 2008 caused the financial crisis. The council’s 10 voting members—all heads of federal financial regulatory agencies—are charged with identifying other companies whose failure could cause another financial crisis. Firms designated as SIFIs are turned over to the Federal Reserve for what Dodd-Frank calls “stringent” regulation.
In reality, Lehman’s role in the crisis is questionable. There was chaos after it failed, but this was due to the government’s sudden reversal of the policy it established six months earlier with the rescue of Bear Stearns. That reversal upended the expectations of market participants; they sought and hoarded cash, creating the liquidity shortage we know as the financial crisis.
Yet no large financial firms failed as a result of Lehman’s bankruptcy. This means there is no real evidence for the widely held idea that large financial institutions are so interconnected that the failure of one will drag down others. Although this undermines the rationale for the SIFI designation process, the metrics the FSOC uses to show dangerous interconnections have never been disclosed.
FSOC regulations outline two principal ways that the distress or failure of a firm could cause instability in the financial system as a whole. One is by causing losses to others financially exposed to the failing firm, say by holding its debt securities. This is called the exposure channel. The other is by a “fire sale” liquidation of assets that drives down asset prices and thus weakens other firms holding the same assets. It’s called the liquidation channel.
In January, MetLife, the nation’s largest insurer, challenged its designation as a SIFI in federal court. Its brief for summary judgment, filed on June 16, demolishes the idea that the FSOC designated MetLife because of dangers posed by MetLife through either channel.
In addressing the exposure channel, Met Life submitted evidence showing that even its total collapse would not pose a threat to other large firms. For example, in the unlikely event that the largest U.S. banks were to lose 100% of their exposure to MetLife, their losses would not exceed 2% of their capital. By comparison the fines recently levied on the largest U.S. banks by the Justice Department were four times as large. Yet those fines had no observable effect on the health of the banks involved.
As for the liquidation channel, a study done for MetLife by Oliver Wyman showed that even in the implausible event that all policyholders were to surrender their policies and ask for return of their cash values—and all other MetLife liabilities that could accelerate would immediately become due—the firm could still liquidate enough assets to cover its liabilities “without causing price impacts that would substantially disrupt financial markets.” The FSOC produced no data to contradict this evidence. Instead, it merely asserted that these assets sales “could” have an adverse effect on the broader economy.
The facts in MetLife’s brief raise some broad policy questions:
First, why, despite the apparent lack of evidence to support its case, did the FSOC designate MetLife as systemically important? I have written in these pages, and some members of Congress have also observed, that the actions of the council mirror the decisions of the Financial Stability Board (FSB), a mostly European group of central bankers and finance ministers of which the U.S. Treasury and the Fed are members. The FSB designated MetLife as a “global” SIFI in July 2013, without disclosing any of its evidence for doing so. The MetLife designation adds weight to the idea that the FSOC considers itself bound by the prior FSB decisions in which the Treasury and Fed concurred.
Second, although there have been three other nonbank SIFI designations—GE Capital, AIG and Prudential Insurance—MetLife’s brief is the first public disclosure of the data the FSOC used. If the interconnections and exposures between large financial firms are so limited that the failure of one will not seriously impair the safety and soundness of others, the rationale for designating particular firms as systemically important is unclear. A SIFI designation, in effect, is a government declaration that a firm is too big to fail—and subjecting firms to pointless designations and onerous regulations cannot be beneficial to the U.S. economy.
Now that we know the weakness of the FSOC’s data, Congress should consider whether the SIFI designation process makes sense. It should not leave the answer to an unaccountable organization of financial regulators.
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The central bank’s expansive regulatory powers should be subject to congressional and executive branch oversight.
With Republicans soon to hold majorities in the House and Senate, many commentators are speculating that the Federal Reserve will receive much more critical attention in 2015. In September, a large bipartisan majority in the House passed a bill to have the Government Accountability Office audit the Fed’s activities, including its monetary policies. The bill went nowhere thanks to Senate Majority Leader Harry Reid, but it could have significant support in next year’s Republican Senate.
Fed Chair Janet Yellen has expressed a legitimate fear that the Federal Reserve Transparency Act would endanger the Fed’s independence on monetary matters. But the Fed has now accumulated so much regulatory power that it can no longer claim the right to avoid congressional oversight. If the central bank hopes to maintain its monetary independence over time, it will have to surrender its regulatory authority.
There are serious potential conflicts of interest between the Fed’s regulatory and monetary roles. This became clear during the financial crisis, when the central bank used its existing authority under the Federal Reserve Act to provide assistance to financial institutions that were having liquidity problems. Many of these firms—bank holding companies, banks and their nonbank subsidiaries—are regulated directly or indirectly by the Fed. Their failure could have been seen as regulatory failure by the Fed. Did the Fed provide financial assistance to avoid this criticism, or because it was best for the economy and the financial system? It’s a painful question to consider, but the fact that it can legitimately be asked suggests the problem—and a reason why the Fed should not have both monetary and regulatory powers.
In 1999 the Gramm-Leach-Bliley Act gave the Fed “umbrella” authority to oversee the capitalization and activities of insurers and broker-dealers that were subsidiaries of bank holding companies. That made the central bank the closest thing to a “systemic regulator” of the U.S. financial system, with the ability to oversee the work of other financial regulators such as the Securities and Exchange Commission.
The Fed clearly failed in this role before the 2008 financial crisis, but in typical Washington fashion the 2010 Dodd-Frank Act enlarged the Fed’s powers. It now has authority to supervise all of the large nonbank financial firms that are designated as systemically important financial institutions by a council of regulators.
While enlarging the central bank’s authority in 2010, Congress never asked whether the Fed’s mandate to promote both stable prices and full employment—itself a situation rife with conflict—led it to pull its regulatory punches. Now Congress is wondering whether the Fed is a captive of the banks. To fight this charge, the Fed is trying to show that it is a tough regulator, flexing its regulatory muscles by telling banks that it doesn’t like some of the loans they are making—such as leveraged loans in corporate acquisitions. This comes perilously close to credit allocation and is especially troubling if it is motivated by an effort to maintain the Fed’s regulatory authority and monetary policy independence.
Apart from whipsawing the financial system so the Fed can make a political point, this practice and other excessive regulation adds significant operating costs for banks and others, causing them to withdraw from lines of business that regulatory costs make less profitable. These costs are also a burden on competition; large banks can bear them more easily than can smaller competitors. That’s why in 2013 Jamie Dimon, chairman of J.P. Morgan Chase, the largest bank in the U.S., referred to more regulation as a “bigger moat” against competition.
Because the Fed’s operating funds come primarily from interest on the government securities it holds, the central bank does not receive congressional scrutiny in the appropriations process. Nor are its expenditures examined by the Office of Management and Budget in preparing the president’s annual budget. Both reviews are ways for Congress and the president to control regulatory overreach.
At a minimum, as long as the Fed retains its regulatory authority, it should be required to provide Congress with a budget for its regulatory activities, to show each year how it met the prior year’s budget, and to explain why it should be permitted to allocate more to its regulatory functions in the year to come. In this review, the Fed should describe its regulatory policies in detail and explain and justify its plans for the future.
These steps would substitute for the authorization and appropriations reviews that occur each year for most other agencies. If there is an annual audit, it should tell Congress, the president and the public whether the funds that the Fed is using for regulation are being used efficiently. This would restore a small degree of accountability.
Before Congress acts on audit legislation that will certainly complicate the agency’s effort to retain its independence on monetary policy, the Fed should offer to support the consolidation of its regulatory authority into a separate federal financial regulatory body. That was recommended in the Ronald Reagan and George W. Bush administrations. The Federal Reserve has always resisted these proposals, but that may no longer be either advisable or possible.
A ‘chain’ of routine securities transactions, the Fed suggests, can transform a nonsystemic firm into a systemic firm.
Recent statements by senior Federal Reserve officials show that the agency is stepping up efforts to investigate and ultimately regulate what they call the “shadow-banking system.” As the regulators define that term, it is nothing less than capital and securities markets—the industries principally responsible for the growth of the U.S. economy over the past 40 years.
In December, Stanley Fischer , the Fed’s vice chairman and head of its internal systemic-risk committee, told an asset-management group that the New York Fed is “mapping” the relationships between and among financial institutions with a view to determining the scope of the shadow-banking system. The Fed, he said, is considering whether it has sufficient authority to regulate shadow banks. If it doesn’t, he said, the Fed will turn the matter over to the Financial Stability Oversight Council—created by the Dodd-Frank law and made up of the heads of all federal financial regulators, with the Treasury secretary as chairman—for appropriate action.
And on Jan. 30, Daniel Tarullo, a Fed governor, told a conference of financial regulators that the agency was working to corral financial activities that “migrate outside the regulated perimeter”—that is, financial activities that are not regulated like banks. The Fed, he said, wants to “serve the macroprudential aim of moderating the build-up of leverage” in shadow banks.
Most people probably imagine that the term shadow banking refers to large nonbank financial institutions that do what regulated banks do—borrow short-term funds like deposits and turn them into long-term assets like loans. Maturity transformation, as it is called, can be risky, because a firm that has lent out funds it has borrowed short-term may be pressed for cash if its short-term creditors want their funds returned immediately. The fear is that large firms facing this difficulty could fail, creating a “systemic” event.
For this reason, Dodd-Frank is based on the idea that all large nonbank financial institutions, including investment banks, finance companies and insurers, should be subject to designation by the FSOC as systemically important financial institutions, or SIFIs. Once designated, SIFIs are turned over to the Fed for stringent regulation.
The regulators apparently want to cast an even wider net. A 2012 report by the international Financial Stability Board—made up of central bankers and bank regulators of which the U.S. Treasury and the Fed are members—stated that systemic risks are created in the shadow-banking system through “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”
What is a “chain of transactions”? As former Fed Chairman Ben Bernanke explained that year, a finance company might create a pool of auto loans for securitization. Afterward, “an investment bank might sell tranches of the securitization to investors. The lower-risk tranches could be purchased by an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing commercial paper that is purchased by money market funds.” In other words, a “chain of transactions” involving many different firms can create the same systemic risks as a single large firm.
These are normal transactions in the securities and capital markets. So when Fed officials say that they are investigating and hope to regulate shadow banking, what they mean is that they want to regulate what kind of transactions occur in the securities and capital markets. What is necessary, Mr. Tarullo noted, is a “significant building out of a regulatory regime” for shadow banks, “and so I think that’s where attention is going to be paid.”
One big, threshold question: Where do the Fed and FSOC imagine that they obtained the grant of such power? It can’t be from Dodd-Frank. As capacious as this legislation is, it doesn’t provide authority to regulate financial firms that by themselves are not systemic but become systemic because they participate in a “complex chain of transactions.”
The most likely possibility is the Financial Stability Board, an entity little known outside the financial industry. This group was deputized by the G-20 leaders in 2009 to reform the international financial system, and since then—with the explicit approval of the G-20—has made the regulation of the shadow-banking system a major objective. Perhaps the FSOC and the Fed see the decisions of the G-20—of which President Obama is a member—as authority for their actions in the U.S.
While this might be true in other countries, the U.S. Constitution provides for a separation of powers in which Congress makes the laws and the president carries them out. The fact that a president has agreed with other G-20 leaders to take international action of some kind would not give federal agencies the authority to act in the absence of explicit legislation.
And yet if Congress fails to insist on a recognition of its authority, the Federal Reserve and the Financial Stability Oversight Council will be free to take control of and regulate sectors of the economy that even the drafters of the far-reaching Dodd-Frank law saw fit not to include.
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A ‘chain’ of routine securities transactions, the Fed suggests, can transform a nonsystemic firm into a systemic firm.
Recent statements by senior Federal Reserve officials show that the agency is stepping up efforts to investigate and ultimately regulate what they call the “shadow-banking system.” As the regulators define that term, it is nothing less than capital and securities markets—the industries principally responsible for the growth of the U.S. economy over the past 40 years.
