Category Archives: financial crisis

The Case against Subsidizing Housing Debt

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SINGAPORE — At the end of the first quarter, according to the Federal Reserve Bank of New York, American consumer debt for the first time exceeded its previous peak (in dollars).  That peak was in the 3rd quarter of 2008, just as the global financial crisis hit.  Although car loans and student debt have been rising especially rapidly, housing debt remains more than 2/3 of the total ($8.6 trillion out of $12.7 trillion).

As a share of income, household debt is nothing like the threat to the national economy that it was ten years ago.   But the new statistic is a good reminder that American households don’t save enough.

Some would say that there must be something cultural in the tendency of Americans to spend while Asians, for example, tend to save.   But there is an important policy component as well.  US government policy is designed as if to encourage as many American families to take on as much housing debt as possible.

Economists hesitate to explain to people that they should borrow less.  The advice sounds too “schoolmarmish.”   It seems to lack sympathy for those whose incomes are not keeping up with the standard of living that they had expected based on historical trends.   But for those concerned with the reach of the nanny state, the state is precisely what encourages citizens to borrow.  And it does nobody any favors to get them overly indebted, as the millions of homeowners who went underwater in the housing crisis ten years ago discovered.

Does homeownership have spillover effects?

Owning your own home is said to be an essential part of the American dream.   There is nothing wrong with planning for a good future.  But there is nothing wrong with renting, either.   Buying a house is not a cause of a family’s prosperity, it is typically a consequence.   Owning is a blessing; over-indebtedness is a curse.

The Economist magazine estimates that the overall effective subsidy to American housing debt runs about 1% of national income per year.   Does owner-occupied housing have spillover benefits to justify this subsidy?

The “ownership society” view argues that homeowners take better care of their properties than renters, which has positive externalities for the neighborhood.   But there is also an argument against artificial public encouragement of home owning:  It contributes to the decline in labor mobility.  In the last recession many who lost their jobs could not move to other parts of the country where jobs were more plentiful, because they couldn’t sell their homes.  There is good evidence that the housing crisis boxed in job seekers.

The mortgage tax deduction

What are the US policies that artificially encourage housing debt?   Top of the list is the tax-deductibility of home mortgage interest.  The deduction, though very popular, is hard to justify on grounds of income distribution:  the benefit only goes to those who have a high enough income to itemize deductions.  Also it loses the treasury a lot of revenue.

Republicans say they want revenue-neutral efficiency-enhancing tax reform, which is properly defined as lowering marginal tax rates but simultaneously eliminating distortionary deductions, so that total tax revenue does not fall and the budget deficit does not rise.  If the desire for revenue-neutrality were genuine, the home interest deduction should probably be the first one to curtail.  Outright elimination is too radical politically.  But the deduction could be limited to $250,000 per person and second homes could be excluded.

If Donald Trump manages to get any economic legislation passed at all, even next year, it is likely to be a tax cut.   The White House has already explicitly said that the home interest mortgage deduction is off the table, a sign that they are not serious about genuinely revenue-neutral tax reform.

Five other policies that subsidize housing finance

Particularly suspicious in the case of Trump is his support for giveaways in the tax code that benefit only real estate developers like him.  One such loophole lets them deduct real estate losses that exceed their investments in the business.  This is how he is presumed to have avoided paying taxes for many years, though the experts have to guess since he won’t release his tax returns.  Another loophole is the use of “like-kind exchanges” to avoid capital gains tax.

But the problem goes well beyond Trump or the Republicans.   The policies that favor mortgage debt are extremely popular.  Virtually all politicians of both political parties have long supported them, taking the goal of maximizing home-ownership as self-evident.  And of course they reflect the views of their constituents.

The list of ways in which the US system tilts toward housing debt goes on.

Some borrowers are encouraged to make down payments as little as 5 per cent (or even less) of the value of the house they buy, rather than the more standard 20%.  Such low capital ratios can quickly go to zero and worse if the house price falls even a little.   Many other countries, such as Korea and Singapore, have ceilings on loan-to-value ratios and other regulations limiting how much households can borrow.   They even manage to tighten the loan limits and tax measures counter-cyclically.  Such macroprudential regulation is the recommended way to help stabilize the housing cycle.

But the US is not the only country with measures that distort decisions toward excessive housing debt.  The United Kingdom has had a sequence of programs such as the Help to Buy initiative, which subsidizes purchases with down payments of only 5%.

Another way the US government has long subsidized housing debt is the role of huge public underwriters, particularly Fannie Mae and Freddie Mac.   They were privately owned leading up to the financial crisis but had an implicit government guarantee from taxpayers, a classic case of moral hazard.  Sure enough, they were put in federal conservatorship in 2008.  Congress could easily repeat the mistake of privatizing them while failing to credibly eliminate the implicit guarantee.   Their capital standards should be raised, just as the regulators have appropriately done for banks.

The Dodd-Frank financial reform bill, signed into law by President Obama in 2010, had many good features to help reduce the chances of another big financial crisis. But the law would have moved us further in the right direction if many in Congress had not spent the last seven years chipping away at it. Here is one example.

