This afternoon, I am supposed to participate in a discussion of financial regulatory policy. There are so many participants, including big shots like John Taylor and John Cochrane, that I may end up not saying anything. I probably will just hand out the post that I put up in 2010, which I still like very much. Here it is:
1. Extricate the government from the mortgage market as soon as is practical. I foresee reducing the maximum mortgage amounts that of Freddie and Fannie to zero in stages over a period of three years, then selling off their portfolios two years after that. I would even get rid of FHA. I would also get rid of the mortgage interest deduction. My guess is that the market would evolve toward higher down payments, and probably toward mortgages like the Canadian five-year rollover.
2. Housing aid to poor people would take the form of vouchers. No other Federal involvement in housing.
3. I would support a law that says that lenders must not make loans with the intent of exploiting borrower ignorance. Allow case law to develop to define rules and norms in support of that principle, rather than try to come up with fool-proof regulations.
4. Break up the top 10 banks into 40 banks. I think that is the best solution to the “too big to fail” problem, although there is no perfect solution to Minsky-type financial cycles.
5. Replace capital requirements with systems that put senior creditors in line to lose money in a default. Let them discipline the risk-taking of financial institutions.
6. Define priorities for creditors in a bank bankruptcy. I think that the solution to the social value–or lack thereof–of derivatives and other exotic instruments can be handled by the priority assigned to them. I would assign them a low priority. That is, first ordinary depositors get paid off. Then holders of ordinary debt. Other contracts, such as swaps or derivatives, come after that. I think that this would provide all the incentives needed either to curb derivatives or lead them to be traded on an organized exchange. I don.t think that getting them onto an organized exchange should be sought after as an end in itself.
7. Get rid of the corporate income tax, which encourages excess leverage. If the private sector, including banks, had lower debt/equity ratios, the financial system would be sounder.
8. Develop emergency response teams and backup systems that can ensure that the basic components of the financial system, particularly transaction processing, can survive various disaster scenarios, both technological and financial.
The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave. By reducing the incentives for debt finance and for exotic finance, you help promote a financial system that breaks the way the Dotcom bubble broke, with much lesser secondary consequences.
[Postscript:
1. I took four books to the meeting, and I got autographs from their authors.
2. We are not supposed to talk about what was said.
3. I did not hand anything out. I requested to be called on at one of the discussions, but my time came just as people had been promised a coffee/bathroom break, so I did not receive very much attention. I tried to say that it is futile to try to make the financial system hard to break. Crises come from surprises, and you cannot outlaw surprises. I suggested instead the approach of making the system easy to fix. Have backup systems to keep ATMs working (Paulson and Bernanke claimed that without TARP the system would have been so frozen that ATMS would have run out of cash. That was a sales pitch that the “common man” needed TARP and I think it was probably a lie, but in any case a backup system would be a good idea.); backup systems for settlement and clearing of transactions on exchanges in case a financial derivatives exchange blows up; and changing the tax bias to favor equity rather than debt.
4. A commenter says that eliminating the mortgage interest deduction would be a blow to the middle class. Actually, if you assume an across-the-board tax cut so that the change is “revenue neutral,” it probably helps the middle class. The benefits of the deduction go mainly to the rich. In fact, you could just cap the deduction at a low level and leave the middle-class borrower alone, and still get most of the revenue from it. But for me, the point of getting rid of the deduction is not to get revenue, but to change the incentives on leverage. So I do not want to cap it. Instead, I would prefer to have it phase out over a period of 5 or 10 years for people who have mortgages.]
Would you keep the FDIC and the NCUA or would prioritizing retail depositors like you suggest mean that they’re redundant?
The problem of making it easy to fix is you encourage skating along the edge. You also need to have systems in place to do it before they are needed or risk bad and highly variable results. Lehman creditors offered little restraint, Bear Stearns even less. That would certain eliminate derivatives. While taxes do encourage leverage, it is really gains that encourage it the most and that won’t change. Growth can and often has to rely on equity alone, but this is unattractive to stable areas. Finally, with an ageing population we will need more assets/debt not less. You can’t ask for more saving and less borrowing as that would be inconsistent.