In December, Stanley Fischer , the Fed’s vice chairman and head of its internal systemic-risk committee, told an asset-management group that the New York Fed is “mapping” the relationships between and among financial institutions with a view to determining the scope of the shadow-banking system. The Fed, he said, is considering whether it has sufficient authority to regulate shadow banks. If it doesn’t, he said, the Fed will turn the matter over to the Financial Stability Oversight Council—created by the Dodd-Frank law and made up of the heads of all federal financial regulators, with the Treasury secretary as chairman—for appropriate action.
And on Jan. 30, Daniel Tarullo, a Fed governor, told a conference of financial regulators that the agency was working to corral financial activities that “migrate outside the regulated perimeter”—that is, financial activities that are not regulated like banks. The Fed, he said, wants to “serve the macroprudential aim of moderating the build-up of leverage” in shadow banks.
Most people probably imagine that the term shadow banking refers to large nonbank financial institutions that do what regulated banks do—borrow short-term funds like deposits and turn them into long-term assets like loans. Maturity transformation, as it is called, can be risky, because a firm that has lent out funds it has borrowed short-term may be pressed for cash if its short-term creditors want their funds returned immediately. The fear is that large firms facing this difficulty could fail, creating a “systemic” event.
For this reason, Dodd-Frank is based on the idea that all large nonbank financial institutions, including investment banks, finance companies and insurers, should be subject to designation by the FSOC as systemically important financial institutions, or SIFIs. Once designated, SIFIs are turned over to the Fed for stringent regulation.
The regulators apparently want to cast an even wider net. A 2012 report by the international Financial Stability Board—made up of central bankers and bank regulators of which the U.S. Treasury and the Fed are members—stated that systemic risks are created in the shadow-banking system through “a complex chain of transactions, in which leverage and maturity transformation occur in stages.”
What is a “chain of transactions”? As former Fed Chairman Ben Bernanke explained that year, a finance company might create a pool of auto loans for securitization. Afterward, “an investment bank might sell tranches of the securitization to investors. The lower-risk tranches could be purchased by an asset-backed commercial paper (ABCP) conduit that, in turn, funds itself by issuing commercial paper that is purchased by money market funds.” In other words, a “chain of transactions” involving many different firms can create the same systemic risks as a single large firm.
These are normal transactions in the securities and capital markets. So when Fed officials say that they are investigating and hope to regulate shadow banking, what they mean is that they want to regulate what kind of transactions occur in the securities and capital markets. What is necessary, Mr. Tarullo noted, is a “significant building out of a regulatory regime” for shadow banks, “and so I think that’s where attention is going to be paid.”
One big, threshold question: Where do the Fed and FSOC imagine that they obtained the grant of such power? It can’t be from Dodd-Frank. As capacious as this legislation is, it doesn’t provide authority to regulate financial firms that by themselves are not systemic but become systemic because they participate in a “complex chain of transactions.”
The most likely possibility is the Financial Stability Board, an entity little known outside the financial industry. This group was deputized by the G-20 leaders in 2009 to reform the international financial system, and since then—with the explicit approval of the G-20—has made the regulation of the shadow-banking system a major objective. Perhaps the FSOC and the Fed see the decisions of the G-20—of which President Obama is a member—as authority for their actions in the U.S.
While this might be true in other countries, the U.S. Constitution provides for a separation of powers in which Congress makes the laws and the president carries them out. The fact that a president has agreed with other G-20 leaders to take international action of some kind would not give federal agencies the authority to act in the absence of explicit legislation.
And yet if Congress fails to insist on a recognition of its authority, the Federal Reserve and the Financial Stability Oversight Council will be free to take control of and regulate sectors of the economy that even the drafters of the far-reaching Dodd-Frank law saw fit not to include.
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From the time it was first proposed by the Obama administration early in 2009, the legislation that eventually became the Dodd-Frank Act was opposed by Republicans in Congress. It got no Republican votes when it passed the House and only two Republican votes when it passed the necessary procedural vote in the Senate.
The reason for this nearly unanimous Republican opposition is simple: the key provisions of the act bore little relationship to the actual causes of the crisis. Indeed, the record shows that in designing and adopting the act neither the Obama administration nor the Democratic Congress made any effort to understand why there was a financial crisis in 2008 or the role of the government’s housing policies in bringing it about.
The necessary information was certainly available. Fannie Mae and Freddie Mac became insolvent in September 2008, and were immediately taken over by their regulator as conservator. Thus, when the Obama administration came into office in January 2009, it had access to all the financial information of both firms.
In August 2009, now under the government’s supervision, Fannie published the first reasonably complete credit report on its mortgage exposures. This showed that 81 percent of Fannie’s 2008 losses had come from its exposure to both subprime loans (loans in which the borrower had a FICO credit score of 660 or lower) and other loans that were particularly risky because they had low or no downpayments or other deficiencies. This should have been a surprise; up to that point, most people thought Fannie only acquired prime loans. Further inquiry would have shown that Freddie Mac had suffered similar losses for the same reason. Because it was now in charge of Fannie and Freddie, the administration had this information well before it was published.
In June of 2008, this and other data showed that there were 31 million subprime and other risky mortgages in the US financial system, amounting to 56 percent of all US mortgages. Of the 31 million loans, 76 percent were on the books of government agencies, primarily Fannie and Freddie (about two-thirds) but also FHA, the Veterans Administration, and others. This showed incontrovertibly that it was the government-and not the private sector-that had created the demand for the vast majority of these loans.
If the administration and Congress had really wanted to know what happened in the financial crisis, the information was at hand. The data cited above made clear that the overwhelming majority of the losses in the mortgage meltdown had come from subprime and other risky loans. If Fannie and Freddie had suffered 81 percent of their losses because of these mortgages, the defaults on these loans were what had driven down housing prices 30-40 percent all over the United States.
Any serious effort to understand the crisis would have asked at this point why government agencies held so many subprime and other risky mortgages, and that inquiry would have turned up the affordable housing goals, adopted by Congress in 1992. These required Fannie and Freddie, when they bought mortgages from banks and other originators, to meet a quota: 30 percent of those mortgages had to be made to borrowers at or below the median income in the communities where they lived. Data from HUD, which administered the goals, would have shown the administration and Congress, had they been curious, that HUD had gradually increased the quota to 50 percent in 2000 and to 56 percent in 2008.
Anyone in the administration who was interested would have realized that as the quota was increased Fannie and Freddie were required to reduce their underwriting standards; it was simply impossible to meet the increasing affordable housing goals for borrowers below median income while maintaining their traditional prime mortgage standards. By 1995, they were accepting loans with 3 percent downpayments, and by 2000 loans with zero downpayments.
From that point on, the analysis would have been easy. Because Fannie and Freddie were the dominant players in the housing finance market, when they reduced their underwriting standards lenders were compelled to follow suit. Mortgage lending is competitive, and consumers went to the lenders that offered the easiest terms. Any observer would have understood why Countrywide, formerly a minor league subprime lender, ultimately became one of the largest mortgage originators in the US. It was the principal supplier to Fannie and Freddie.
But neither the Obama administration nor Congress was interested in this analysis. The narrative they adopted, and sold to the American people, was that Wall Street and other large financial institutions had taken excessive mortgage risks because they had not been sufficiently regulated. Fannie and Freddie, as HUD secretary Donovan later told Congress, bought all those subprime loans for profit or market share. The government’s role, and the affordable housing goals that drove down underwriting standards, were conveniently ignored.
The conclusion one should draw from this is that the Dodd-Frank Act is illegitimate. Although the American people were told that the act was a response to the 2008 financial crisis, and was intended to prevent similar financial crises in the future, neither the administration nor Congress ever made any effort to determine what actually caused the crisis. Instead, the narrative that drove the Dodd-Frank Act was concocted to achieve an ideological purpose: to impose greater regulation on the US financial system.
Just last week, Treasury Secretary Jack Lew wrote in an op-ed: “Given how far we have come…it is hard to understand the efforts of some to undermine our ability to protect consumers and taxpayers from excessive risks taken by financial institutions.” The false narrative will never be abandoned until the American people know the truth.
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Because of the government’s extraordinary role in bringing on the crisis, it should not be treated as an inherent part of a capitalist or free market system, or used as a pretext for greater government control of the financial system. On the contrary, understanding the financial crisis for what it was will permit the debate we should have had about the Dodd-Frank Act.
Far from being a failure of free market capitalism, the Depression was a failure of government. Unfortunately, that failure did not end with the Great Depression. . . . In practice, just as during the Depression, far from promoting stability, the government has itself been the major single source of instability. — Milton Friedman
Political contests often force the crystallization of answers to difficult political issues, and so it was with the question of responsibility for the financial crisis in the 2008 presidential election. In their second 2008 presidential debate, almost three weeks after Lehman Brothers had filed for bankruptcy, John McCain and Barack Obama laid out sharply divergent views of the causes of the financial convulsion that was then dominating the public’s concerns. The debate was in a town-hall format, and a member of the audience named Oliver Clark asked a question that was undoubtedly on the mind of every viewer that night:
Clark: Well, senators, through this economic crisis, most of the people that I know have had a difficult time. . . . I was wondering what it is that’s going to actually help these people out?
Senator McCain: Well, thank you, Oliver, that’s an excellent question. . . . But you know, one of the real catalysts, really the match that lit this fire, was Fannie Mae and Freddie Mac . . . they’re the ones that, with the encouragement of Sen. Obama and his cronies and his friends in Washington, that went out and made all these risky loans, gave them to people who could never afford to pay back . . .
Then it was Obama’s turn.
Senator Obama: Let’s, first of all, understand that the biggest problem in this whole process was the deregulation of the financial system. . . . Senator McCain, as recently as March, bragged about the fact that he is a deregulator. . . . A year ago, I went to Wall Street and said we’ve got to reregulate, and nothing happened. And Senator McCain during that period said that we should keep on deregulating because that’s how the free enterprise system works.
Although neither candidate answered the question that Clark had asked, their exchange, with remarkable economy, effectively framed the issues both in 2008 and today: was the financial crisis the result of government action, as McCain contended, or of insufficient regulation, as Obama claimed?
Since this debate, the stage has belonged to Obama and the Democrats, who gained control of the presidency and Congress in 2008, and their narrative about the causes of the financial crisis was adopted by the media and embedded in the popular mind. Dozens of books, television documentaries, and films have told the easy story of greed on Wall Street or excessive and uncontrolled risk-taking by the private sector — the expected result of what the media has caricatured as “laissez-faire capitalism.” To the extent that government has been blamed for the crisis, it has been for failing to halt the abuses of the private sector.
The inevitable outcome of this perspective was the Dodd-Frank Wall Street Reform and Consumer Protection Act, by far the most costly and restrictive regulatory legislation since the New Deal. Its regulatory controls and the uncertainties they engendered helped produce the slowest post-recession US recovery in modern history. Figure 1 compares the recovery of gross domestic product (GDP) per capita since the recession ended in June 2009 with the recoveries following recessions since 1960.
Unfortunately, Dodd-Frank may provide a glimpse of the future. As long as the financial crisis is seen in this light — as the result of insufficient regulation of the private sector — there will be no end to the pressure from the left for further and more stringent regulation. Proposals to break up the largest banks, reinstate Glass-Steagall in its original form, and resume government support for subprime mortgage loans are circulating in Congress. These ideas are likely to find public support as long as the prevailing view of the financial crisis is that it was caused by the risk-taking and greed of the private sector.
For that reason, the question of what caused the financial crisis is still very relevant today. If the crisis were the result of government policies, the Dodd-Frank Act was an illegitimate response to the crisis and many of its unnecessary and damaging restrictions should be repealed. Similarly, proposals and regulations based on a false narrative about the causes of the financial crisis should also be seen as misplaced and unfounded.
