Politics & Policy

Fighting the Last War on Wall Street

The Obama administration’s proposed regulatory overhaul is looking increasingly like a minor regulatory adjustment — a few tweaks here and there to convey the impression of reform. Not that we much mind; emerging from a crisis, the greater threat is almost always overreaction. The Sarbanes-Oxley Act, passed in the wake of the Enron collapse, did little more than impose large compliance costs on businesses and drive an increasing number of start-ups overseas.

Arguably the most important change would be the creation of a resolution authority giving the federal government the power to seize financial holding companies if they become insolvent. This is actually not as scary as it sounds — it is essentially what the Federal Deposit Insurance Corporation does when it determines that a depository bank is on the verge of failing. It is what Fannie Mae and Freddie Mac’s regulator was empowered to do (and should have done) when those companies teetered on the brink of collapse.

Instead, the Federal Housing Finance Agency opted to place Fannie and Freddie into conservatorship, the difference being that a conservator seeks to conserve the basic structure of the failed company. A receiver, by contrast, tends to break the failed firm into pieces, sell off the good parts and unwind the bad parts in the most orderly way possible. Fannie and Freddie should have been broken up and downsized. Unfortunately, they will live on as tools of America’s unaffordable affordable-housing agenda.

The federal receivership option is far from perfect. Traditional bankruptcy would be preferable. However, the bailouts have set the precedent that once a firm grows “too big to fail,” its secured creditors will be protected, regardless of cost to the taxpayer, in order to prevent systemic spillover effects. The receivership option — if considered as an alternative to bailouts — would remove a layer of moral hazard by making failure a possibility, even for the largest firms.

Some moral hazard would remain, of course. The government would decide which creditors got bailouts and which ones took losses, meaning that political favoritism would often trump concern for systemic soundness. Nevertheless, in post-bailout America, we have bad and less-bad options to choose from, and we’ve seen the alternative: a series of ad hoc and largely lawless bailouts, jerry-rigged by the Treasury and the Fed. The receivership authority, done right, would at least put us back on the road to a rule-based system.

Other aspects of the administration’s plan are more troubling. As usual, policymakers appear to be planning for the last crisis. Obama’s team has put forward a number of proposals to address the complete collapse of lending standards that occurred as the housing bubble inflated, but none of these would prevent a similar collapse from occurring in the future.

Foremost among these proposals is a requirement that mortgage originators keep a 5 percent stake in any package of loans they sell to Fannie, Freddie, or Wall Street. According to the administration, mortgage originators let lending standards slide because they didn’t have an incentive to make sure borrowers could pay. But Fannie, Freddie, and investors on Wall Street had plenty of incentive to make sure borrowers could pay, and it just isn’t true that they didn’t know what they were buying.

This aspect of the administration’s plan treats the bubble as an information asymmetry, when in fact, it was a giant mispricing of risk. Everyone bought into the fantasy that housing prices would keep going up and default rates would stay the same, even though the risk profiles of the borrowers had changed. It was the same combination of wishful thinking and greed that drives every speculative bubble. Not all mortgage bankers sold all their loans to Wall Street. Plenty held their own portfolios of risky mortgages, and they too believed that rising real-estate prices would enable these borrowers to repay or refinance.

If the administration were serious about lending standards, it could simply ask Congress to impose some. Require borrowers to post substantial down payments and to document their incomes and assets. The administration won’t do this, however, because it would anger the left-wing affordable-housing advocates that cheered on the elimination of these requirements, Paul Krugman’s risible attempt to pin that development on Ronald Reagan notwithstanding. Instead, Obama’s team has offered largely toothless measures that could nevertheless have sizable unintended consequences. For instance, the imposition of portfolio requirements on mortgage bankers could lead them to charge higher interest rates as their ability to manage risk is reduced.

The administration’s approach gets at least one big thing right, but it would be better if it acknowledged that the government’s obsessive promotion of homeownership contributed more to the crisis than a lack of regulation did.

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