The Dodd-Frank law wisely required banks and other mortgage originators to retain on their books at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others. The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans. Under heavy pressure from Congress, that requirement was gutted in 2014.  This was yet another way to encourage the borrower and lender to skip the part of the meeting in the lender’s office where they check to see if the borrower will be able to pay back the loan.

Home ownership rates

One would think that the US encouragement of housing debt would at least raise home ownership rates.  But it doesn’t seem to, relative to other countries.  Even at the peak of the housing boom, the subsidies bid up the price of housing more than they increased the quantity.  Home ownership was no higher than in many countries with more sensible mortgage policies like Canada (which has no tax deduction for interest).  The result of the 2007-09 crisis was to bring ownership rates down, from 69% to 63%.  And of course the housing debt distortion was itself a key contributor to the housing bubble and crash — perhaps the policy mistake that was most easily identified ahead of time.

People are not aware that most economists have long considered these policies bad for the economy.  They may not care:   We are told that they no longer want to hear from experts.  When did that loss of faith happen?   Wasn’t it when the economy was hit by a housing and financial crisis — which economists supposedly failed to predict?

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Let the US Fiduciary Rule Go Ahead

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The quantity of financial regulation is not quite as important as the quality.  One must get the details right.  The case of the US “fiduciary rule” strongly suggests that President Trump will not get the details right.

Could Dodd-Frank be improved?

Earlier this month, amid the flurry of tweets and other executive orders, the new occupant of the White House issued an executive order directing a comprehensive rethinking of the Dodd-Frank financial reform of 2010.

One can imagine various ways to improve the current legislation.   The most straightforward would be to restore many of the worthwhile features of the original plan that Republicans have undermined or negated over the last seven years.  (Most recently, the House this month voted to repeal a Dodd-Frank provision called “Publish What You Pay,” designed to discourage oil and mining companies from paying bribes abroad.  Score one for the natural resource curse.)

In theory, one might also attempt the difficult and delicate task of modifying, for example, the Volcker Rule, so as to improve the efficiency tradeoff between compliance costs for banks and other financial institutions, on the one hand, and the danger of instability in the system, on the other hand.  Some in the business community are acting as if they believe that Trump will get this tradeoff right.  I see no grounds whatsoever for thinking so.

In particular, the financial system has been strengthened substantially by such features of Dodd-Frank as higher capital requirements for banks, the establishment of the Consumer Financial Protection Bureau, the designation of Systemically Important Financial Institutions, tough stress tests on banks, and enhanced transparency for derivatives.  If these features were undermined or reversed, it would raise the odds of a damaging repeat of the 2007-08 financial crisis down the road.

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Who is right on US financial reform? Sanders, Clinton, or the Republicans?

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Eight years after the financial crisis broke out in the United States, there is as much confusion as ever regarding what reforms are appropriate in order to minimize the recurrence of such crises in the future.

There continue to be some good Hollywood movies concerning the crisis, including one nominated for multiple Oscars at the February 28 Academy Awards.  The Big Short has been justly praised for making such concepts as derivatives easy for anyone to understand.  As has been true since the first of the movies about the crisis, they are good at reflecting and crystalizing the audience’s anger.  But they are not as good at giving clues to those walking out of the theater as to the implications.  What policy changes would help?  Who are the politicians that support the desirable reforms?  Who opposes them?

If an American citizen is “mad as hell” at banks, should he or she respond by voting for the far left?  By voting for the far right?   (Or by refusing to vote at all?)   Each of these paths has been chosen by many voters.  But each is misguided.

There is a place in political campaigns for short slogans that fit on cars’ bumper stickers.  (“Wall Street regulates Congress.”)   And there is a place for ambitious goals.  (“Shrink the financial sector.”)  But the danger is that those who are attracted to inspirational rallying cries and sweeping proposals will lack the patience required to identify which is the right side to support in the numerous smaller battles over financial regulation that take place every year and that ultimately determine whether our financial system is becoming structurally safer or weaker.

Breaking up banks

Senator Bernie Sanders has proposed breaking up the banks into little pieces.  It is the centerpiece of his campaign for the Democratic presidential nomination.   The goal is to make sure that no bank is too big to fail without endangering the rest of the financial system.   That would require quite a sledge hammer.  The American banking system historically featured thousands of small banks.   But having thousands of small banks did not prevent runs on depositary institutions in the United States 1930s.

Continental Illinois was the original case of a bank that was deemed “too big to fail” in 1984, when it was bailed out by the Reagan Administration.   So banks would have to be broken into smaller pieces than that.  Merely turning the deregulatory clock back 30 years would not be enough to do it.

I am not sure whether or not, if one were designing a system from scratch, it would be useful to make sure that no bank was above a particular cap in size chosen so that any of them could later be allowed to fail with no further government involvement.   I do know that having a financial system dominated by just five large banks did not prevent Canada from sailing through the Global Financial Crisis of 2008-09 in better shape than almost any other country.

Attacking banks is emotionally satisfying, for understandable reasons.  But it won’t prevent financial crises.