Figure 1. Current rebound in GDP per capita compared to previous cycles
Sources: Bureau of Economic Analysis; Census Bureau; authors’ calculations. Adapted from Tyler Atkinson, David Luttrell, and Harvey Rosenblum, “How Bad Was It? The Costs and Consequences of the 2007–09 Financial Crisis,” Staff Papers (Federal Reserve Bank of Dallas) no. 20 (July 2013): 4. Note: The gray area indicates the range of major recessions since 1960, excluding the short 1980 recession.
As demonstrated by Dodd-Frank itself, first impressions are never a sound basis for policy action, and haste in passing significant legislation can have painful consequences. During the Depression era, it was widely believed that the extreme level of unemployment was caused by excessive competition. This, it was thought, drove down prices and wages and forced companies out of business, causing the loss of jobs. Accordingly, some of the most far-reaching and hastily adopted legislation — such as the National Industrial Recovery Act and the Agricultural Adjustment Act (both ultimately declared unconstitutional) — was designed to protect competitors from price competition. Raising prices in the midst of a depression seems wildly misguided now, but it was a result of a mistaken view about what caused the high levels of unemployment that characterized the era.
In the 1960s, Milton Friedman and Anna Schwartz produced a compelling argument that the Great Depression was an ordinary cyclical downturn that was unduly prolonged by the mistaken monetary policies of the Federal Reserve. Their view and the evidence that they adduced gradually gained traction among economists and policy makers. Freed of its association with unemployment and depression, competition came to be seen as a benefit to consumers and a source of innovation and economic growth rather than a threat to jobs.
With that intellectual backing, a gradual process of reducing government regulation began in the Carter administration. Air travel, trucking, rail, and securities trading were all deregulated, followed later by energy and telecommunications. We owe cell phones and the Internet to the deregulation of telecommunications, and a stock market in which billions of shares are traded every day — at a cost of a penny a share — to the deregulation of securities trading. Because of the huge reductions in cost brought about by competition, families don’t think twice about making plane reservations for visits to Grandma, and we take it for granted that an item we bought over the Internet will be delivered to us, often free of a separate charge, the next day. These are the indirect benefits of a revised theory for the causes of the Depression that freed us to see the benefits of competition.
We have not yet had this epiphany about the financial crisis, but the elements for it — as readers will see in this book — have been hidden in plain sight. Accordingly, what follows is intended to be an entry in a political debate — a debate that was framed in the 2008 presidential contest but never actually joined. In the following pages, I argue that but for the housing policies of the US government during the Clinton and George W. Bush administrations, there would not have been a financial crisis in 2008. Moreover, because of the government’s extraordinary role in bringing on the crisis, it is invalid to treat it as an inherent part of a capitalist or free market system, or to use it as a pretext for greater government control of the financial system.
I do not absolve the private sector, although that will be the claim of some, but put the errors of the private sector in the context of the government policies that dominated the housing finance market for the 15 years before the crisis, including the government regulations that induced banks to load up on assets that ultimately made them appear unstable or insolvent. I hope readers will find the data I have assembled informative and compelling. The future of the housing finance system and the health of the wider economy depend on a public that is fully informed about the causes of the 2008 financial crisis.
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With Republicans soon to hold majorities in the House and Senate, many commentators are speculating that the Federal Reserve will receive much more critical attention in 2015. In September, a large bipartisan majority in the House passed a bill to have the Government Accountability Office audit the Fed’s activities, including its monetary policies. The bill went nowhere thanks to Senate Majority Leader Harry Reid, but it could have significant support in next year’s Republican Senate.
Fed Chair Janet Yellen has expressed a legitimate fear that the Federal Reserve Transparency Act would endanger the Fed’s independence on monetary matters. But the Fed has now accumulated so much regulatory power that it can no longer claim the right to avoid congressional oversight. If the central bank hopes to maintain its monetary independence over time, it will have to surrender its regulatory authority.
There are serious potential conflicts of interest between the Fed’s regulatory and monetary roles. This became clear during the financial crisis, when the central bank used its existing authority under the Federal Reserve Act to provide assistance to financial institutions that were having liquidity problems. Many of these firms—bank holding companies, banks and their nonbank subsidiaries—are regulated directly or indirectly by the Fed. Their failure could have been seen as regulatory failure by the Fed. Did the Fed provide financial assistance to avoid this criticism, or because it was best for the economy and the financial system? It’s a painful question to consider, but the fact that it can legitimately be asked suggests the problem—and a reason why the Fed should not have both monetary and regulatory powers.
In 1999 the Gramm-Leach-Bliley Act gave the Fed “umbrella” authority to oversee the capitalization and activities of insurers and broker-dealers that were subsidiaries of bank holding companies. That made the central bank the closest thing to a “systemic regulator” of the U.S. financial system, with the ability to oversee the work of other financial regulators such as the Securities and Exchange Commission.
The Fed clearly failed in this role before the 2008 financial crisis, but in typical Washington fashion the 2010 Dodd-Frank Act enlarged the Fed’s powers. It now has authority to supervise all of the large nonbank financial firms that are designated as systemically important financial institutions by a council of regulators.
While enlarging the central bank’s authority in 2010, Congress never asked whether the Fed’s mandate to promote both stable prices and full employment—itself a situation rife with conflict—led it to pull its regulatory punches. Now Congress is wondering whether the Fed is a captive of the banks. To fight this charge, the Fed is trying to show that it is a tough regulator, flexing its regulatory muscles by telling banks that it doesn’t like some of the loans they are making—such as leveraged loans in corporate acquisitions. This comes perilously close to credit allocation and is especially troubling if it is motivated by an effort to maintain the Fed’s regulatory authority and monetary policy independence.
Apart from whipsawing the financial system so the Fed can make a political point, this practice and other excessive regulation adds significant operating costs for banks and others, causing them to withdraw from lines of business that regulatory costs make less profitable. These costs are also a burden on competition; large banks can bear them more easily than can smaller competitors. That’s why in 2013 Jamie Dimon, chairman of J.P. Morgan Chase, the largest bank in the U.S., referred to more regulation as a “bigger moat” against competition.
Because the Fed’s operating funds come primarily from interest on the government securities it holds, the central bank does not receive congressional scrutiny in the appropriations process. Nor are its expenditures examined by the Office of Management and Budget in preparing the president’s annual budget. Both reviews are ways for Congress and the president to control regulatory overreach.
At a minimum, as long as the Fed retains its regulatory authority, it should be required to provide Congress with a budget for its regulatory activities, to show each year how it met the prior year’s budget, and to explain why it should be permitted to allocate more to its regulatory functions in the year to come. In this review, the Fed should describe its regulatory policies in detail and explain and justify its plans for the future.
These steps would substitute for the authorization and appropriations reviews that occur each year for most other agencies. If there is an annual audit, it should tell Congress, the president and the public whether the funds that the Fed is using for regulation are being used efficiently. This would restore a small degree of accountability.
Before Congress acts on audit legislation that will certainly complicate the agency’s effort to retain its independence on monetary policy, the Fed should offer to support the consolidation of its regulatory authority into a separate federal financial regulatory body. That was recommended in the Ronald Reagan and George W. Bush administrations. The Federal Reserve has always resisted these proposals, but that may no longer be either advisable or possible.
Mr. Wallison is a senior fellow at the American Enterprise Institute. His latest book, “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again,” will be published in January by Encounter Books.
WASHINGTON — SEVEN years after the housing bubble burst, federal regulators backed away this month from the tougher mortgage-underwriting standards that the Dodd-Frank Act of 2010 had directed them to develop. New standards were supposed to raise the quality of the “prime” mortgages that get packaged and sold to investors; instead, they will have the opposite effect.
Responding to the law, federal regulators proposed tough new standards in 2011, but after bipartisan outcries from Congress and fierce lobbying by interested parties, including community activists, the Obama administration and the real estate and banking industries — all eager to increase home sales — the standards have been watered down. The regulators had wanted a down payment of 20 percent, a good credit record and a maximum debt-to-income ratio of 36 percent. But under pressure, they dropped the down payment and good-credit requirements and agreed to a debt-to-income limit as high as 43 percent.
The regulators believe that lower underwriting standards promote homeownership and make mortgages and homes more affordable. The facts, however, show that the opposite is true.
In the late ’80s and early ’90s, down payments were 10 to 20 percent. The homeownership rate was 64 percent — about where it is now — and nearly 90 percent of housing markets were considered affordable (that is, home prices were no more than three times family income). By 2011 only 50 percent were considered affordable, and by 2014, just 36 percent — even though down payments as low as 5 percent are now common.
How could this be? Consider this: If the required down payment for a mortgage is 10 percent, a potential home buyer with $10,000 can purchase a $100,000 home. But if the down payment is dropped to 5 percent, the same buyer can purchase a $200,000 home. The buyer is taking more risk by borrowing more, but can afford to bid more.
In other words, low underwriting standards — especially low down payments — drive housing prices up, making them less affordable for low- and moderate-income buyers, while also inducing would-be homeowners to take more risk.
That’s why homes were more affordable before the 1990s than they are today. Back then, when traditional standards for “prime” mortgages prevailed, homes were smaller; they had fewer bathrooms, and the kitchens were not appointed by Martha Stewart. A family could buy and live in a “starter home” for several years before selling it and using the accumulated equity to buy a bigger or better appointed home.
In a competitive housing market not subsidized by lax standards, home builders would similarly adjust by reducing the size and amenities of new homes to meet the financial resources of home buyers entering the market. Home prices would stabilize and not rise faster than incomes. Low- and moderate-income families and millennials might have to wait to save for a first home, but they would be able to afford it.
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The Financial Stability Oversight Council announced last week that it had preliminarily designated MetLife, the nation’s largest life insurer, as a systemically important financial institution, or SIFI. This means that the FSOC, established after the financial crisis by the 2010 Dodd-Frank law, believes the financial distress of MetLife could threaten the U.S. financial system.
MetLife has a chance to appeal, but if the designation is finalized, the insurer will be subject to banklike regulation from the Federal Reserve, though the Fed has never regulated an insurance company nor said how it would do so.
The FSOC is composed of the heads of nine federal financial regulators and one independent presidential appointee, with the Treasury secretary as chairman. It embodies the underlying premise of Dodd-Frank: The financial crisis was caused by insufficient regulation. Although several heavily regulated banks failed in the crisis, the FSOC was given the authority to single out nonbank financial firms for similar supervision.
This phenomenon is not limited to the U.S. In 2009, the G-20 leaders deputized the Financial Stability Board—a largely European organization of central bankers and bank regulators—to reform the international financial system. The Financial Stability Board has no enforcement powers, and so it relies on regulatory organizations like the FSOC to enforce its writ.
Both the Treasury and the Fed are influential members of the Financial Stability Board, and, not coincidentally, the board decided to designate certain nonbank financial firms as global SIFIs. In July 2013, the board designated AIG, Prudential and MetLife as SIFIs. The FSOC quickly followed suit with AIG and Prudential, but only last week got around to MetLife.
Yet MetLife’s designation was a foregone conclusion. Though the FSOC “investigated” whether MetLife should be deemed a SIFI for more than a year, the council would not overturn a decision the Financial Stability Board, the Treasury and the Fed had already approved.
The sham of the FSOC’s designation process became clear recently when, in a hearing before the House Financial Services Committee, Treasury Secretary Jack Lew was unable to explain how the FSOC could conduct a fair and objective investigation of MetLife when he himself—as a member of the Financial Stability Board and chairman of the FSOC—had already approved the Financial Stability Board’s designation of MetLife as a global SIFI.
When the FSOC finally publishes the basis for the MetLife decision, after the administrative hearing process ends, it will likely resemble the justification paper for the FSOC’s 2013 Prudential designation. If so, the justification paper will not explain to the public or other insurers why MetLife deserves designation as a SIFI.
Indeed, the FSOC’s only guidepost seems to be that the Financial Stability Board did it first. Not surprisingly, the FSOC’s only insurance expert, Roy Woodall, dissented from the final Prudential decision.
