When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act last month, the rationale for yet another monolithic regulatory bill was that the economic and housing bubble crisis was caused by too little regulation.
In fact, the evidence is becoming increasingly clear that over-regulation and Washington interference were the major culprits.
All bubbles burst, so the key question is not “Why did housing collapse beginning in 2007?”, but “Why did the bubble appear in the first place?”
The answer has many facets, but a common element is government support for home ownership.
History of interference
As far back as 1913, Uncle Sam carved out a tax deduction for interest that has since become the politically sacrosanct but economically unsound tax break for home loans. Essentially, this is welfare for the wealthy, since it primarily benefits rich homeowners. Even worse, a comparison with other countries that don’t provide such a deduction shows that this tax break doesn’t necessarily help home ownership.
Government increased its role in housing during the Great Depression with the creation of Fannie Mae, which was designed to create a liquid secondary mortgage market, thus freeing lenders to make more loans. Washington expanded this effort in the 1970s by creating Freddie Mac.
Prior to the federal government getting into the business of financing houses, banks didn’t need a lot of regulations to keep them from lending to borrowers with poor credit history. Without the moral hazard of knowing that they could unload questionable mortgage loans on to taxpayer-supported entities, banks required at least a 20 percent down payment and a satisfactory credit history.
But over time, as the government passed regulations such as the Community Reinvestment Act of 1977 to encourage lending to marginal borrowers, banks were pressured into unloading their loans on the government, thereby letting the taxpayers assume the risk of nonpayment. As a result, banks didn’t have to worry about nonpayment, only about how many fees they could generate by originating the loans.
This trend accelerated during the Clinton years when Congress made the first $500,000 of capital gains on the sale of a home tax free, making real estate a very lucrative investment. And the Clinton administration pushed excessively high quotas on Fannie and Freddie to buy mortgages made to low-income borrowers.
In 2004, President Bush helped put the icing on the cake when he pushed for a new “Zero Down Payment” program for federally insured home loans. Soon thereafter, a whole new bracket of income-earners could afford homes.
Given the distorting nature of these incentives, what is remarkable is not that the mortgage market collapsed, but that the collapse was not even more severe. Nor was the purported rationale of these heavy-handed regulations – that it would encourage home ownership – ever vindicated.
Many other developed countries have achieved far higher rates of home ownership without encouraging banks to make bad loans, allowing banks to unload loans on taxpayers, or rewarding their richest citizens with tax benefits and subsidies of up to a million dollars for buying the most extravagant homes.
Stack of disclosures
Even before the Dodd-Frank law, all homeowners were familiar with the stack (often several inches high) of documents and “disclosures” that they reviewed and signed before completing a home purchase. While this paperwork no doubt satisfies government regulators, few if any homeowners were equipped to read them, much less understand them.
In fact, a single-sentence regulation would have been more effective in curbing both predatory lending and foolish borrowing – namely, a requirement that would-be homeowners must make a minimum 20 percent down payment. And marginal borrowers who couldn’t afford conventional loans and down payments should have been made to sign a one-page statement in bold, 16-point type before agreeing to an exotic loan:
I UNDERSTAND THAT MY MONTHLY PAYMENT COULD DOUBLE IN SIX MONTHS, AND THAT MY INTEREST RATE MAY TRIPLE BY NEXT YEAR. I FURTHER UNDERSTAND THAT, STATISTICALLY, GIVEN MY UNSATISFACTORY CREDIT HISTORY AND MINIMAL DOWN PAYMENT, MY CHANCES OF LOSING MY HOME TO FORECLOSURE WITHIN THREE YEARS EXCEEDS 90 PERCENT.
Such a warning would actually serve the public, but in the real world, the stacks of government rules may be harming more than helping.
Cost of regulations
According to a 2010 study by the Competitive Enterprise Institute, in 2009 federal regulatory agencies generated 3,503 “final rules,” each consisting of hundreds, often thousands, of pages of barely-intelligible rules.
The study further found that “annual regulatory compliance costs hit $1.18 trillion in 2009.” And more were the in the pipeline, with 59 different federal departments, agencies, and commissions in the process of promulgating more than 4,000 regulations, 184 of which are “economically significant rules, packing at least $100 million in economic impact.”
These byzantine rules have become so complicated that even the regulators can’t understand them, let alone enforce them. And lack of enforcement makes the public more susceptible to whiz kids at high-flying investment banks who create exotic investments such as credit default swaps, inverse floaters, and synthetic collateralized debt obligations. All of these exotic instruments have one feature in common: they create extreme leverage.
Yet the thousands of pages of additional regulations in the Dodd-Frank law don’t effectively address this underlying problem.
Again, a simple, one-page banking regulation would be far more effective:
EVERY BANK OR INVESTMENT HOUSE IS REQUIRED TO MAINTAIN A RESERVE OF 20 PERCENT FOR EVERY DOLLAR LOANED OR INVESTED, AND NO INVESTMENT SHALL BE OFFERED WHICH DOES NOT REQUIRE THAT AN INVESTOR MAINTAIN A 50 PERCENT EQUITY.
Instead of addressing extreme leverage simply and aggressively, the Dodd-Frank law will soon unload countless new rules on hapless regulators, banks, and consumers.
Uncle Sam is right to take action to prevent another housing bubble. To do that, it’s going to have to pop its own inflated sphere: the regulatory bubble.