According to some online calculator I found, on a $300,000 home and an average middle class tax rate, the mortgage deduction value would work out to $2,600/year for 30 years at current interest rates. That’s $78,000 over the life of the loan.
As such, any immediate elimination of the mortgage interest tax deduction would in effect be like handing a young middle class homeowner a $78,000 bill.
That seems to hard to swallow. You’d have to come up with some other plan if you wanted to reduce or phase out the deduction without causing a major backlash from a large political block. I’d start by trying to lower the cap of deductibility (currently way higher then most middle class can afford) and completely eliminate it on second mortgages.
If it’s a tax increase spread over 30 years, it’s not like getting a bill.
$2,600 a year for 30 years is a lot of money any way you slice it.
Bottom line its easier to phase this in over time rather then create a large block of people that feel like they got majorly screwed because they happened to buy a house at just the wrong time.
I get the point, but is that taking into account the difference between itemizing and the standard deduction?
Standard deduction is $12,600 for a married couple. So you need to find $10,000 more deductions for your mortgage deduction to matter at all. Mortgage deduction doesn’t matter at all to the middle class.
Will it be recorded?
1. I agree.
2. I agree on the need to limit federal housing involvement, but I wouldn’t use vouchers. I’d have a mix of something like a basic income grant (though relatively low in size, and named ‘refundable tax credit’ instead of BIG) married to a flat tax otherwise free of deductions/credits, and public housing with paid employee supervision for those who weren’t able to make it on their own.
3. I’d require consumer loans to be non-recourse, and a minimum 20% down payments for all securitized loans. If a foreclosure occurs, the lender only has legal recourse to the house or other underlying asset itself.
4/5. I don’t care that much about the issue, but I wouldn’t break up the banks. Relative to the size of the economy, American banks are tiny. Canada seems to do well with financial institutions that are, as a percent of GDP, much larger. I’d keep capital requirements, but make them simplistic, with a CoCo cushion. I would also require that 50% of senior management compensation be in the form of CoCos which mature in 5 year periods, so they would be incented towards safe practices rather than just boosting stock prices.
6. Agree
7. I’d keep the corporate income tax, but lower the rate and include interest expense as part of the tax base for the same reason.
8. Agree
Do you have a ballpark figure of how many first mortgage loans are recourse? I have never seen one.
I don’t know what proportion are recourse or non-recourse. However, I figure non-recourse loans increase risk to the lender and therefore should provide incentives more decision making regarding lending. It also provides a way for truly constrained borrowers to quickly get out of their debts by turning over control of the financed asset.
Poorly worded by me.
How many states there are where first mortgages are recourse?
On #4, Canada actually provides a good case for contrast with the US from the Great Depression that likely illustrates precisely why breaking up big banks and/or capping their size is actually a very bad idea. Before the depression, the US heavily regulated banks and restricted the founding of branches; there lots of small banks tethered to local markets. In contrast, Canadian banks didn’t face such stringent regulations and were larger and more diversified. For this reason, in the US we had an epidemic of bank failures, and Canada did not.
So banks being big isn’t (at least purely) a bad thing; large banks absorb risk better. The problem, IMO, isn’t so much that when one big bank fails, the others aren’t very able/willing to fill in the gap. In this case, barriers to entry into banking may be an important factor limiting competition and rendering the whole system less stable.
In my college days I wrote an econ paper arguing the benefits of getting rid of the mortgage interest deduction. Suggested the political/economical way to do it was by phasing it in over 20 years, i.e.: 100% deductible this year, 95% the next, 90% in year three and so on. This would give homeowners and the market time to adjust without sudden financial shocks.
Still consider it the best paper I wrote in college.
“Actually, if you assume an across-the-board tax cut so that the change is “revenue neutral,” it probably helps the middle class.”
If…my guess is that eliminating the mortgage interest deduction, like eliminating tax deductibility of health benefits, would not be revenue neutral. Certainly not revenue neutral in terms of middle class taxes. If you want this, you do need to fight hard for that condition.
