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