Fortunately, Congress has at last become aware of the FSOC’s arbitrary decision-making. In July nine members of the Senate Banking Committee, led by Sens. Pat Toomey (R., Pa.), Mike Crapo (R., Idaho) and Richard Shelby (R., Ala.), sent an open letter to Mr. Lew urging the FSOC “to suspend any further SIFI designation” because “the FSOC is consigning financial firms to stringent regulation by the Federal Reserve without knowing how these firms will be regulated.”
House Financial Services Committee Chairman Jeb Hensarling (R., Texas) has also called on the FSOC to “cease and desist” further designations until Congress has evaluated the economic effects of designating a nonbank financial firm as a SIFI. The House backed Mr. Hensarling in July by passing an appropriations-bill amendment that imposed a one-year moratorium on SIFI designations.
The FSOC hasn’t been completely deaf to congressional complaints. In a meeting at the end of July, the agency directed its staff to focus on the “activities and products” of asset managers, rather than on whether they should be individually designated as SIFIs. This was a climb-down from the more high-handed position it had taken in the past.
That was important for another reason: It could stymie the Financial Stability Board’s campaign to regulate “shadow banks,” which the FSB defined as asset managers, mutual funds, securities firms and hedge funds. The Financial Stability Board moved to regulate so-called shadow banks when it declared in a January 2014 report that asset managers with more than $100 billion under management should be investigated for SIFI designation.
If the FSOC follows the Financial Stability Board’s script, it would place the largest asset managers under the Fed’s purview, giving the central bank an opportunity to determine what activities they finance. This could seriously impair the financing available to U.S. companies.
It may be a head fake, but if the FSOC has set aside implementing the Financial Stability Board’s shadow-bank regulation, that would be good news. Whether it becomes a permanent retrenchment may depend on whether the midterm elections move the Senate away from the highly regulatory approach that was the essence of Dodd-Frank.
Mr. Wallison is a senior fellow at the American Enterprise Institute.
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The financial law has restricted credit and let regulators create even more too-big-to-fail companies
When the Dodd-Frank Wall Street Reform and Consumer Protection Act took effect on July 21, 2010, it immediately caused a sharp partisan division. This staggeringly large legislation—2,300 pages—passed the House without a single Republican vote and received only three GOP votes in the Senate. Republicans saw the bill as ObamaCarefor the financial system, a vast and unnecessary expansion of the regulatory state.
Four years later, Dodd-Frank’s pernicious effects have shown that the law’s critics were, if anything, too kind. Dodd-Frank has already overwhelmed the regulatory system, stifled the financial industry and impaired economic growth.
According to the law firm Davis, Polk & Wardell’s progress report, Dodd-Frank is severely taxing the regulatory agencies that are supposed to implement it. As of July 18, only 208 of the 398 regulations required by the act have been finalized, and more than 45% of congressional deadlines have been missed.
The effect on the economy has been worse. A 2013 Federal Reserve Bank of Dallas study showed that the GDP recovery from the recession that ended in 2009 has been the slowest on record, 11% below the average for recoveries since 1960.
There is always a trade-off between regulation and economic growth, but Dodd-Frank—by far the most intrusive and costly financial regulation since the New Deal—placed few if any limitations on regulatory power. Written broadly and leaving regulators to fill in the details, the act has often left regulators in doubt about what Congress meant. Even after regulations have been finalized, interpreting them can be a trial. For example, the regulations implementing the inconsistent Volcker Rule, which prohibited banks and their affiliates from trading securities for their own account, took more than three years to write, but key provisions are still unclear.
These uncertainties, costs and restrictions have sapped the willingness or ability of the financial industry to take the prudent risks that economic growth requires. With many more regulations still to come, Dodd-Frank is likely to be an economic drag for many years.
None of this was necessary. The administration and Congress acted hastily. The Treasury Department sent draft legislation to Congress only a few months after taking office in 2009, and the law—spurred by a promise from then-Rep. Barney Frank for a “new New Deal”—passed a year later. The left’s view had been settled: the crisis would be blamed on Wall Street greed and insufficient regulation. The act set out to implement that worldview by subjecting American finance to unprecedented government control.
It is now clear, however, that government housing policies—implemented primarily byFannie MaeFNMA -2.86% and Freddie MacFMCC -2.88% —forced a reduction in mortgage underwriting standards, which was the real cause of the crisis. The goal was to foster affordable housing for low-income and minority borrowers, but these loosened standards inevitably spread to the wider market, building an enormous housing bubble between 1997 and 2007.
By 2008 roughly 58% of all U.S. mortgages—32 million loans—were subprime or otherwise low quality. Of these 32 million loans, 76% were on the books of government agencies, primarily Fannie and Freddie, showing incontrovertibly where the demand for these loans originated. When the housing bubble burst, mortgage defaults soared to unprecedented levels. Although the left’s narrative placed all blame on the private sector, these numbers show that private firms were responsible for less than a quarter of the problem.
Yet Dodd-Frank said nothing about government housing policies and ignored Fannie and Freddie. It focused on placing additional restrictions on financial firms, often for no apparent purpose other than to extend government control. For example, all bank holding companies with consolidated assets of more than $50 billion were automatically designated as systemically important financial institutions, although a bank of that size would not bring down the multitrillion-dollar U.S. financial system.
The Volcker Rule was inserted in the act, even though there is no evidence that banks trading securities for their own account had anything to do with the financial crisis.
Even the Constitution’s checks and balances did not impede the left’s objectives. To block Congress from limiting the Consumer Financial Protection Bureau’s activities, Dodd-Frank set up the agency to be funded directly by the Federal Reserve. This is a clear evasion of the constitutional structure in which Congress appropriates funds for executive-branch operations.
Dodd-Frank also created the Financial Stability Oversight Council, consisting of the leaders of all federal financial regulators and headed by the Treasury secretary. FSOC has the extraordinary power to designate certain nonbank financial firms as systemically important financial institutions ( SIFIs ) if, in the judgment of the council, the firm’s “material financial distress” would cause financial “instability.” By definition, then, SIFI designation means a nonbank financial institution is “too big to fail.” Although we are currently saddled (thanks to past government policies) with several enormous banks that may be too big to fail, the act gave the FSOC the power to create more too-big-to-fail institutions in other industries.
The SIFI process is underway, with AIG, Prudential FinancialPRU -1.29% and GE Capital already designated. These firms are now subject to banklike regulation by the Fed—though the central bank has given no hint of what this regulation will ultimately entail.
The FSOC is now turning to asset-management firms and mutual funds, with what looks like an effort to bring large players in the capital markets and securities industry under Fed regulation. The obvious danger in subjecting the unique and innovative U.S. capital markets to banklike restrictions recently drove the House Financial Services Committee to pass a one-year moratorium on additional SIFI designations.
There is much more, but one example says it all. Several months ago J.P. Morgan ChaseJPM -2.06% announced that it plans to hire 3,000 more compliance officers this year, to supplement the 7,000 brought on last year. At the same time the bank will reduce its overall head count by 5,000. Substituting employees who produce no revenue for those who do is the legacy of Dodd-Frank, and it will be with us as long as this destructive law is on the books.
Correction: Due to an editing error, an earlier version of this article misspelled the word systemically as systematically.
Money market funds were a victim, not a cause, of the financial crisisTweet This
Unless banks are allowed to establish ABCP conduits, the Treasury won’t seek to use taxpayer funds to protect the shareholders of MMFs in the futureTweet This
Blaming the creation of Treasury’s MMF insurance fund on the “run” on the Reserve Primary Fund distracted many from the reasons it was created
As in medicine, the wrong diagnosis of a policy issue can lead to the wrong prescription. A good example is the persistent argument by the Financial Stability Oversight Council (FSOC) and the editorial pages of the Wall Street Journal that a stable $1 net asset value (NAV) for money market mutual funds (MMFs) is somehow a threat to the taxpayers or the stability of the financial system. The error, I believe, comes from a mistake about the facts.
For some reason, the idea has become embedded in the lore of the financial crisis that the Treasury was required to set up a special insurance fund for MMFs after the bankruptcy of Lehman Brothers because one fund, the Reserve Primary Fund, “broke the buck” — that is, was unable to redeem all its shares at the stable NAV price of $1 per share. Therefore, runs the argument, the government will have to do the same thing the next time a MMF breaks the buck, and that puts the taxpayers at risk.
This claim led the FSOC-an organization of federal financial regulators set up by the Dodd-Frank Act-to push the SEC for a change in the accounting rules for MMFs, so that they could no longer set their net asset value (NAV) at a stable price of $1. The proponents of change want the NAV to float, believing that this will eliminate the possibility that MMFs will break the buck in the future. The MMFs, on the other hand, argue on the basis of surveys that their customers prefer the stable NAV and many will abandon the MMF structure if a floating NAV is adopted.
It was always a bit implausible that Treasury would set up an insurance system just to protect the shareholders of MMFs against what many were calling a “run.” What interest could Treasury possibly have in whether MMF shareholders suffer losses? Clearly, when the Reserve Fund broke the buck, some of its shareholders were hurt; eventually their losses were somewhere between 1 and 2 cents on the dollar. But at that time shareholders all over the market were taking a severe beating, far larger than the losses suffered by the shareholders of the Reserve Fund. Even if shareholders of other MMFs, frightened by redemptions in the Reserve Fund, sought to redeem their shares, why should Treasury care, or risk taxpayer funds to keep those shareholders from converting their shares to cash?
One possibility is that the Treasury simply panicked. The market’s reaction to the Lehman failure was devastating, and-as shown by the subsequent rescue of AIG-the Treasury and the Fed were now going to rescue everything that moved. The Troubled Asset Relief Program, a huge rescue fund in which the Treasury and the Fed asked for and received $700 billion from Congress, followed soon after. So panic is certainly one conceivable reason for the Treasury’s action.
But there’s another and more plausible reason for what Treasury did. By the mid-2000s, MMFs were a major financing source for $1.3 trillion in commercial paper that had been issued by off-balance sheet entities established and guaranteed by the largest U.S. banks. These entities, known as asset backed commercial paper conduits (ABCP conduits) had been set up with the approval of the Fed and had invested in prime and subprime mortgage-backed securities. Supporting long term assets like mortgages with short term commercial paper is profitable, but risky. If the mortgages begin to lose value, the financing sources may not roll over, and what would the banks do then?
Beginning in 2007, this is exactly what happened. As the mortgage market began to weaken, the funding sources for these ABCP conduits began to dry up, requiring the banks to pick up more of the funding themselves or to take the assets back onto their balance sheets. By early 2008, the conduits’ commercial paper outstanding had been substantially reduced, but largely because the original bank sponsors had been compelled to furnish their own funding. This had substantially weakened the banks’ capital and liquidity positions, well before the financial crisis began in September 2008. That the Fed allowed the banks to set up such a risky structure off their balance sheets-avoiding the Fed’s own capital requirements-is something that Congress should investigate, but its role in the financial crisis seems clear.
By the time Lehman failed and the Reserve Primary Fund broke the buck, the banks were already weak and strapped for cash; they were in no position to take on more of the commercial paper issued by their off-balance sheet conduits. But things only got worse for the banks. When Lehman failed, there was a wholesale rush to quality by investors. Almost all the nongovernment MMFs, like the Reserve Primary Fund, were hit by redemptions as investors moved their funds to MMFs that invested principally in government securities.
This was dangerous for the banks, since the MMFs were not going to roll over their loans to the banks’ conduits if most of the non-government MMFs were losing shareholders in the flight to quality. It was essential, accordingly, to keep those shareholders in place so the MMFs would continue — relying on bank liquidity guarantees — to roll over the commercial paper of the conduits. The way to keep funds in the nongovernment MMFs was to insure them against losses. In that way, many of their shareholders would stay where they were and the MMFs would, or at least could, continue to support the conduits, reducing the pressure on the banks.