Still, revenue neutral to “the middle class” isn’t revenue neutral to a newly minted homebuyer.
“In fact, you could just cap the deduction at a low level and leave the middle-class borrower alone, and still get most of the revenue from it.”
I suggested this.
“Instead, I would prefer to have it phase out over a period of 5 or 10 years for people who have mortgages.”
That’s seems more reasonable to me. Politically and in the interest of fairness this is the best way to achieve your goal especially if it can be coupled with a payroll tax deduction or something similair.
Yeah, let’s take a successful program like FHA(why not VA too) and get rid of it.
That way we can make sure that we can have a constant supply of renters who would never be able to come up with 20% down on a purchase.
Then again, if the program is priced and underwritten correctly(which it has been for a long, long time) it poses no risk to the financial system.
Almost unbelievable to see a financial policy that contains no mention of policing the banks to insure they are following the law. Which is what got us into the financial crisis in the first place.
What’s wrong with renting?
Seriously, what is with the fetishization if increasing home ownership rates? The government should not be in the business of encouraging home ownership over renting, end of story.
And you seem to (repeatedly) forget (regarding the housing and financial crisis) that the incentive for overleveraging (and government and FED encouragement of it) is rising housing prices due to excessive land use restrictions.
All more ‘policing’ will do is reduce the availability of credit; and then the same people complaining about banks giving out too many loans will start complaining that they’re no t giving out enough loans to (especially to poor/black/victim group de jour) people. And then we get nonsensical laws like Dodd-Frank that simultaneously make lending more costly while making it easier to sue a bank for refusing to give you a loan.
You need to make up your mind. On one hand you think banks loan too frivolously. On the other you are a big fan government programs underwriting mortgages suggesting you think banks aren’t lending enough. Well which is it? It can’t be both.
There is nothing wrong with renting. There is nothing wrong with buying. But for those who find themselves in a position where buying is less expensive on a monthly basis then renting, then buying is a better option.
I saw no government program where overleveraging(as you call it) was a negative. I saw a ton of private programs where overleveraging was a feature. Strangely enough those loans were what built and collapsed the bubble.
Yeah, I got it. Lower down payments mean a greater chance of delinquency. So? You charge more for that and the buyer pays it. Guess what? Been going on for centuries. Price the loan correctly and the program works.
The difference between an FHA loan and a 80/20 that proliferated in the bubble was simply this. The 80/20 loan was priced like a 20% down payment loan. Which would you rather invest in?
In terms of policing? How about the effect of the Bush admin listening to the FBI about fraud in appraisals, investment rating firms and banks? Easy answer, no bubble.
Banks did loan frivolously during the bubble. They were well aware of what they were doing. They were well aware of their control of appraisers and ratings firms, they didn’t care.
Unless you believe in the idea that all the hairdressers in the world fooled Goldman Sachs meme.
I do not think you understand what happened, which is why you ask me silly questions.
“Moody’s and S&P both assigned the investment vehicle, Cheyne Finance, their highest credit ratings in the years preceding its liquidation in 2007.
An analyst from Moody’s said at the time the Aaa rating on Cheyne meant it “should survive the equivalent of the US Great Depression”.
Cheyne Finance, a so-called structured investment vehicle or SIV, was designed to profit from borrowing short-term through issuing commercial paper and investing in long-term securities, many of them backed by residential mortgages.
The implosion of a number of SIVs when the US mortgage market started to malfunction in 2007 contributed to a wide-scale liquidity crisis across the financial services sector, culminating in multiple bank bailouts and an unprecedented injection of funds by the US Federal Reserve.
Instant messenger dialogue provided as evidence in the case revealed credit analysts at S&P had misgivings about signing off on the risks involved in the deal before it was launched.
