Regulators Should Zero In on Strong, Clear Capital Requirements

Politicians and regulators want taxpayers to believe two things: first, that financial crisis had multiple complex causes mostly related to excessive risk-taking, conflicts of interest and deregulation — a view unconvincingly supported by the exculpatory 662 page summary Report of the Financial Crisis Inquiry Commission; second, that public regulation is a sisyphean task requiring the 2313 page Dodd-Frank Act. This diagnosis and prescription are both wrong.

Financial market participants have historically imposed capital requirements on all parties to mitigate excessive risk-taking (moral hazard) and incentive conflicts. If capital had been required in relation to risk according to historical norms there may well have been a U.S. housing boom fueled by a global savings glut, but the subprime lending debacle and the resulting systemic financial crisis would not have occurred.

Two federal policies have long encouraged excessive leverage. First, debt costs are tax deductible whereas equity costs are paid after the issuer pays corporate taxes. Second, federally sponsored deposit insurance, introduced in the U.S. during the Great Depression, removed the risk premium from deposit rates. Bank capital levels fell from about 16% — and shareholders were on the hook for more as needed — to only five percent within a decade, about where they remained for several decades thereafter, reflecting the regulatory minimum. Home borrower equity — cash down payment requirements — similarly fell from about 40% first to about 20% during the post war period and subsequently to about 5% with federal mortgage insurance.

Market participants should have responded to the housing boom and unprecedented bubble in house prices during the early part of the last decade by significantly raising the cost of debt and by requiring more capital from all parties, but public regulation had by then completely and comprehensively replaced market pricing and leverage limits. Fannie Mae and Freddie Mac could leverage 100 to 1 — about ten times their likely private market limit — and still borrow at slightly above the Treasury cost of funds. Insured banks were able to exploit off-balance sheet opportunities to achieve a similar leverage ratio and funding cost by securitizing pools of mortgages. But securitization had the additional consequence of separating "lenders" into independent loan originators, loan brokers, loan servicers and investment bankers that had little or no capital stake in the credit performance of the loans. Federally insured banks and Fannie and Freddie financed the senior securities while state and local retirement funds funded much of the subordinated debt, leaving taxpayers with most of the risk.

To compensate for this lack of lender capital, borrowers should have been required to post more. But national housing policy encouraged both lower income underwriting requirements and lower cash down payment requirements — to the extent that both were largely inconsequential and hence often ignored in practice during the subprime lending debacle.

Lower borrower and lender capital requirements are well documented, but most observers seriously underestimated the extent of capital depletion and the consequences of simultaneously depleting both. Borrowers, lenders, "Wall Street" securitizers and Fannie and Freddie all had virtually nothing to lose, and most gained a lot until the much maligned speculators — using derivatives — burst the bubble, belatedly because government housing policy implemented through Fannie and Freddie kept the bubble inflating — and you can't short the government even when it runs a loss-making enterprise. This left taxpayers with total costs measured in the trillions of dollars, partly transparent (the approximately $200 billion already injected into Fannie and Freddie), but mostly opaque (the ongoing costs of supporting banks and Fannie and Freddie of about $100 billion annually as well as the cost of the Great Recession.)