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
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.)
Less clear is why regulators systematically and universally failed to do the one thing required of them: impose appropriate capital requirements. The first potential explanation is that they were serially and universally incompetent. The second is that neither they nor their political supervisors had incentives aligned with this core regulatory mission.
There is ample evidence of the first hypothesis, especially among commercial and investment bank regulators. But political roadblocks to imposing even mild capital requirements on Fannie and Freddie were quite explicit and transparent. Market discipline, while far from perfect, historically posed less systemic risk, popping bubbles before they became over-inflated. That it failed to re-emerge in the wake of "deregulation" is entirely myth.
The appropriate policy is to restore transparent enforceable capital requirements. First, remove the tax incentive to leverage excessively by eliminating the corporate tax on banks. They mostly avoid it anyway and the lost revenue can be made up by raising the deposit insurance and/or too-big-to-fail fee.
Second, impose transparent uniform capital requirements, eliminating the special treatment for issuers and investors in mortgages and mortgage backed securities in bank risk-based capital requirements, off balance sheet financing, the special capital requirements for Fannie and Freddie, and other forms of regulatory arbitrage, e.g., capital forgiveness for credit default swaps with undercapitalized counterparties. Also, restore home-owner cash down payment requirements to their historical 20% norm, requiring private — hence well capitalized — insurance for loans up to a maximum 90% of value.
Basel III provides for significantly higher capital requirements. Regulators will still have to guard against bank off-balance sheet leverage and excessive bank leverage provided to non-banks that leveraged private mortgage securities excessively. Covered bond investors require not only capital — they are senior bank obligations — but over-collateralization as well, potentially a form of regulatory arbitrage if depositors have less collateral in the event of bankruptcy. The FDIC complains that when Indy Mac failed the FHLB, a covered bond issuer, had priority access to about half the collateral due to over-collateralization because the loan quality was so bad, leaving the FDIC with deep losses.
Investor over-collateralization requirements reflect a complete lack of confidence that regulators will monitor the quality of both capital and loans, for good historical reasons. Requiring appropriate reserves — more capital — would solve the problem. But requiring excessive capital imposes unnecessary costs on both borrowers and lenders. Bank regulators should be held to account for better prudential regulation without the distraction and potential conflict of enforcing social goals for mortgages.
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is an economic and financial consultant and a principal of University Financial Associates.
