Category Archives: financial crisis

Explaining Dodd-Frank

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Nine years ago this month, the US sub-prime mortgage crisis morphed into a severe global financial crisis.  Many Americans across the political spectrum angrily demanded financial reform, by which they meant a tightening of financial regulation.  Indeed, important reforms were subsequently enacted, in particular the 2010 Dodd-Frank bill.

Today, those reforms are increasingly under assault.  Most recently, the Trump Administration is proposing a roll-back of regulation of banks as well as of other financial institutions.  The recent decisions of Fed Governors Stan Fischer and Dan Tarullo to retire are also worrisome signs.

Part of the problem is that few voices are heard in support of shoring up Dodd-Frank.  Have those who wanted more financial regulation in 2010 changed their minds, and decided that banks deserve to “get the government off their backs”?  Or do they not understand how much Dodd-Frank accomplished?  I think it may be the latter.

I have just written a short explanation of the Dodd–Frank Wall Street Reform and Consumer Protection Act.  I tried to make it accessible to a general readership.

It is my first contribution to EconoFact, which is a non-partisan publication designed to bring key facts and incisive analysis to the national debate on economic and social policies. The brain-child of Professor Michael Klein, EconoFact is written by a network of leading economists from across the country and published by the Edward R. Murrow Center for a Digital World at The Fletcher School at Tufts University.

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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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