By William K. Black
(Cross posted at Benzinga.com)
I explained in a prior column that Gregory Mankiw, Governor Romney’s lead economist, wrote a column endorsing the regulatory “competition in laxity.” “Romney’s Lead Economist Urges Policies that will Cause the Next Financial Crisis.” One of the key events in “winning” the regulatory race to the bottom is welcoming significantly dangerous institutions (SDIs). The SDIs are the leading contributor to U.S. politicians – and the politicians of many nations). The difficulty is that “too big to fail” (TBTF) institutions are unpopular with both parties’ voters. Historically, TBTF was a misleading phrase, for TBTF banks could fail. TBTF actually meant that the general creditors would be bailed out by the government.
Romney needed a way to come out against TBTF as a policy without attacking his primary contributors – the largest banks. His answer was his non-plan to address the existing housing crisis and future crises: “Securing the American Dream and the Future of Housing Policy.”
Whenever possible, politicians blame the devil. Conveniently, Fannie Mae and Freddie Mac were treated by the Bush and Obama administrations as TBTF. Republicans have been taught to blame Fannie and Freddie – government sponsored entities (GSEs) as the immediate cause of the ongoing crisis. Better yet, Republicans blame Fannie and Freddie’s failures on the Democrats. The Republican meme casts the Democrats as the villains for blocking President Bush’s heroic effort to prevent the GSEs from causing the crisis. I have written several articles explaining why this meme is false which this article will not repeat.
This article explains why Romney sought to conflate “TBTF” and “GSE” in his September 21, 2012 white paper and why his effort fails and is dangerous. Romney’s white paper contains one paragraph about the problem of TBTF and one paragraph describing Romney’s solution to TBTF.
“Perhaps the greatest failure in housing policy is the failure of this Administration to reform two of the greatest contributors to the financial crisis. The President has boasted that Dodd-Frank ended “too-big-to-fail” institutions, yet the legislation did nothing to reform Fannie Mae and Freddie Mac, whose bailouts currently represent the biggest taxpayer losses of the financial crisis at more than $140 billion.6 We have now passed the four-year anniversary of the government takeover of Fannie Mae and Freddie Mac, and the Obama Administration has failed to come up with anything more than noncommittal options to reform these institutions.
End “Too-Big-To-Fail” And Reform Fannie Mae And Freddie Mac: The Romney-Ryan plan will completely end “too-big-to-fail” by reforming the GSEs. The four years since taxpayers took over Fannie Mae and Freddie Mac, spending $140 billion in the process, is too long to wait for reform. Rather than just talk about reform, a Romney-Ryan Administration will protect taxpayers from additional risk in the future by reforming Fannie Mae and Freddie Mac and provide a long-term, sustainable solution for the future of housing finance reform in our country.”
The political context in which Romney issued his whitepaper was that he was being pummeled for failing to explain what specific policies he would implement if he were elected, e.g., what tax loopholes he would close, what parts of Romneycare/Obamacare he would readopt, and what his policies would be on GSEs, TBTF, housing, and banking regulation.
SDIs and the TBTF Policy
There are roughly 20 U.S. SDIs and dozens of foreign SDIs operating in the U.S. financial markets. The Bush and Obama administration viewed these financial institutions as so large that their failure would likely cause a systemic, global crisis akin to Lehman’s failure unless the firms’ general creditors were implicitly guaranteed by the U.S. Treasury against suffering any loss. Eliminating Fannie and Freddie could not “completely end” TBTF because it would deal with only two of the SDIs. Indeed, it would not make a meaningful dent in the SDIs or TBTF. Dodd-Frank does not end SDIs or TBTF. Moreover, Romney does not call for eliminating Fannie and Freddie or even call for shrinking them to below the level (roughly $50 billion) where they would no longer pose a systemic risk. Instead, at a time when he is being successfully pilloried for his “I’ll tell you after you elect me what my policies are” campaign, the promise of his white paper is that his GSE policy will be “a long-term, sustainable solution.” We are all relieved, but not informed.
Matthew Yglesias aptly calls Romney’s GSE proposal “vacuous,” but then gets lost himself in that vacuity.