“That deal is ridiculous … we should not be rating it,” said one analyst. “We rate every deal,” replied another. “It could be structured by cows and we would rate it.”
http://www.thenational.ae/business/banking/moodys-and-s-p-set-to-face-us-fraud-claim-over-ratings
“But for those who find themselves in a position where buying is less expensive on a monthly basis then renting, then buying is a better option.”
In which case, they will buy instead of rent. If the government needs to subsidize their purchase to get them to purchase, then it’s not a better option.
“I saw no government program where overleveraging(as you call it) was a negative. I saw a ton of private programs where overleveraging was a feature. Strangely enough those loans were what built and collapsed the bubble.”
Then you must be ignoring the Fed’s target rate, and the fact that the SEC (your ‘policeman’) specifically gave 4 big banks an exemption to capital requirements in 2004 for express purpose of inducing them to lend more. And the FDIC. But yeah, if you ignore those trifles, nothing.
The rest of your post is just anecdotal “evidence.” Nothing quantitative, not surprising. Sometimes banks do bad stuff. Yeah, I know. And sometimes restaurants serve undercooked food, and I’m sure I can find plenty of cases where they do; doesn’t mean they’re the leading cause of vomiting nationwide.
I’ll leave you with Ed Glaeser’s assessment: cheap credit cannot explain the bulk of the housing boom. (http://www.nber.org/papers/w16230)
So bad police work means we should not have police?
Got it.
Fed rate was unimportant(as Glaeser said).
You need to figure out that the problem was caused by people not being able to pay their mortgages, and why that happened.
I have shown you the link many times who did not pay. You ignore it.
So let’s see about your buy/rent thing. You seem fine with people paying more for housing. Of course, after 30 years their mortgage is paid, and then they really benefit from owning.
Meanwhile, you want to get rid of
“How is FHA funded?
FHA is the only government agency that operates entirely from its self-generated income and costs the taxpayers nothing. The proceeds from the mortgage insurance paid by the homeowners are captured in an account that is used to operate the program entirely. FHA provides a huge economic stimulation to the country in the form of home and community development, which trickles down to local communities in the form of jobs, building suppliers, tax bases, schools, and other forms of revenue.”
https://portal.hud.gov/hudportal/HUD?src=/program_offices/housing/fhahistory
Again.
The best description of a sub prime loan is one that does not meet GSE guidelines.
And the reason for that is :
“Or check out the FHFA study that compares, on an apples-to-apples basis, GSEs loan originations with those for private label securitizations. The study segments loans four ways, by ARMs-versus-fixed-rate, as well as by vintage, by FICO score and by loan-to-value ratio. In almost every one of 1800 different comparisons covering years 2001 through 2008, GSE loan performance was exponentially better. On average, GSE fixed-rate loans performed four times better, and GSE ARMs performed five times better.
Mortgage analyst Laurie Goodman estimated that private label securitizations issued during 2005-2007 incurred a loss rate of 24%, whereas the GSE loss rate for 2005-2007 vintage loans was closer to 4%.”
https://www.americanbanker.com/opinion/gse-critics-ignore-loan-performance
I think the FDIC should get more attention. Doing away with it would probably be too controversial, but it should definitely be revised so instead of insuring all deposits under a certain amount entirely, it only partially (or even just mostly) insures deposits so depositors are at risk of taking at least some kind of loss, so banks would have a better reason to be less risk seeking.
Another nice and relevant reform would be relaxing restrictions on private currencies.
I agree with a co-insurance approach. I also like the idea of a different in insurance between checking accounts and savings accounts. The effect of shortages from bank insolvencies in checking accounts is pretty dire. Savings accounts are not so problematic. There might be a similar difference between savings accounts redeemable on demand (even if the number of demands in a time period is limited) and those that are not (or for which there is an early withdrawal penalty).
Personally, I think the people on this blog would benefit greatly from reading the FCIC report, so they can form a basis of facts to formulate a financial policy.
https://fcic.law.stanford.edu/report
Really interesting is this testimony from the Citibank underwriting VP
http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0407-Bowen.pdf
As it clearly shows what the banks(not just Citi) did to F&F and many, many other investors. F&F, if not taken over by the government, could easily have driven them all into the ground.
