I've got two tickets to paradise.
Won't you pack your bags, we'll leave tonight.
I've got two tickets to paradise."
- Eddie Money
Dodd Frank is based upon two pillars:
- Public sector prevention is the source of systemic stability - the function of regulators is to prevent the excesses of the unruly private sector.
- Federal regulators should not remediate. Government should not "bail out" economic entities in Crises.
But the evidence points in the other direction.
- Poor government economic policy has been a major source of systemic risk in the United States, since at least the turn of the 20 th Century.
- Government is the sole practical solution to the economic problems created following a Crisis.
The federal government is, like the public, a hostage of the global economy. Any reasonable discussion of our domestic financial crises must concede that neither the federal government nor the private sector, homeowners and the management of commercial banks, large and small, were prepared for the winds of risk that blew through US financial markets after the collapse of Bretton Woods in the early 1970's. These economic forces are largely responsible for the big second blip in this chart.
The two swords of government intervention: prevention and bail-outs.
The Two Swords tarot card. A blindfolded woman surrounded by uncertainty with no idea which way to strike. Sound familiar?
We will examine the two key sectors that federal subsidies and rules have dominated since the Depression: housing and banking. This article will focus on housing particularly. The conclusion is that government influence has been negative when applied to provide economic stability; positive, when applied to remediate it.
Government's before-the-crisis effect on housing is a fat pitch down the middle of the plate.
Acharya, et. al., " Guaranteed to Fail: Fannie, Freddie, and the Debacle of Mortgage Finance," summarize the excesses behind the design of federal housing finance. They describe the federal mortgage finance business plan:
Suppose that we offered you the following opportunity: We will invest $1, you lend us $39. With this $40, we will buy bank-originated pools of mortgages that are not easy to sell and face significant long-term risks. Although we'll attempt to limit that risk by using sophisticated financial hedging instruments, our models have large error and uncertainty. We'll invest 15% of the funds in low-quality mortgages that households will be unable to pay in a recession or a severe housing downturn.
And to make it even more interesting, we'll become the largest financial institution in terms of assets that are related to mortgages and together buy around $1.7 trillion worth, making us truly too-big-to-fail.
But it doesn't stop here. We're going to offer insurance on a whole lot more mortgages taken out in America, say $3.5 trillion (together), and guarantee them against default. We don't want much for offering this insurance -- maybe around 20 cents per $100 of mortgage -- but that will provide us with $7 billion in profits per year (assuming absolutely zero foreclosures). As a lender to us, you might be worried how much capital we'll hold as a buffer against all future defaults: for every $100 that we guarantee, we'll hold only 45 cents. And because we want as big a market share as possible, we're going to backstop some dicey mortgages. For this type of risky investment, we know that you are expecting a big return. However, we are only going to pay you the yield on government bonds plus a little extra. You would think our investment pitch was crazy and reject the deal outright.
But if we came along and whispered to you that we have a wealthy uncle - his name is Sam - that will make you whole on the money that you lent us no matter what happens, do you care about the risk? If you believe that Sam will be there, you'll give us your money freely."
I remember thinking "It's too good to be true." And so it was. In the early going of the Crisis, the Treasury injected a total of $148.2 billion into Fannie and Freddy. Yet Dodd Frank barely mentions them, using the familiar sop: Let's conduct a study.
Are we now in the Dodd Frank state of nirvana: A situation where the government has placed the housing agencies in a secure, private sector cocoon of security? Or is the guarantee that the Federal Government will bail out Fanny and Freddy again still an absolute necessity?
Are we ready to let the commercial banks take care of the US mortgage market? Are we ready to allow Fannie and Freddie to stand on their own without a Federal Government bail-out guarantee?
The answer is "no" on both counts, spectacularly so in the case of Fannie's and Freddie's independence from Federal bail-outs. In the case of housing finance, there is no governmental attempt to pretend that the private sector is being rescued. Rather it is trapped in a vice, the implicit "whisper in the ear" to investors holding Fannie and Freddie's commitments is now accompanied by an arm around the throat and a knife in the back. In the words of the Congressional Budget Office (CBO):
In 2012, the Treasury and the two GSEs revised their agreements: Rather than pay a fixed dividend on the Treasury's preferred shares, Fannie Mae and Freddie Mac began in 2013 to return almost all of their profits to the Treasury. However, those payments do not reduce the amount of preferred stock held by the Treasury, and the GSEs are prohibited from buying back that stock under their agreements with the Treasury and FHFA. Thus, the terms of the agreements and the conservatorship ensure that the federal government effectively retains complete ownership and control of Fannie Mae and Freddie Mac."
As most readers of SA are aware, the pre-existing stockholders are not amused by federally financed housing.
And the policies concerning Fannie and Freddie are only the beginning of what the Federal Government is doing to bail out the housing market. Government focus concerning mortgage finance also included mortgage debt relief and mortgage refinancing, for households that had experienced falling house values there was the Home Affordable Modification Program (OTCPK:HAMP). The Home Affordable Refinance Program (NASDAQ:HARP) helped families with lost incomes, unaffordable increases in expenses, lower home values.
Did the take-over of Fannie and Freddie and the other programs help the US economy out of the crisis? Passmore and Sherlund, in their paper " Government-Backed Mortgage Insurance, Financial Crisis, and the Recovery from the Great Recession," say "Yes." Comparing counties that depended on the FHA and the Agencies to counties more dependent on financing from private sources, the federally dependent counties did better. In their words:
In particular, counties with high levels of participation from government-sponsored enterprises and the Federal Housing Authority had relatively lower unemployment rates, higher home sales, higher home prices, lower mortgage delinquency rates, and less foreclosure activity, both in 2009 (soon after the peak of the financial crisis) and in 2014 (six years after the crisis) than did counties with lower levels of participation. The persistence of better outcomes in counties with heavy participation in federal government programs is consistent with a view that lower government liquidity premiums, lower government credit-risk premiums, and looser government mortgage-underwriting standards yield higher private-sector economic activity after a financial crisis.
Thus in the case of the housing market, prevention of Crisis was a disaster, bail-out after the Crisis, a necessity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.