The trajedy [sic] here is that GSE reform is a fine idea. Conservatives have been pushing it for years and they’re right. The virtue of this proposal is that it was as right in 2002 or 1992 as it is today.
The problem with Yglesias’ reasoning is that “GSE reform” is a vacuous phrase – and any Republican reform proposals from “1992” and “2002” would be both out of date and unresponsive to the actual problems. The proposed “reforms” he is discussing would not have prevented Fannie and Freddie from being SDIs and would not have prevented their failures. The Bush proposals about the GSEs were not addressed to the problems that actually caused the losses at the GSEs (recurrent accounting control fraud, perverse executive compensation, CDOs, and liar’s loans). Bush’s, Poole’s, Greenspan’s, and Wallison’s concerns about the GSEs were aimed overwhelmingly at “fighting the last war” (when Fannie and Freddie engaged in accounting control fraud by growing their portfolios massively in order to take extreme interest rate risk and then hid their losses (Fannie) and gains (Freddie) through accounting fraud. To the extent Bush proposed granting the GSE regulator additional powers prior to the crisis; those powers have been conferred by legislation and the appointment of the GSE’s regulator (the FHFA) as conservator for the GSEs. Indeed, the FHFA has substantially greater power than Bush sought to give its regulatory predecessor (OFHEO) prior to the crisis.
Senate Republicans blocked the confirmation of President Obama’s nominee to run the FHFA even though he had an excellent reputation as a state regulator. FHFA continues to be run by an “acting” head – a holdover from the Bush administration. Romney’s white paper ignores the fact that the Republicans have left the FHFA to twist slowly in the wind and disingenuously accuses Obama of inaction on the Fannie and Freddie.
Romney’s proposal for banking regulation
The Romney white paper provides this explanation of what he will replace the Dodd-Frank Act with after he repeals it in its entirety.
“Sensible, Not Overly Complex, Financial Regulation That Gets Credit Flowing Again: By replacing the Dodd-Frank Act with sensible regulation, a Romney-Ryan Administration will usher in a new era of responsible lending with sensible regulation to allow banks to approve loans to families with good credit rather than rejecting their mortgage applications.”
Ok, we get it – Romney repeated the phrase “sensible regulation” three times in one sentence. Again, we are comforted that he does not wish nonsensical regulation, but we are not informed. It is possible to have sensible underwriting rules, for we had them for decades. They had three sensible requirements for lenders that were not overly complex:
- Lenders must underwrite before they make the loan
- The underwriting must verify that the borrower has the capacity to repay the loan
- The lender must keep a written record of the underwriting
Those three requirements impose no costs on honest, competent lenders – who would do considerably greater underwriting even if regulators did not exist. The three requirements greatly reduce fraud and incompetence and make it far easier to take effective action against frauds and incompetents.
The other great requirements of sensible lending are:
- No perverse incentives may be created from the compensation paid to loan brokers, loan officers, and their superiors. “Performance” pay must be tied (and largely deferred) so that is paid on the basis of long-term loan performance rather than quantity or yield.
- All real estate appraisals have to be independent and meet the professional requirements for approaches to value. No lending on the basis of “drive by” or “automated” appraisals.
- The lender cannot select the appraiser and cannot communicate the sales price and loan amount to the appraiser. The appraisers should be assigned randomly from a qualified pool and the results of their work should be tracked to weed out those with significant error rates.
I did not invent any of these six proposals. Each specific proposal reflects the norms that allowed safe residential lending for decades. Individually and collectively the proposals impose no net costs on lenders. Not underwriting may seem cheaper in the short-term during a bubble, but it produces “adverse selection” and causes a bank’s loans to have a “negative expected value.” In plain English, a lender whose CEO causes the bank to violate these rules will experience three “sure things.” (George Akerlof and Paul Romer, 1993. “Looting: the Economic Underworld of Bankruptcy for Profit.”) The bank will report record income through accounting fraud, but it will actually suffer massive losses and the CEO will promptly gain great wealth because his compensation will be largely tied to short-term reported income. I noted in a prior column that Jamie Dimon explained these points in his famous letter to shareholders.
“Low-quality revenue is easy to produce, particularly in financial services. Poorly underwritten loans represent income today and losses tomorrow.”