EMichael, I have a reading recommendation for you. That is “Days of Slaughter,” by Susan Gates. You will see there that Freddie Mac bought the securities that were issued by the private banks that you blame for the crisis. In that way, Freddie made short-term profits from its “portfolio” while providing support for the market for loans that did not meet GSE standards.
Also, you should not dismiss the careful research of Ed Pinto on the proportion of loans that did not meet traditional GSE standards that the GSEs wound up holding. The fact that their overall portfolios outperformed other portfolios is irrelevant. What matters is the risk that they took relative to their capital. The GSEs took too much risk relative to their capital, and as a result they had to be taken over by the government, which used its borrowing capacity to keep them going. Had they not been taken over by the government, I believe that they would have been insolvent within weeks, because their borrowing costs were rising rapidly as investors lost confidence. As far as I know, you are the only person who believes that they would have survived if they had not have been taken over by the government.
I firmly believe that Mudd(fannie) and Syron(freddie) should have been indicted for their actions in buying the MBSs they bought late in the game. While the banks did commit fraud in their reps and warranties(as clearly shown), at that point in time their due diligence should have been off the charts. But as you say, they bought them, and solely because of their declining market share and own salaries.
With all due respect, I have absolutely no regard for Ed Pinto at all( Wallison’s toady)). He makes up numbers and definitions; crams his ideology into them; and then comes up with results that are truly worthless and meaningless.
“Unfortunately, Pinto’s research findings relied upon so heavily by Wallison and others are false. Pinto’s work is based on a series of faulty assumptions and serious methodological flaws. Pinto’s controversial conclusion that federal housing policies were responsible for 19 million high-risk mortgages is based on radically revised definitions for the two main categories of high-risk mortgages, subprime loans and so-called Alt-A mortgages, which refer to loans with low documentation of income and wealth. Importantly, these revised definitions are not consistent with how the terms subprime and Alt-A are used for data collection, as this paper will demonstrate.”
https://www.americanprogress.org/issues/economy/reports/2011/02/08/9126/faulty-conclusions-based-on-shoddy-foundations/
In terms of the GSEs surviving, I am certain that the Fed could have done the same for them as they did for the investment banks home and abroad. Loans and guarantees of a couple trillion would have sufficed to keep them afloat, just like conservatorship did. But then they would have become the investment banks greatest fear. Bernake killed tweo birds with one stone.
Everyone wants to deregulate housing markets and finance…great!
And when do we unzone property?
Free markets in property!
Hey, where did everyone go?
This is the thing I would add to Arnold’s list.
9. Create a federal office that sues state and local governments over zoning laws that are excessively restrictive, in order to get injunctions against those laws. This can be founded on the interstate-commerce clause (harm to interstate commerce by making state-to-state migration more difficult — maybe a stretch for a libertarian federalist) and on the 14th amendment due-process clause (arbitrary interference with property rights).
1. The mortgage deduction punishes renters and owners, and rewards borrowers. I agree with Arnold that this can’t be good.
2. Housing aid, if any, should be neutral wrt buying or renting. Lower income people may choose to rent in search of work, higher income may rent in search of promotions and opportunities, but for anybody, renting increases mobility of labor and, surely, is a good thing.
I have nothing to add to the other proposals, but they all sound like good ideas, therefore they stand no chance.
I do not like the mortgage deduction either(though nowhere near as much as I hate the charitable deduction), but I do not see how it hurts “owners”.
Hi EMichael – it hurts owners compared to a revenue-neutral tax that does not incentivize mortgage debt.
The point of any expense deduction is that the expense was incurred to earn income. This is clearly not the case for nearly all home mortgages and therefore an unnatural excrescence that really ought to go.
The one topic on which you have written nothing is proper penalties for bank wrongdoing. There will always be individual bankers who cause banks to do evil and we currently punish the individual wrongdoer not enough and the bank shareholders too much. As well, consider the perverse incentives of regulators imposing huge fines on banks for the benefit of the regulators or their pet political causes.