Financial Reform for Dummies

Most of us haven’t a clue about what happens on Wall Street.  We wouldn’t know a “credit swap,” from a “derivative” or a “mortgage pass through” (this last one sounds like it might be painful).  The 1700+ page bill being written in the US Senate proposes to hire legions of bureaucrats to understand and regulate this complexity for us, and thus outsmart the Wall Street traders.  It is in many ways a dubious proposition.  There are better and more simple means to finance reform that even a dummy can understand.

In the recent financial crisis, most of us have some vague idea that a lot of bad mortgage debt got packaged together, disguised, sold, and bought using more debt.  Wall Street played a lot of games with this bad mortgage debt packaging that most of us will never understand.  Government regulation and a new bureaucracy aim mostly to end these games. Wouldn’t it be better and easier to end most of the bad mortgage debt instead?

Progressives stress that the predatory lending practices of mortgage companies allowed them to sell mortgages to people who could not afford to maintain them.  Before the home owner had time to default, the mortgage was already sold off by the lender and disguised in a bundle advertised as containing only good mortgages.

Conservatives point out that government policies implemented through the Community Reinvestment Act, and Fannie Mae and Freddie Mac, which were intended to expand home ownership among minority groups and the poor, were the drivers that established lowered lending standards and created all of those bad mortgages.

It does not matter which of these narratives is more true.  The sensible public response should be not to create a vast new regulatory bureaucracy, but instead to simply raise lending standards and thus discourage the creation of more bad mortgages.

For whatever reason, in the 1990s credit standards for mortgages began to slip.  Today the government should insist that these same standards be tightened up.  No one with less than very good credit should be allowed to buy real estate, since taxpayers ultimately share in the underwriting through Fannie Mae, Freddie Mac, the FDIC and the implicit doctrine of “too big too fail.”

No buyer should be able to walk painlessly away from a mortgage.  Five, ten or even twenty percent down should be required in some cases.  Shockingly, highly intelligent  public-policy makers have learned nothing with regard to down-payment requirements since the housing collapse.   Congressman Barney Frank, Chair of the House Financial Services Committee, has led efforts for the approval of FHA loans of up to $700,000 with almost no money down (See “Rolling the Dice with Barney Frank”).  Is this not a sort of ongoing public-policy madness, or is there something us dummies are missing?

Common sense says that we should eliminate or make it more difficult to obtain more exotic loans.  Perhaps higher income and longer job stability should be required to obtain an Adjustable Rate Mortgage.  And as for so-called ”No Doc Loans,” mortgages that require almost no documentation at all, these seem designed for criminals engaged in disguising the sources of their wealth.

Republicans are correct to challenge the usefulness of Freddie Mac and Fannie Mae, government mortgage agencies that by their nature privatize profit and socialize risk.  Not only did they encourage loose lending standards, but they are so far the biggest sink holes for taxpayer bailout money.  All of the private “too big too fail” banks have paid back their debts, but not so Fannie and Freddie, which remain unreformed in the Democrats’ bill.  Instead, their debt ceilings were raised, giving them more of our money to lose.

“Too big to fail” is not going away.   Breaking up the banks is not the answer.  Having many medium-sized financial institutions going belly-up is not better than a fewer large ones kicking the bucket.  In that case we would have “too medium to fail.”  The language in our legislation can swear up and down many times that we are going to let big institutions fail “next time.”  Promise.  But the odds are that the next President who finds him or herself staring into the abyss of a huge financial crisis will act just like George W. “Deer in the Headlights” Bush did, and start cutting big checks to bail out private industry.  The important thing is not to reduce bigness, but to reduce the risk of failure.

The biggest obstacle to the kind of simple and sensible finance reform that even us dummies can understand is politics.   Renters want to buy homes today, not tomorrow.   Home buyers want bigger and more expensive homes, not larger down-payments.  Voters with bad credit want their elected leaders to cut them a break.  The banking and housing industries want customers and profits.  Tightening up on lending standards will make all of these groups unhappy, which makes politicians unhappy.  But sometimes unhappy politicians are a good thing, and sometimes dummies are not so dumb after all.