Dimon knows that “poorly underwritten loans represent [fictional reported] income today and [real] losses [recognized] tomorrow.” He also knows that if enough fraudulent lenders follow the accounting control fraud “recipe” “tomorrow” may be delayed for over five years as the bubble hyper-inflates and bad loans can be refinanced and restructured to delay the inevitable tsunami of defaults. The industry slogan has remained the same through our last three financial crises: “a rolling loan gathers no loss.”
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @williamkblack
Details such as these don’t matter. As we learned in the Mother Jones tape Romney is not counting on any new proposals for policy to rescue the economy. The very act of him being elected will be such a boost to the confidence of the nation that the economy will recover on its own. There will be no reason to actually do anything. Only fools would question this.
The Republicans are now believing the lies that they made up. The ultimate victims of propaganda are the propagandists themselves. Obama is incompetent so we only have to be competent. Fannie Mae and Freddie Mac caused the housing crisis so we only have to change them, presumably only with competence. The unemployed chose to be unemployed so we don’t need to worry about them. The economy is suffering from a lack of confidence so all we have to do is to restore confidence. Simply electing Romney will do that so nothing more has to be done.
A nice professional article having time tested six proposals especially emphasizing that whatever is endorsed, should be put in writing. It seems that in the long run there is no financial institution which should be considered so big that it does not face risks of failure.
Even “prudent” credit creation is theft of purchasing power. Why? Because “loans create deposits” and the purchasing power for those new deposits dilutes the value of all other deposits and physical currency. That dilution particularly harms the poor since they are considered less “credit-worthy.”
We need to quit trying to save the banking cartel from itself and seek means to ABOLISH it in a just manner that avoids unnecessary pain.
A ban on further credit creation and a metered universal bailout till all deposits are 100% backed by reserves is a start.
The banking cartel killed 50-86 million of us in WWII alone. Why, oh why, should it ever be allowed to threaten world peace again?
Why is all credit creation necessarily theft of purchasing power?
For example, let’s say my bank account is credited with 100 trillion dollars. And let’s also say I don’t spend any of that money. How does that steal purchasing power away from other people? And even if I spend some of it, so long as I’m not putting strain on competition for real resources, how is purchasing power stolen?
I can understand how crediting bank accounts with too much money, that leads to spending excessive enough to put strain on real resources, could ‘steal’ purchasing power. But isn’t this process much more complicated than simply stating that “credit creation is theft of purchasing power”
***I realize you were talking about loans creating deposits, and the banking system in general, but since you said new deposits dilute the value of existing deposits, I figure my example is relevant.
Obviously if nothing is done with the 100 trillion, there is no effect. But people don’t borrow money from banks in order to do nothing with the money.
Next I’ll deal with your point about: “so long as I’m not putting strain on competition for real resources”. You are alluding to a situation where the economy is not at capacity. In that situation stimulus is needed, and that stimulus COULD COME FROM people borrowing and spending more – or it could come from spending more on the army, education, massage parlours, you name it.
I see no good reason to inject stimulus via any of the above, or indeed any specific or narrow selection of activities. The purpose of the economy is to produce what Mrs & Mrs Average want. So if stimulus is needed it should come in the form of giving Mr & Mrs Average more to spend and boosting public spending in general, because Mr & Mrs Average voted at election time to have part of their income given to them in the form of government provided goodies (e.g. education for their kids).
No doubt part of that stimulus will bring more borrowing, but it’s entirely up to market forces to decide how much.
As to where the economy is at capacity, credit creation must involve the theft of purchasing power assuming constant GDP. I.e. if one person spends more, someone else must spend less. Alternatively, the additional spending might boost inflation, that’s just another form of theft.
There is a good article by George Selgin (who is ironically a leading advocate of fractional reserve) on how private banks steal the right to create money from government. It’s here:
Thanks for the reply. Based on what you said, I agree with you about where the stimulus should be targeted. I was just trying to probe the notion of stealing purchasing power.
I find the topic of inflation confusing. Even among MMT the issue seems to be glossed over. What exactly “is” full productive capacity? Yea, I get it, we can’t make any more stuff. That sounds very static. The economy seems much more dynamic. I wonder if there is even such a ‘place/time’ that can be considered full produtive capacity.