These facts provide a completely different perspective than the conventional view of the of the Treasury’s action. It was not to save the shareholders of the MMFs — there was literally no reason for the Treasury to do that — but to ease the financial pressures on the banks that had guaranteed the commercial paper of their off-balance sheet conduits. It follows that in any future crisis — unless the banks are again allowed by the Fed to establish ABCP conduits — there is no likelihood that the Treasury will seek to use taxpayer funds to protect the shareholders of MMFs, even if one or more of those MMFs break the buck.
Blaming the creation of Treasury’s MMF insurance fund on the so-called “run” on the Reserve Primary Fund distracted many — apparently including the Wall Street Journal — from the real reasons the Treasury’s insurance system was established. The fact that these real reasons were not immediately recognized is only one of the many errors about the causes of the financial crisis that remain to be corrected. This particular error, however, has led to unnecessary pressure on the SEC to change a system of accounting for MMFs that — in light of the success of the product — clearly meets the needs of their retail and business consumers. In this sense, MMFs were a victim — rather than a cause — of the financial crisis.
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Chairman Hensarling, Ranking Member Waters and members of the Committee:
Thank you for the opportunity to testify this morning.
Under Dodd-Frank, the Financial Stability Oversight Council (FSOC) has the authority to designate any non-bank financial firm as a systemically important financial institution, or SIFI—if the institution’s “financial distress” will cause “instability in the US financial system.”
Firms designated as SIFIs are turned over to the Fed for what appears to be bank-like regulation.
The troubling aspects of the FSOC’s authority were revealed recently when it designated Prudential Financial as a SIFI.
Every FSOC member who was an expert in insurance (and not an employee of the Treasury Department) dissented from the decision.
Virtually all the other members, knowing nothing about insurance or insurance regulation, dutifully voted in favor of Prudential’s designation.
How could we entrust the decision to regulate a large insurer like a bank, to a group with no expertise about insurance regulations?
Even more troubling was the fact that the FSOC offered no facts, no analysis and no standards in in support of its decision.
For example, interconnections are supposed to be one of the main reasons characteritics of a SIFIs.
All financial institutions are interconnected, but the FSOC’s Prudential decision says nothing about the degree of Prudential’s interconnections or why they constitute a danger to the financial system.
The same is true of all the FSOC’s prior designations.
Let me say it plainly: This emperor has no clothes.
The FSOC seems to have no idea how to assess the danger of “interconnections” or any of the other reasons that SIFIs and are considered such a threat to financial stability that they require bank-like regulation.
This means its decisions are completely arbitrary, and sSince these decisions can have seriously adverse effects on competition and economic growth, they should not be allowed to continue until the FSOC can explain its decisions to Congress.
There are also other reasons to be concerned.
Two months before the FSOC’s Prudential decision, the Financial Stability Board (FSB), an international body of regulators empowered by the G-20 leaders to reform the international financial system, had already declared Prudential a SIFI—also without any facts or analysis.
Since the Treasury and the Fed are members of the FSB, they had already approved the FSB’s designation well before the FSOC designated Prudential as a SIFI in September.
This raises two questions: First about the fairness and objectivity of the FSOC designation process, and second whether the FSOC will simply “rubber stamp” the decisions of the FSB in the future.
This is important because the FSB looks to be a very aggressive source of new regulation of nonbank financial firms.
In early September, the FSB published plans to apply what it called its “SIFI Framework” to “securities firms, finance companies, asset managers and investment funds, including hedge funds.”
These firms are the so-called “shadow banks” that bank regulators are so eager to regulate.
It will be very difficult to show that these nonbank firms pose any threat to the financial system, but the Prudential decision shows that neither the FSB nor the FSOC believes it has any obligation to do so.
As others have said this morning, collective investment funds are not like the banks or investment banks that suffered losses in the financial crisis.
But the question before this committee is not solely whether investment funds are SIFIs.
The FSB has already suggested it will apply the SIFI Framework to securities firms, mutual funds, hedge funds and many others.
If the FSOC follows suit—and that has been the pattern—we may see many of the largest non-bank firms in the US financial system brought under bank-like regulation.
As shown in my prepared testimony, these capital markets firms—and not the banks—are the main funding sources for US business.
Subjecting them to bank-like regulation will reduce their risk-taking and innovation, and thus have a disastrous effect on competition and economic growth.
And this outcome would be the result of decisions by the FSB, carried out by the FSOC.
About two weeks ago, Mr. Chairman, you said the FSOC should “cease and desist” on designations until Congress can assess the consequences.
I agree.
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Since the financial crisis in 2008, central bankers and bank regulators world-wide have repeatedly called for controls on “shadow banking.” Federal Reserve officials, including former Chairman Ben Bernanke, have been among the most outspoken. But if bank regulators get their way, much of the U.S. financial system will lose its capacity for risk-taking as well as its dynamism, innovativeness
and flexibility.
And the U.S. economy would not be any safer. Bank regulators have been cagey about exactly what firms they consider to be engaged in shadow banking. But in recent months (as outlined below), the targets have become clear. Shadow banking consists of all participants in the capital markets and the securities business that are not already covered by the prudential supervision of risk-taking and capital requirements that characterize bank regulation.
The stakes are high. The capital markets and the securities industry are far and away the principal sources of credit for American business. According to the Fed’s flow-of-funds data, in the past 25 years the capital markets’ financing of businesses—as well as state and local governments—has grown more than three times faster than bank lending. By 2013, the capital markets’ outstanding
loans to these borrowers were approximately $10 trillion while those of banks were less than $4 trillion, and the gap continues to widen.
Over the years, because of better communications technology, it has become easier for borrowers to disseminate their financial information directly to investors and other funding sources. For firms that registered securities with the Securities and Exchange Commission, and thus had access to the capital markets, it was far more efficient to sell bonds, notes and commercial paper through a broker or underwriter than to negotiate a loan from a bank.
The 2008 financial crisis, however, offered regulators a once-in-a-lifetime opportunity to expand their reach. The government’s narrative about the financial crisis, accepted by the media, claimed that any large financial institution could pose a danger to the financial system if it fails.
The implication: Every large financial institution requires bank-like prudential regulation to prevent failure. Chief among these financial institutions were the illicit-sounding “shadow banks,” which were (not coincidentally) out-competing the regulated banking system.
The principal moving party in this effort has been the Financial Stability Board (FSB)—an international group of central bankers, finance ministers and financial regulators. In 2008, shortly after the financial crisis, the G-20 (the heads of government of the 20 major economies) met in Washington and charged the FSB with responsibility for developing plans to prevent another crisis.
The FSB has since moved aggressively, with the concurrence of the U.S. Treasury and the Federal Reserve (who are members, along with the Securities and Exchange Commission), to designate large financial firms as “systemically important financial institutions.” SIFIs are institutions that, supposedly, could cause a breakdown in the financial system if they fail. Thus far the FSB has designated 39 banks and nine insurance firms.
The FSB is now turning its sights on the securities business, reporting in September 2013 that it is “reviewing how to extend the SIFI Framework to global systemically important nonbank noninsurance (NBNI) financial institutions.” This category of firms, said the FSB, “includes securities broker dealers, finance companies, asset managers and investment funds, including hedge funds.”
When companies are designated as systemically important, the FSB assumes that their home-country supervisors will place them under much stricter regulation. In the U.S., this will be done by the Financial Stability Oversight Council, a body created by the Dodd-Frank Act and made up primarily of the heads of the federal financial regulators. The council, led by Secretary of the Treasury Jack
Lew, has the authority to designate U.S. firms as systemically important. When it does, they are turned over to the Fed for the bank-like regulation that Dodd-Frank requires.
Last July the FSB designated three insurance companies—AIG, Prudential and MetLife —as systemically important. The Financial Stability Oversight Council then promptly designated AIG and Prudential as systemically important and is investigating MetLife for this purpose.
Before the FSB had suggested publicly, in January 2014, that asset managers with $100 billion under management should be considered for designation as systemically important, the Financial Stability Oversight Council had already asked the Office of Financial Research, another Treasury agency set up by Dodd-Frank, for a report on whether asset managers might cause a systemic breakdown of the U.S. financial system.
The agency, following Treasury policy, said yes. In its September 2013 report, the Office of Financial Research argued that “a certain combination of fund- and firm-level activities within a large, complex firm . . . could pose, amplify, or transmit a threat to the financial system.” The agency seemed not to understand that, unlike a bank, the losses of a managed fund fall on its investors and do not threaten creditors or create systemic risk.
The FSB and the Financial Stability Oversight Council are clearly working in tandem. The council follows the FSB’s lead, although Congress probably expected that the council would make independent and fact-based judgments about which firms should be considered systemically important.
This leaves the most important financial sources in the U.S. economy exposed to stringent and unnecessary bank-like regulation. If nothing is done by Congress, and soon, we can expect that—after the FSB’s decisions about securities firms, asset managers, finance companies, hedge funds and the like—these institutions will disappear into the welcoming arms of the Fed.
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In September 2013, the Financial Stability Oversight Council (FSOC) designated Prudential Financial as a systemically important financial institution (SIFI); its rationale was perfunctory and data-free, suggesting that the FSOC sees no need to justify its designation decisions.
Thus far, the FSOC has been following—and is expected to implement in the US—the decisions and policy positions of the Financial Stability Board, a group of mostly European central banks and regulators that has been designating US firms as global SIFIs.
If this pattern continues, large sectors of the financial system beyond banking—particularly the securities and capital markets—will be swept into bank-like regulation by the Fed, and firms considered too big to fail may come to dominate currently competitive financial industries. Congress must step in, and quickly.
In September 2013, the Financial Stability Oversight Council (FSOC) determined that Prudential Financial Inc., one of the country’s largest insurers, was a systemically important financial institution (SIFI). Under the Dodd-Frank Act, accordingly, Prudential was turned over to the Federal Reserve for what the act calls “stringent” regulation. In the context of the act, this appears to mean bank-like regulation and supervisory control of risk taking.
The FSOC is a creation of the Dodd-Frank Act and is a uniquely powerful body within the executive branch of the US government. It consists of 15 members, of which 9 are the chairs of other federal financial regulatory agencies. Five are nonvoting members.[1] The secretary of the Treasury is the chairman and has an effective veto over any major FSOC action because the act requires his affirmative vote. In addition, because the members are the chairs of various regulatory agencies, they have all been appointed by the presidential administration in power and are likely to follow the lead of the Treasury secretary on policy simply because he is the highest-level political official at the table.
Insurance is regulated at the state level in the United States, so no federal agency has expertise in insurance. For this reason, the Dodd-Frank Act authorizes the president to appoint (with the consent of the Senate) one voting member of the FSOC who is called the “independent member with insurance expertise.”
The Prudential decision was the second FSOC decision involving an insurance-related firm. In July 2013, the agency designated American International Group (AIG) as a SIFI. That decision was expected, perhaps even politically compelled; AIG had famously been bailed out by the Treasury and the Federal Reserve during the financial crisis. If the SIFI idea has any validity, it would have to apply to AIG. The Prudential decision, however, was the first to designate a nonbank financial institution as a SIFI when that firm had not suffered any significant financial distress during the financial crisis.
Dodd-Frank enjoins the FSOC to “identify risks to the financial stability of the United States that could arise from the material financial distress or failure, or ongoing activities, of large interconnected bank holding companies or non-bank financial companies” (Section 112). The decision to designate Prudential as a SIFI was made under Section 113, which authorizes the FSOC to designate a nonbank financial firm as a SIFI if “the Council determines that material financial distress at the US nonbank financial company . . . could pose a threat to the financial stability of the United States.”
The first thing to be said about this language is that it is a remarkable grant of authority and essentially permits the FSOC to determine the scope of its own jurisdiction. Although the courts frown on this when it is called to their attention, it is possible that this grant of authority will never be challenged; regulated firms, fearing retaliation, are very reluctant to
challenge the legal authority of their regulators. In addition, because the key terms the FSOC must apply to take jurisdiction over any particular firm—“financial distress” and “market instability”—have no clear meaning, and because both involve making predictions about the future, they amount to a grant of discretionary authority to the FSOC that may be an unconstitutional delegation of legislative power.