Reforms proposed by Hillary Clinton

Hillary Clinton is correct in pointing out that the most worrisome problems lie elsewhere:  hedge funds, investment banks, and the other so-called non-banks or shadow banks.  These are financial institutions that are not commercial banks and that therefore have not been subject to the same regulatory oversight and the same restrictions on capital standards, leverage, and so on.  Recall that Lehman Brothers was not a commercial bank and AIG was an insurance company.

Secretary Clinton has done her homework and proposes specific measures to address specific problems with the non-banks.     Four examples:

  • She puts priority on closing the “carried interest” loophole that currently allows hedge fund managers to pay lower tax rates on their incomes than the rest of us pay.  This is a more practical step than most proposals to address the very high compensation levels in the financial sector that cause so much resentment.  It would help moderate inequality, reduce distortion, and raise some tax revenue to help reduce the budget deficit.
  • She proposes a small tax targeting certain high-frequency trading prone to abuse. (Sanders proposes a tax on all financial transactions.)
  • She also supports higher capital requirements on financial institutions, including non-banks, if necessary, beyond those increases already enacted.
  • She proposes a “risk fee” on big financial institutions that would rise as they get bigger.  This is reminiscent of a fee on the largest banks that the Obama Administration proposed in 2010, to discourage risky activity while at the same time helping recoup some revenue from bailouts.  It was going to be part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, but in the end three Republican senators demanded that it be dropped as their price for supporting it.

The Dodd-Frank reforms

The Dodd-Frank law was a big step in the direction of needed financial reform.  It included such desirable features as increasing transparency for derivatives, requiring financial institutions to hold more capital, imposing further regulation on those designated “systemically important,” and adopting Elizabeth Warren’s idea of establishing the CFPB, the Consumer Financial Protection Bureau.

It goes without saying that Dodd-Frank did not do everything we need to do.  But the law  would have moved us a lot further in the right direction if many in Congress  had not spent the last six years chipping away at it.  Those who worked to undermine the financial regulatory reform legislation – mostly Republicans – appear to have paid no political price for it, since most of these issues are below the radar for most voters.

Here are a few examples of how Dodd-Frank has been undermined:

  • I mentioned the abandonment of the fee to discourage risk-taking by large banks and of an earlier proposed global bank levy.
  • Auto-dealers, amazingly, lobbied successfully to get themselves exempted from regulation by the CFPB, allowing the resumption of some abusive lending practices that resemble the sub-prime mortgages which played such a big role in the 2008 financial crisis.  There are 17,838 auto dealers.  I guess highly concentrated industries are not the only ones that can buy their way to special-interest carve-outs.
  • The Dodd-Frank law was supposed to require banks and other mortgage originators to retain at least 5% of the housing loans they made, rather than repackaging every last mortgage and reselling it to others.  The reason is that the originators need to have “skin in the game” in order to have an incentive to take care that the borrowers would reasonably be able to repay the loans.  Under heavy pressure from Congress, that requirement was gutted in 2014.   (This one is not especially the fault of the Republicans.  Virtually every American politician in both parties still acts as though the goal should be to get as many people into as much housing debt as possible, even if many will not be able to repay the loans and even after such practices caused the worst financial crisis and recession since the 1930s. Other countries manage to do this better.)
  • The Congress has refused to give regulatory authorities such as the SEC (Securities and Exchange Commission) and CFTC (Commodities Futures Trading Commission) budgets commensurate with their expanded regulatory responsibilities, in a deliberate effort to hamper enforcement.  Many Republicans appear still to believe that these agencies represent excessively aggressive regulation.  This is remarkable in light of the financial crisis.  Remember that Bernie Madoff — who is himself now the subject of new Hollywood portrayals — was able to run his Ponzi scheme right up until 2008 despite repeated tip-offs to the SEC, because it systematically refrained from pursuing investment management cases during this period.

Who can get the job done?

Sanders has indicated that if he were president, nobody with past experience on Wall Street would be allowed to serve in his administration.  A blanket rule like this would be a mistake.  Judging people by such superficial criteria as whether they have ever worked for Goldman Sachs, for example, would have deprived us of the services of Gary Gensler.  As CFTC chairman from 2009-2014 Gensler worked tirelessly to implement Dodd-Frank.  To the consternation of many former Wall Street colleagues, he aggressively pursued regulation of derivatives and, for example, prosecution of a case against five financial institutions who had colluded to manipulate the LIBOR interest rate (London Interbank Offered Rate]. Yet Sanders tried to block his appointment in 2009.

Financial issues are complicated.  Getting the details of regulation right is hard.  (The examples mentioned here are just the tip of the iceberg.)  We need leaders and officials who have the wisdom, experience, patience, and perseverance to figure out the right measures, push for their enactment and then implement them.  If such people are not the ones who receive political support for their efforts, we should not be surprised if the financial sector again escapes effective regulation and crises recur in the future.

[I have given my subjective evaluation of various specific legislative proposals – some in Dodd-Frank, some proposed by Bernie, some proposed by Hillary– on a 1-slide diagram.  A shorter version of this column was published at Project Syndicate.  Comments can be posted there or at the Econbrowser post.]

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