Or, is full produtive capacity a blurry area near and around full employment?
I see that Romney wants to “protect taxpayers from additional risk.” Of course, taxpayers are at zero risk, unless they also are creditors of TBTF banks. The only — repeat ONLY — risk to taxpayers is taxes. Since taxes do not pay for federal spending, government payments to creditors or to banks or to anyone else, cost taxpayers exactly $0, to the penny.
All the blather about needing to save taxpayer dollars, or doing “something” about TBTF banks ignores a fundamental truth. Federal spending grows the economy.
GDP = Federal spending + Non-federal Spending – Net Imports.
The real need is not to protect taxpayers, but rather to protect borrowers and individual lenders. The em-PHAS-is is on the wrong syl-AB-l.
The solution is to end private banking. All banks should be owned by the federal government. There is not one good reason for private banking, and numerous reasons for federal ownership. Remove the profit motive, and the real problems will be solved.
Rodger Malcolm Mitchell
The solution is to end private banking. Rodger Malcolm Mitchell
The solution is to end credit creation which is INHERENTLY discriminatory. Just because someone has an income or owns collateral is no reason he should be allowed to borrow stolen purchasing power.
“End credit creation”? You mean end all lending and borrowing? I wonder what would happen to the economy if somehow that were enforced (which it never could be) — especially since the vast majority of all dollars in America are created by lending.
You mean end all lending and borrowing? Rodger Malcolm Mitchell
No. Honest lending of existing money should still be allowed. But banks don’t lend existing money (except between themselves). Instead they create money (“loans create deposits”) as they lend. That is essentially counterfeiting.
Or at least all government privileges for the banks should be ended. What is “free market” about government deposit insurance and a legal tender lender of last resort?
— especially since the vast majority of all dollars in America are created by lending. Rodger Malcolm Mitchell
Which is why (if credit creation is banned) we need a universal bailout with new reserves until all deposits are 100% backed by reserves (to prevent massive deflation as existing credit is paid off with no new credit to replace it.)
We need a universal bailout anyway so why not kill two birds with one stone?
I have read the article and the responses. My response is that Mr. Black makes sense. I have studied Modern Monetary Theory, as well as other economic systems and views. I have come to the conclusion that the MMTers are essentially correct regarding the situation regarding national debt and the nature of our concerns or what they should be regarding this issue. Mr. Romney is just a politician, and, apparently, a rather ignorant one when it comes to understanding, creating or propounding public policy with specific regard to just how to go about regenerating the US economy. His statements have all been purely party centric or personally centered on his own experiences as a wealthy investor/director. I understand that he has public experience, but his tenure in Massachusetts seems, in my view, to be essentially inapplicable, or completely inadequate to the job which he is seeking to win. What Mr. Black suggests is that he is fully incapable, or, at least unwilling, to give detail to what his aspirations are, and, even in their partially baked state, simply cannot withstand critique, or even scrutiny. Mr. Romney simply does not provide even an iota of detail, and general statements regarding promised achievements without detail are useless and a simple waste of time. My guess would have to be that Mr. Romney is, at heart, a neoliberal, a trickle downer, and an economic rapist (as he was at Bain) in “sheep’s clothing” making pretense without substance. I was not great fan of Reagan, who, at least, exhibited some amazing leadership qualities, and could effectively communicate and convince with his speaking ability. Mr. Romney evidently, based upon his expressed affection for deregulation and tax “fairness,” as well as reduction in the size of government (promised but with no plan, of course), is cut from the Ayn Rand, Alan Friedman, neoliberal/libertarian school of wealth accumulation. He’s gaming us, by flooding the election arena with slick ads which fail to be truthful in any way, but can be convincing to our fellow citizens simply because of production quality and entertainment value. Few who will vote are critical thinkers. Most just like to feel a part of something important. We are left, as Mr. Black, to try to convince our fellow citizens that Mr. Romney is simply a wisdom-free empty suit when it comes to economic policy and regeneration of a real economy. QE could work if it were done effectively. The US Tax Code could work if it were mostly trashed. Our economy could work if we faced truths uncluttered by the massive fictions dealt into the public arena by the austerist neoliberals. I am not hopeful.