Although the doctrine of unconstitutional delegation has not been used since the 1930s, the two cases to which it was applied by the Supreme Court have not been overruled. If ever there were a candidate for a holding of unconstitutional delegation in the modern era, the grant of authority to the FSOC would be it.[2] As I will discuss, the fact that the FSOC was unable to develop any intelligible principle on which to designate Prudential as a SIFI strongly suggests that Congress delegated the vast discretionary authority that, constitutionally, it alone can exercise. Still, if a firm should in the future challenge its SIFI designation as an unconstitutional delegation or on any other ground, the case is likely to move slowly up to the Supreme Court. During that time, the Financial Stability Board (FSB) and the FSOC may continue to designate SIFIs, ultimately creating a fait accompli in which many firms are already functioning under the control of the Fed by the time the Supreme Court hands down its ruling.
In its Prudential decision, the FSOC makes full use of its discretionary authority; it failed to develop or implement any intelligible standard for determining whether a particular financial firm is a SIFI. The same was true of its prior designations of AIG and GE Capital, which are both equally devoid of any coherent or rational standards. The most descriptive word for all these decisions is “perfunctory.” If it can continue to get away with this, the agency will be free to implement in the United States the designations and other decisions of the FSB. In September 2013, the FSB announced that it plans to extend what it calls the “SIFI framework” to securities firms, asset managers, mutual funds, hedge funds, and others that operate in the capital markets.
Unless Congress intervenes, and soon, to tell the FSOC that it wants to have a say in how SIFIs are designated, large portions of the US financial system will be brought under bank-like regulation by the Fed. This will not only slow the growth of the American economy but also almost certainly create a too-big-to-fail problem in industries that have previously been competitive.
The Prudential Decision
Dodd-Frank sets out the standards that the FSOC is required to use in determining whether a nonbank financial institution threatens the stability of the US financial system. About a dozen factors can be taken into account, but the key ones are
Leverage;
Off-balance-sheet exposures;
The nature, scope, size, scale concentration, interconnectedness, and mix of activities; and
Reliance on short-term funding.
Whether any or all of these applied to Prudential can only be guessed at by reading the document the FSOC published in support of its decision. In that paper, entitled Basis for the Financial Stability Oversight Council’s Final Determination Regarding Prudential Financial, Inc. (the Basis), the FSOC summarizes its decision as follows:
Prudential is a significant participant in financial markets and the U.S. economy and is significantly interconnected to insurance companies and other financial firms through its products and capital markets activities. Because of Prudential’s interconnectedness, size, certain characteristics of its liabilities and products . . . material financial distress at Prudential could lead to an impairment of financial intermediation or of market functioning that would be sufficiently severe to inflict significant damage on the broader economy.[3]
Although this statement is only a summary, we will see that the agency never adduced any specific evidence to back its assertions. That explains why the two members of the FSOC who had insurance expertise (and were not employees of the Treasury Department) dissented from the FSOC’s decision. On the other hand, the banking regulators—who have no experience or knowledge in this area—all voted for it, following the Treasury’s lead.
The dissent by Roy Woodall, the presidentially appointed independent member with insurance expertise, was particularly stinging:
In making its Final Determination, the Council has adopted the analysis contained in the Basis. Key aspects of said analysis are not supported by the record or actual experience; and, therefore, are not persuasive. The underlying analysis utilizes scenarios that are antithetical to a fundamental and seasoned understanding of the business of insurance, the insurance regulatory environment, and the state insurance company resolution and guaranty fund systems. As presented, therefore, the analysis makes it impossible for me to concur because the grounds for the Final Determination are simply not reasonable or defensible, and provide no basis for me to concur.[4]
The FSOC’s discussion of how Prudential might cause financial instability in the US market was organized under two key subjects, called the asset liquidation channel and the exposure channel. A third channel, critical functions or services, did not add anything to the discussion in the other two and will not be covered in this Outlook.
Asset Liquidation Channel. In its asset liquidation channel argument, the FSOC argued that if policyholders choose to terminate their relationships with Prudential in sufficient numbers, or to seek the cash surrender value of their policies, this could cause Prudential to “liquidate a substantial portion of its general account assets to meet redemption and withdrawal requests.”[5] This in turn “could cause significant disruptions in key markets.”[6] However, the FSOC never explained what a “substantial portion” of Prudential’s assets was, how many policyholders would have to withdraw their funds, or what actual effect that might have on markets.
The FSOC’s liquidation channel argument would be plausible only if there were some likelihood that it might occur. On this question, Woodall again dissented:
While there have in fact been liquidity runs on life insurance companies, no historical, quantitative or qualitative evidence exists in the record which supports a run of the scale and speed posited, or to support a rapidly spreading sector-wide run. The asset liquidation analysis appears to assume a contemporaneous run against the general and separate accounts by millions of life insurance policyholders and a significant number of annuity and other contract holders of products with cash surrender value—a scale for which there is no precedent, and for which the likelihood is believed by most experts to be extraordinarily low.[7]
Nevertheless, the FSOC could have made an argument for its liquidation channel scenario if it had data to show that Prudential substantially relied on leverage and short-term funding. In that case, a sharp change in the availability of short-term credit in the market could cause a lack of confidence in Prudential that might lead to fund withdrawals.
But the FSOC apparently did not have such data or did not bother to present it. In fact, its decision paper did not discuss leverage and noted that Prudential did not use short-term funding. Without either unusual leverage or major short-term funding, it is highly unlikely that policyholders would run in the event of a financial downturn, even a severe one.
Insurance firms, unlike banks, match their assets with their long-term liabilities. The claims of policyholders are the long-term liabilities of insurers and are generally supported by long-term assets like corporate bonds or mortgages. A collapse in the short-term funding market, as occurred in 2008, would not put policyholders in any danger.
The Exposure Channel and Interconnectedness. The question addressed in the exposure channel was whether Prudential’s failure would harm the rest of the market because of the firm’s interconnections. As in its discussion of the liquidation channel, the FSOC simply says that Prudential’s interconnections are “significant” but does not define what that means for either Prudential or its counterparties. Without that clarification, it is impossible to determine what the FSOC considered significant or sufficient to cause financial instability in the market as a whole. The FSOC said:
The financial system is exposed to Prudential through the capital markets, including as derivatives counterparties, creditors, debt and equity investors, and securities lending and repurchase agreement counterparties. . . . Prudential also uses derivatives to hedge various exposures related to its assets and liabilities. Prudential’s derivatives counterparties include several large financial firms, which aresignificant participants in the global debt and derivatives markets. . . . Prudential’s off-balance sheet exposures could serve as a mechanism by which material financial distress at Prudential could be transmitted to banks and to financial markets more broadly. For example, Prudential’s total off-balance sheet exposure due to derivatives counterparty and credit facilities commitments with large global banks is significant.[8] [emphasis added]
The word “significant” is used 47 times in the 12-page FSOC document—mostly to describe the effect that a Prudential failure might have on the markets and on counterparties—but the FSOC made no effort to support its characterizations with the kind of numerical data that would give the word some meaning. Again, the same is true of the designation decisions on GE Capital and AIG, with the word “significant” used 42 times in the 14 page AIG decision and 32 times in the 14 page GE Capital decision. Indeed, in all these decisions, the only useful numbers are page numbers.
In any event, the interconnectedness idea is invalid as a basis for designating a firm as a SIFI.[9] It posits that when a large financial institution fails, its interconnections with others will have knock-on effects, causing others to weaken or fail. The notion that interconnectedness among large financial institutions is a source of danger to the financial system is at the heart of the Dodd-Frank Act. The reason for designating certain bank and nonbank financial firms as SIFIs and subjecting them to bank-like and other stringent regulation by the Fed was to prevent them from failing and then, supposedly, causing a financial crisis by dragging down others.
But we know from the Lehman Brothers bankruptcy that interconnectedness was not a factor in the financial crisis.[10] Lehman’s failure, to be sure, caused chaos in the financial markets, but no major (or even minor) financial institution failed as a result. This was true, even though Lehman, with over $600 billion in assets, was one of the largest financial firms in the world and was active in such inherently “interconnected” activities as the credit default swap market—and even though the financial markets were in the midst of an unprecedented panic so great that banks were refusing to lend to one another, even overnight.
The only serious knock-on effect of the Lehman bankruptcy was the inability of one money market mutual fund, the Reserve Primary Fund, to maintain the value of its shares at $1 per share. The fund had continued to hold Lehman commercial paper (probably expecting that Lehman, like Bear Stearns, would be bailed out by the government), and its potential losses in the bankruptcy were great enough to reduce its net asset value to less than $1 if the Lehman paper was uncollectible. This is known as “breaking the buck.”
In the midst of a panicky market and a general flight to quality, this produced what has been called a “run” on the fund, but in the end the losses to the Reserve Fund shareholders were minimal, about 1 or 2 percent. Whatever might be said about the Reserve Fund’s “breaking the buck,” it was not akin to a firm’s being dragged into bankruptcy by the failure of a counterparty; it was simply a firm encountering an unexpected 1–2 percent loss.
Some also occasionally argue that AIG’s bailout following the Lehman failure is an example of the dangers of interconnectedness, but this idea also fails under any serious examination. First, AIG had virtually no exposure to Lehman. In addition, despite a lot of speculation in the media about the Fed’s reasons for rescuing AIG two days after Lehman was allowed to fail, the officials involved at the Treasury and Fed have never said anything other than that they stepped in to rescue AIG because it was so large that its bankruptcy—in the midst of the post-Lehman panic—would have caused a complete meltdown of the financial system. It is not then a case of interconnectedness, but of the Treasury and Fed’s view of market psychology at a time of particular turmoil.
Although interconnectedness had no role in the financial crisis, the idea is catnip for regulators because it provides a basis for more comprehensive regulation of financial institutions—something they arguably know how to do. The old adage comes to mind: if all you have is a hammer, everything looks like a nail. Thus, the Dodd-Frank Act assumes that stringent regulation can keep large financial institutions such as Prudential from failing and bringing down other firms with which they are “interconnected.”
The FSOC’s use of the interconnectedness idea in its Prudential decision could have been barely persuasive—at least in theory—if the FSOC had shown that Prudential’s counterparties and creditors had unusually large exposures to Prudential. But as in the AIG and GE Capital decisions, the FSOC did not even attempt to demonstrate this.
The failure of the FSOC to justify its Prudential or earlier decisions in any intelligible or coherent way suggests two possibilities. First, the agency did not want to articulate any standard because this would restrict its discretion in the future. Or second—perhaps more troubling—is the likelihood that there is in fact no intelligible standard for determining whether a firm is a SIFI. In this extremely important area with major implications for the US economy, the FSOC is making what can only be called a political or ideological decision—choosing to designate firms as SIFIs for no other reason than that it wants to increase the government’s regulatory control of the financial system. The same question arises when we get to a discussion of the Financial Stability Board.
The Role of the Financial Stability Board
As noted earlier, the FSB is an international group of central banks, government ministers, and financial regulators. In November 2008, shortly after the financial crisis, the G-20 leaders met in Washington and directed the FSB to reform the international financial system so that a financial crisis would not recur.[11] Since then, the FSB has been aggressive in designating large banks and insurers as SIFIs, and it is beginning a program for doing the same in the securities and capital markets industry, which is what the FSB and US regulators call “shadow banking.”[12] Both the Treasury and the Fed are members of the FSB—and probably its most influential members. It is inconceivable that the designations of three US insurers would have gotten through the FSB without the express approval of the Fed and the Treasury.
