The Illusion of Reform and the Next Housing Crisis

This article is adapted from the authors’ new book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (Princeton University Press, 2014). 

Is America’s housing finance crisis finally behind us? On the surface, there seem to be many positive changes, but when one looks a little deeper, the fundamental problems that got us into the mess have not been addressed. Unless major changes are made, it won’t be long before we experience another mortgage-related banking crisis.

Though central bankers and treasury officials like to pretend that banking crises happen as a result of random “shocks” that cannot be foreseen, the grim truth is that they are predictable events. They occur when two conditions occur simultaneously: banks take on high levels of risk in their loans and other investments, and regulators allow banks to back those loans and investments with low levels of capital. 

In Fragile by Design, we explore how this toxic combination is almost always the product of a purposeful political deal. In the case of the Subprime Crisis, that deal involved megabanks that were seeking support at Federal Reserve hearings for their ambitious merger plans, activist groups that were seeking subsidized mortgage credit for their constituents, and the initially reluctant housing finance giants, Fannie Mae and Freddie Mac, which eventually saw their participation in the deal as a means to lax regulation and the ability to repurchase and securitize loans backed by borrowed money, rather than shareholder capital. Politicians on both sides of the aisle jumped on this bandwagon. The results of the grand bargain these actors struck were mortgage underwriting standards that were amazingly permissive, capital requirements for banks and Fannie and Freddie that were paper thin, and the worst recession we have had since the 1930s. 

Have the reforms that have been put in place since the Subprime Crisis insulated the banking system from this kind of deal making? There is plenty of evidence that the answer is no. In fact, the watered down nature of the reforms that have been put in place indicate that there has been plenty of deal making going on already. A survey of the political landscape suggests that these deals are just the beginning.

Consider the recently issued rules by the Consumer Financial Protection Bureau governing “Qualifying Mortgages,” (loans that are supposed to ensure low risk to lenders and affordability for borrowers). As initially proposed, home loans could only obtain QM status if they met strict standards, such as a 20 percent downpayment and a housing-cost-to-income ratio of 28 percent. The final version of the rules, however, dropped the 20 percent downpayment and the 28 percent ratio was watered down to a total-debt-to-income ratio of 43 percent. Worse, mortgages that can be repurchased or securitized by Fannie or Freddie are exempt from these standards; they automatically count as QM loans provided they do not contain certain very high-risk features, such as negative amortization.

The Volcker Rule, a provision of the 2010 Dodd-Frank Bill that was implemented this past December provides similar evidence of deal making. It was meant to prevent banks from engaging in proprietary trading (using depositors’ money to invest in securities), but the rule as enacted specifically exempts real estate–related securities—the very type of securities that were so problematic in the Subprime Crisis. In short, the Volcker Rule has a loophole as big as a house.

What about Fannie Mae and Freddie Mac? Most everyone on Capitol Hill joins the chorus of the need to reform these government sponsored enterprises, but no one can agree on what that means. Proposals made in the House, which would entail serious reform, have no chance of passing the Senate, and proposals in the Senate, which would create a new substitute government mortgage guarantee system, have no chance of passing the House. The absence of agreement means the continuation of the government conservatorship of Fannie and Freddie by the Federal Housing Finance Agency—and its recently appointed director is former congressman Mel Watt, who is a longtime political supporter of taxpayer-subsidized mortgage risk. Watt’s appointment was so controversial that President Obama had to use the new filibuster-proof confirmation process to get him appointed. Watt did not disappoint his critics: he has already announced a delay of increases in Fannie and Freddie guarantee fees, which is to say that banks will continue to have strong incentives to buy and hold Fannie and Freddie securities as a mechanism to lower the amount of capital backing their portfolios. 

What about Dodd-Frank’s abolition of too-big-to-fail bailouts by designating certain banks as Systemically Important Financial Institutions and then creating a committee headed by the Secretary of the Treasury that can respond to the threats that these institutions present to the stability of the financial system? As a number of prominent economists have pointed out, this step does not end bailouts; instead, it institutionalizes them by specifying the steps that need to be taken to bail out institutions, using “fees” charged on surviving institutions (also known outside of Washington as a tax). 

An optimist might say that these steps are just the beginning of reform; that there is more coming. We would suggest that if one takes a look at the political landscape there are strong reasons not to be optimistic. Income inequality has become a salient issue. Indeed, it will almost certainly be central to the presidential election of 2016. As the debate about Obamacare made clear, taxation and spending policies to effect redistribution tend to be politically difficult because they appear on the government’s budget, where taxpayers can see them. Incentivizing banks to lend to targeted groups for redistributive purposes is politically easier. But bankers are not sheep to be fleeced; they only go along with redistributive lending if they can extract some valuable concession, like a government guarantee of the loans. The implication is that even if Fannie and Freddie go away, it is likely that some other government-affiliated entity will be created in order to make this deal possible. And once the contours of that deal begin to take shape, you can rest assured that the National Association of Realtors, the National Association of Homebuilders, and other interested parties will point out the positive impact that this entity will have on job creation in the construction industry. 

In short, not only are we very far from anything that resembles a real reform agenda, we are likely to find our way to yet more ways to subsidize mortgage risk-taking. 

CHARLES W. CALOMIRIS is the Henry Kaufman Professor of Financial Institutions at Columbia Business School and a visiting fellow in the research department of the International Monetary Fund. STEPHEN H. HABER is the A. A. and Jeanne Welch Milligan Professor in the School of Humanities and Sciences at Stanford University and the Peter and Helen Bing Senior Fellow at the Hoover Institution.