Thus, the principal players in the FSOC—the Treasury and the Fed—had already approved designating Prudential as a SIFI before the FSOC took any action. In other words, the entire Prudential decision process was a kind of show trial; the issue had already been decided. A sham proceeding, in turn, was necessary because the Dodd-Frank Act seems to require the FSOC to do an analysis of some kind before it determines that a particular financial institution is a SIFI, but the Treasury and the Fed had already decided the issue through their membership in the FSB and their participation in the FSB’s earlier designation of Prudential as a global SIFI. Obviously, the Treasury and the Fed cannot continue to both participate in decisions of the FSB that designate US firms as SIFIs and then turn around and act as though the same decision by the FSOC is a case of first impression.
In the FSOC’s defense, it might be possible to argue the FSB did the kind of analysis about the three US insurers that the FSOC should have done, and therefore that the FSOC’s failure to create any intelligible standard about the “SIFIness” of Prudential can be excused. The FSB’s test for SIFIs is whether they are “institutions of such size, market importance, and global interconnectedness that their distress or failure would cause significant dislocation in the global financial system and adverse economic consequences across a range of countries.”[13] This language stresses international effects, but if an insurer is considered to create systemic risk globally, it will certainly have a systemic effect in its home country. Accordingly, the FSB standard is not materially different from Dodd-Frank’s reference to “instability in the US financial system,” and thus FSB designations could involve roughly the same judgments about what factors will constitute a SIFI as the Dodd-Frank and FSOC standard.
However, it appears that FSB did no such analysis. The FSB purported to base its decision on a methodology developed by the International Association of Insurance Supervisors (IAIS) for determining whether an insurer is a SIFI.[14] The methodology was reasonably thorough, showing that if the FSOC had actually been interested in doing a serious analysis of whether Prudential was a SIFI it could have done so by adopting and publishing a similar methodology.
But in the end the FSB did no more than what the FSOC had done; in fact, it did less. It designated ninelarge insurers as SIFIs—including AIG, Prudential, and MetLife—but gave no indication of how, or even whether, the IAIS methodology had been applied to each of them. Moreover, the IAIS methodology differs substantially from the “channels” structure the FSOC uses, so the FSOC clearly did not implicitly adopt the IAIS methodology. For example, the IAIS methodology assigned weights to specific activities of insurers, assigning 45 percent weight to engaging in bank-like activities and only 5 percent to size. None of this shows up in the FSOC decision paper.
Since the FSB is completely opaque and does not allow independent observers or the media at its meetings, it is impossible to know for certain if the IAIS methodology was used. However, given that none of the nine insurers that were designated as SIFIs made any public statement accepting the FSB’s decision or disputing the facts it used, it seems likely that none of the insurers had any idea what facts, if any, the FSB used to designate them as SIFIs or how the methodology was applied.[15]
The nontransparent, indeed secretive, role of the FSB raises a question about what effect the FSB’s SIFI designations are expected to have in the US. Thus far, the FSB has been acting as though it is another Basel Committee on Bank Supervision. Since at least the mid-1980s, the Basel Committee has functioned as a supranational decision-making body on bank capital regulation; the committee agrees on capital regulations for banks and expects all members of the organization to implement these decisions within their respective jurisdictions. Congress has generally not interfered with bank capital regulation, but it is not clear how and when US regulators were authorized to participate in what is essentially the development of rules that may not meet the requirements for rule making under the Administrative Procedure Act (APA) or have never been specifically authorized by Congress.
The issue becomes more acute when the Treasury and the Fed participate in the FSB’s SIFI decisions, if these decisions are ultimately to apply in the United States. On its face, this seems inconsistent with both the APA and the Dodd-Frank Act, especially because the outcome of these decisions may be far more consequential for the US economy than bank capital regulations.
Thus far, it appears that the FSOC is simply implementing the earlier FSB policy and designation decisions. For example, the FSB has recommended that if money market mutual funds do not adopt a floating net asset value, they should be subject to capital requirements like banks.[16] The FSOC then pressured the US Securities and Exchange Commission to adopt similar rules for money market funds. The FSB indicated that all asset managers with assets of more than $100 billion may be subject to prudential regulation.[17] Then, the Office of Financial Research, another Treasury agency created by Dodd-Frank, produced two reports at the request of the FSOC to support the idea that large asset managers should be designated as SIFIs. The FSB has designated three US insurance firms as SIFIs—AIG, Prudential, and MetLife—and the FSOC has already designated AIG and Prudential as SIFIs and is currently investigating MetLife for a possible SIFI designation. These parallel policy pronouncements and decisions again suggest that, unless Congress asserts its interests, the SIFI designation process—despite the requirements of the APA and Dodd-Frank—will devolve into the implementation of policies and decisions of the FSB.
An Unprecedented Opportunity for Increasing Regulatory Power
The financial crisis has in many ways changed the rules that formerly confined financial regulators to a limited range of powers. Bank-like regulation—which includes supervisory control of risk taking and minimum capital requirements—was previously approved for federal regulators only where government support, such as deposit insurance, threatened to create moral hazard. However, the narrative that came out of the 2008 financial crisis was that any large financial institution could cause another financial crisis if it failed. This provided the authority for the FSOC and the FSB to adopt prudential bank-like standards for the largest financial institutions—not just banks—because any one of them could, under the prevailing theory, cause a financial crisis if it failed.
For this reason, the FSOC (empowered by the Dodd-Frank Act) and the FSB (empowered by the G-20) were given what seems to be quasi-judicial authority to make decisions about specific institutions and not just general rules. The FSB, as mentioned earlier, has already outlined an aggressive program that could eventually result in the designation of SIFIs in many other financial fields, reporting in September 2013 that it is “reviewing how to extend the SIFI Framework to global systemically important non-bank non-insurance (NBNI) financial institutions” (emphasis added). This category of firms, the FSB continued, “includes securities broker-dealers, finance companies, asset managers and investment funds, including hedge funds.”18 When those designations occur, it seems the firms so designated will be required by the Dodd-Frank Act to have bank-like capital requirements, as well face stress tests and liquidity coverage ratios that regulators have prescribed for banks under the Basel standards.
All of the participants in this process—the G-20 leaders who authorized the FSB, the FSB itself, the FSOC, and the Fed—are government or regulatory organizations. For this reason, the FSB and the FSOC have an interest in increasing regulation of the largest financial institutions—not just because the conventional narrative holds that any of these institutions could cause the next financial crisis—but more importantly because regulators always want more power. This is not a new idea; one of the fundamental elements of what is known as public choice theory is that it models the actions of government officials as self-interested.[19] The narrative about the financial crisis has given the regulators an unprecedented opportunity to extend their power, and they are not likely to waste it.
This is a key point that those representing institutions under threat of SIFI designation must bear in mind. The lack of a factual basis or clear standards behind FSB’s decision on nine large insurers and the FSOC’s Prudential and other decisions demonstrate that their discretion is essentially unbounded. Decisions of this kind—especially when they serve the interests of regulators rather than the public—are too important for Congress to ignore. If the FSB and FSOC intend to follow the precedents set by the Basel Committee on Bank Supervision, they will expect that the international agreement of regulators on what firms are SIFIs would be supported in the United States through decisions of the FSOC.
Given the incentives of regulators and the prospect for vastly enlarging regulatory control, it is very doubtful that either the FSB or the FSOC will be responsive to factual presentations in the future. The benign interpretation of the Prudential decision is that the FSOC does not want to limit its discretion in designating SIFIs by articulating any standards. The more troubling interpretation is that the FSOC has no idea how to determine whether a particular firm is a SIFI. The famous remark about pornography by former Supreme Court Justice Potter Stewart, “I know it when I see it,” should not be acceptable in a process as important to the US economy as determining whether a multibillion-dollar business ought to be turned over to bank-like regulation by the Fed. Yet that is where we seem to be heading with the designation of SIFIs by both the FSB and the FSOC.
If this happens, the consequences for the US economy could be dire. The designation of SIFIs is a statement by the government that the designated firms are too big to fail. We can see the effects of ignoring this danger in the condition of the banking industry today. We have no way of knowing whether the gigantic banks we have created are dangerous because of their size or what size they ought to be to eliminate the danger. What we do know is that in other industries, particularly insurance, there has never been a sense that any firm is too big to fail or would be treated as such by the government if it exhibited financial distress. With the designation of SIFIs among insurers, we are paving the way for these large firms to claim that they are safer investments and safer sources of insurance protection than their smaller competitors because the government has determined that they cannot be allowed to fail.
It is worth noting that the chairman of AIG, Robert Benmosche, welcomed AIG’s SIFI designation because he believed that it implied that the government had endorsed the safety and soundness of his firm—what he called a government “seal of approval.”[20] This raises the possibility—never fully explored by Congress—that SIFI designations may extend the spread of too-big-to-fail firms beyond the banking industry. Accordingly, although expanding these designations may be in the interests of regulators, it decidedly does not serve the interests of the US economy.
Moreover, it is not a mitigating factor that a firm designated as a SIFI then becomes eligible for the “orderly liquidation” process set up by Title II of Dodd-Frank. Under the act, the secretary of the Treasury has the power to seize any financial firm—whether or not the firm is a SIFI—and turn it over to the Federal Deposit Insurance Corporation (FDIC) for liquidation if he believes that its financial distress will cause “instability in the US financial system.” Thus, any firm, whether or not designated as a SIFI, can be placed in the orderly liquidation process of the FDIC through a decision of the Treasury secretary that involves discretionary power at least as unbounded as the SIFI designation itself.
Conclusion
A close study of the FSOC’s Prudential decision tells us several important things.
1. Either the FSOC does not take seriously its responsibility to designate SIFIs or it is unable to develop a coherent or intelligible set of standards for performing this function. In either case, the agency should not be permitted to proceed with these designations without further review by Congress.
2. The participation of the Treasury and the Fed in the FSB’s opaque process for designating SIFIs is inconsistent with the idea that the FSOC will do a full and fair analysis before designating a firm as a SIFI.
3. The new powers to designate SIFIs offer an unprecedented opportunity for regulators, both at the FSB and the FSOC, to enhance their control over the financial system. With this incentive, it is highly unlikely that they will stop the SIFI designation process before all large financial firms—in all financial industries—have been designated.
4. The designation of SIFIs is likely to spread the dangers of too big to fail beyond the banking industry to industries such as insurance, securities, and capital markets.
The only way to slow or stop this train will be through some action by Congress. That does not necessarily mean that Dodd-Frank must be amended at this point, but only that the FSOC, Treasury and Fed should be advised by members of Congress that SIFI designations are not just another version of the Basel Committee process. A resolution in the House or a joint letter by a large number of influential lawmakers in the House and Senate might be enough to stop or significantly slow the movement currently underway.
Comments Off on What the FSOC’s Prudential decision tells us about SIFI designation
Chairman McHenry, Ranking Member Green and members of the Committee:
My testimony today will focus on a different aspect of bank competition—the competition between banks and nonbank financial firms—what bank regulators call “shadow banking.” This needs more attention from Congress.
Under Dodd-Frank, Financial Stability Oversight Council (FSOC) has the authority to designate any financial firm as a systemically important financial institution, or SIFI, if the institution’s “financial distress” will cause “instability in the US financial system.” Non-bank financial firms designated as SIFIs are turned over to the Federal Reserve for what appears to be prudential bank-like regulation.
The troubling extent of the FSOC’s authority was revealed recently when it designated the large insurer, Prudential Financial, as a SIFI. Every member of the FSOC that was an expert in insurance (and was not an employee of the Treasury Department) dissented from the decision, arguing that the FSOC had not shown that Prudential’s financial distress could cause instability in the financial system. Virtually all the other members, knowing nothing about insurance or insurance regulation, dutifully voted in favor of Prudential’s designation.
Indeed, there was little in the document that the FSOC issued in support of its decision. The best word to describe the decision is perfunctory. There is a reason for this.
In effect, the decision on Prudential had already been made before the FSOC voted. The previous July, the Financial Stability Board, an international body of regulators empowered by the G-20 leaders to reform the international financial system, had already declared that Prudential was a SIFI. The FSOC’s action was simply the implementation in the US of a decision already made by the FSB. Since the Treasury and the Fed are members of the FSB, they had already approved its July action.
This raises a question whether the FSOC will be doing a thorough analysis of whether financial firms are SIFIs or simply implementing the decisions of the FSB. This is important because the FSB looks to be a very aggressive source of new regulation of nonbank financial firms.
In early September, it said that it was looking to apply the “SIFI Framework” to securities firms, finance companies, asset managers and investment funds, including hedge funds. These firms are the so-called shadow banks that the regulators want so badly to regulate. But it will be very difficult to show that these nonbank firms pose any threat to the financial system.
For example, designating large investment funds as SIFIs would be a major and unwarranted extension of government bank-like regulation. Collective investment funds are completely different from the banks or investment banks that suffered losses in the financial crisis.
When a bank suffers a decline in the value of its assets—as occurred when mortgage-backed securities were losing value in 2007 and 2008—it still has to repay the full amount of the debt it incurred to acquire those assets. Its inability to do so can lead to bankruptcy.
But if an investment fund suffers the same losses, these pass through immediately to the fund’s investors. The fund does not fail and thus cannot adversely affect other firms. Asset management, therefore, cannot create systemic risk.
Nevertheless, right after its Prudential decision, and following FSB’s lead, the FSOC now seems to be building a case that asset managers of all kinds should also be designated as SIFIs and regulated by the Fed. It recently requested a report from the Office of Financial Research, another Treasury body created by Dodd-Frank, on whether asset management might raise systemic risk. Not surprisingly, the OFR reported that it did.
Unless the power of the FSOC is curbed by Congress, and soon, we may see many of the largest non-bank firms in the US financial system brought under the control of the FSOC and ultimately the Fed.
As shown in my prepared testimony, these capital markets firms, and not the banks, are now the main funding sources for US business. Bringing them under bank-like regulation will have a disastrous effect on economic growth and jobs. And this outcome could be the result of decisions by the FSB, carried out by the FSOC.
WASHINGTON — IN November, housing starts were up 23 percent, and there was cheering all around. But the crowd would quiet down if it realized that another housing bubble had begun to grow.
Almost everyone understands that the 2007-8 financial crisis was precipitated by the collapse of a huge housing bubble. The Obama administration’s remedy of choice was the Dodd-Frank Act. It is the most restrictive financial regulation since the Great Depression — but it won’t prevent another housing bubble.
Housing bubbles are measured by comparing current prices to a reliable index of housing prices. Fortunately, we have one. The United States Bureau of Labor Statistics has been keeping track of the costs of renting a residence since at least 1983; its index shows a steady rise of about 3 percent a year over this 30-year period. This is as it should be; other things being equal, rentals should track the inflation rate. Home prices should do the same. If prices rise much above the rental rate, families theoretically would begin to rent, not buy.
Housing bubbles, then, become visible — and can legitimately be called bubbles — when housing prices diverge significantly from rents.
In 1997, housing prices began to diverge substantially from rental costs. Between 1997 and 2002, the average compound rate of growth in housing prices was 6 percent, exceeding the average compound growth rate in rentals of 3.34 percent. This, incidentally, contradicts the widely held idea that the last housing bubble was caused by the Federal Reserve’s monetary policy. Between 1997 and 2000, the Fed raised interest rates, and they stayed relatively high until almost 2002 with no apparent effect on the bubble, which continued to maintain an average compound growth rate of 6 percent until 2007, when it collapsed.
Today, after the financial crisis, the recession and the slow recovery, the bubble is beginning to grow again. Between 2011 and the third quarter of 2013, housing prices grew by 5.83 percent, again exceeding the increase in rental costs, which was 2 percent.
Many commentators will attribute this phenomenon to the Fed’s low interest rates. Maybe so; maybe not. Recall that the Fed’s monetary policy was blamed for the earlier bubble’s growth between 1997 and 2002, even though the Fed raised interest rates during most of that period.
Both this bubble and the last one were caused by the government’s housing policies, which made it possible for many people to purchase homes with very little or no money down. In 1992, Congress adopted what were called “affordable housing” goals for Fannie Mae and Freddie Mac, which are huge government-backed firms that buy mortgages from banks and other lenders. Then, as now, they were the dominant players in the residential mortgage markets. The goals required Fannie and Freddie to buy an increasing quota of mortgages made to borrowers who were at or below the median income where they lived.
Through the 1990s and into the 2000s, the Department of Housing and Urban Development raised the quotas seven times, so that in the 2000s more than 50 percent of all the mortgages Fannie and Freddie acquired had to be made to home buyers who were at or below the median income. To make mortgages affordable for low-income borrowers, Fannie and Freddie reduced the down payments on mortgages they would acquire. By 1994, Fannie was accepting down payments of 3 percent and, by 2000, mortgages with zero-down payments. Although these lenient standards were intended to help low-income and minority borrowers, they couldn’t be confined to those buyers. Even buyers who could afford down payments of 10 to 20 percent were attracted to mortgages with 3 percent or zero down. By 2006, the National Association of Realtors reported that 45 percent of first-time buyers put down no money. The leverage in that case is infinite.
This drove up housing prices. Buying a home became preferable to renting. A low or nonexistent down payment meant that families could borrow more and still remain within the monthly payment they could afford, especially if it was accompanied — as it often was — by an interest-only loan or a 30-year loan that amortized slowly. In effect, then, borrowing was constrained only by appraisals, which were ratcheted upward by the exclusive use of comparables in setting housing values.
Today, the same forces are operating. The Federal Housing Administration is requiring down payments of just 3.5 percent. Fannie and Freddie are requiring a mere 5 percent. According to the American Enterprise Institute’s National Mortgage Risk Index data set for Oct. 2013, about half of those getting mortgages to buy homes — not to refinance — put 5 percent or less down. When anyone suggests that down payments should be raised to the once traditional 10 or 20 percent, the outcry in Congress and from brokers and
homebuilders is deafening. They claim that people will not be able to buy homes. What they really mean is that people won’t be able to buy expensive homes. When down payments were 10 to 20 percent before 1992, the home ownership rate was a steady 64 percent — slightly below where it is today — and the housing market was not frothy. People simply bought less expensive homes.
If we expect to prevent the next crisis, we have to prevent the next bubble, and we will never do that without eliminating leverage where it counts: among home buyers.
Peter J. Wallison, a senior fellow at the American Enterprise Institute, was a member of the Financial Crisis Inquiry Commission.
Mel Watt is a long-time champion of mortgage quotas for affordable housing. Here we go again.
By banning filibusters of most executive-branch and judicial nominations, the Democrats have done historic damage to the Senate. This will have long-term consequences for the nation, but the most significant initial fallout will likely be the confirmation of Rep. Mel Watt (D., N.C.) to head the Federal Housing Finance Agency, which regulates mortgage giantsFannie MaeFNMA -1.27% and Freddie Mac. FMCC +0.67%Since these two government-sponsored enterprises became insolvent in September 2008, FHFA has also been their conservator, with the power to control their operations and policies. Mr. Watt is a good man, but he is a man of the left, and he will use his control of Fannie and Freddie to return to the policies that brought on the mortgage meltdown in 2007 and the financial crisis in 2008.
Just before the crisis, 58% of all U.S. mortgages—32 million loans—were subprime or otherwise weak. Of these, 24 million, or 76%, were on the books of government agencies, primarily Fannie Mae and Freddie Mac. This shows incontrovertibly that the government itself was the source of the demand for these low-quality loans.
The U.S. had once been known for the high quality of its mortgage loans, but this began to change once Congress enacted affordable-housing goals in 1992. Under that legislation, Fannie and Freddie—which were then, as now, the standard-setters for the mortgage market—were required by the Department of Housing and Urban Development to purchase an increasing quota of loans to borrowers at or below the median income where they lived.
As HUD increased this quota between 1992 and 2008, Fannie and Freddie were forced to reduce their underwriting standards—accepting loans with 3% down payments in 1995 and 0% down in 2000—in order to find eligible borrowers. Mortgage financing is a competitive business, and as Fannie and Freddie’s underwriting standards deteriorated, they spread to the wider market.
Rep. Mel Watt (D., N.C.), left, is President Obama?s choice to head the Federal Housing Finance Agency, which controls mortgage giants Fannie Mae and Freddie Mac. Bloomberg
Borrowers who could afford down payments of 10% or more were happy to take loans with 3% or nothing down and buy larger homes. The increased borrower leverage and the sheer number of new borrowers fed an enormous housing price bubble between 1997 and 2007. When the bubble collapsed in 2007 and 2008, an unprecedented number of mortgage defaults drove down housing values 30% to 40%—and drove Fannie and Freddie into insolvency.
A government bailout of more than $180 billion enabled Fannie and Freddie to continue operating after September 2008 under FHFA’s acting director, Edward DeMarco. A nonpolitical civil servant, Mr. DeMarco has seen it as his duty to protect taxpayers from another bailout. To this end, he has increased the underwriting standards that Fannie and Freddie employ before they acquire a loan, raised the fees they get for guaranteeing mortgage-backed securities, and limited the scope of the affordable-housing goals. The two enterprises are now profitable and able gradually to repay the government.
Mr. DeMarco’s actions have aroused the opposition of the left. Critics complain that his underwriting standards are too high, meaning that many low-income borrowers will not be able to buy homes. This is the same argument community activists made when they pressed Congress to adopt the affordable-housing goals. Today, the idea underlying the goals goes by a new term—”opening the credit box.” But the objective is the same: reduce underwriting standards so borrowers who have poor credit records and don’t have down payments will be able to buy homes.
This is exceptionally bad policy. Even Barney Frank, the principal backer of the affordable-housing goals for much of his career in Congress, admitted in 2010 that “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.”
The only way to maintain a stable housing market is by requiring reasonable underwriting standards. This means a down payment of at least 10%, a FICO credit score above 660, and a debt-to-income ratio, after the mortgage is closed, of no more than 38%. When those standards were generally in force between 1970 and 1992, mortgage defaults in the U.S. were under 1% and the national homeownership rate was 64%—about where it is today after all the foreclosures in recent years.
Unfortunately, Mr. DeMarco’s underwriting standards will almost certainly change, and for the worse, once Mr. Watt is in charge of the Federal Housing Finance Agency. The stage has already been set. The Consumer Financial Protection Bureau (CFBP), an agency created by the Dodd-Frank Act, has outlined a minimum quality mortgage that will permit a borrower to get a loan with a 3% down payment and a FICO credit score well below 660. Under Dodd-Frank, a lender could be subject to severe penalties if it turns out that the borrower cannot repay the loan—but the CFPB’s rule protects the lender against liability if Fannie and Freddie’s automated underwriting systems approve the loan.
Enter Mr. Watt. The North Carolina congressman is a consistent, long-time supporter of affordable-housing quotas. He joined Barney Frank in 2003 to block the Bush administration’s attempt that year to increase government oversight of Fannie and Freddie. And in 2007 he cosponsored legislation that would have pushed the two GSEs even deeper into the subprime mess. One can be sure that there will be many low-quality mortgages approved by Fannie and Freddie on his watch.
In August, the six financial regulatory agencies that Dodd-Frank directed to define a high-quality mortgage (the Federal Reserve, Comptroller of the Currency, Federal Deposit Insurance Corporation, Securities and Exchange Commission, FHFA and HUD) reported that they’re quite happy with the CFPB’s minimum-quality loan. Despite the mandate in Dodd-Frank, they decided not to propose a high-quality mortgage.
The six agencies reported that mortgages that met the CFPB’s low standards between 2005 and 2008 had a default rate of 23%. Incredibly, they were still OK with that. Why? We are “concerned,” they said, “about the prospect of imposing further constraints on mortgage credit availability at this time, especially as such constraints might disproportionately affect groups that have historically been disadvantaged in the mortgage market, such as lower-income, minority, or first-time home buyers.”
As we gaze into the open credit box the financial regulators have set before us, is there any doubt where the housing market is headed?
Mr. Wallison is a senior fellow at the American Enterprise Institute
Key points in this Outlook:
