Financial Reform Bill Won't Stop Next Crisis

by Mark A. Calabria

The House and Senate will soon vote on a finalized financial-regulation bill, one that was mostly hammered out in a closed-door conference between the two chambers. Legislators will have a stark, simple choice: support a bill that gives us more of the same flawed banking regulations, or reject it in the hopes that new congressional leadership next year will address the actual causes of the financial crisis.

Perhaps it should come as no surprise that Sen. Christopher Dodd and Rep. Barney Frank, the bill's primary authors, would fail to end the numerous government distortions of our financial and mortgage markets that led to the crisis. Both have been either architects or supporters of those distortions. One might as well ask the fox to build the henhouse.

Nowhere in the final bill will you see even a pretense of rolling back the endless federal incentives and mandates to extend credit, particularly mortgages, to those who cannot afford to pay their loans back. After all, the popular narrative insists that Wall Street fat cats must be to blame for the credit crisis. Despite the recognition that mortgages were offered to unqualified individuals and families, banks will still be required under the Dodd-Frank bill to meet government-imposed lending quotas.

Mark A. Calabria is director of financial-regulation studies at the Cato Institute.

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While apologists for government-mandated lending are correct in pointing out that much of the worst lending was originated by state-chartered lenders, such as Countrywide, and not federally chartered banks, they either miss or purposely ignore the truth that these non-bank lenders were selling the bulk of their loans to Fannie Mae, Freddie Mac, or the government corporation Ginnie Mae. About 90 percent of loans originated by Countrywide, the largest subprime lender, were either sold to Fannie Mae or backed by Ginnie Mae. Subprime lenders were so intertwined with Fannie and Freddie that Countrywide alone constituted over 25 percent of Fannie's purchases.

While one can debate the motivations behind Fannie and Freddie's support for the subprime market, one thing should be clear: Had Fannie and Freddie not been there to buy these loans, most of them would never have been made. And had the taxpayer not been standing behind Fannie and Freddie, they would have been unable to fund such large purchases of subprime mortgages. Yet rather than fix the endless bailout that Fannie and Freddie have become, Congress believes it is more important to expand federal regulation and litigation to lenders that had nothing to do with the crisis.

The legislation's worst oversight is to ignore completely the role of loose monetary policy in driving the housing bubble. A bubble of such historic magnitude as the one we went through can only occur in an environment of extremely cheap and plentiful credit. The ultimate provider and price-setter of that credit was the Federal Reserve. Could anyone truly have believed that more than three years of a negative real federal-funds rate — where one is essentially being paid to borrow — would not end in tears?

As the Federal Reserve's monetary policy is largely aimed at short-term borrowing, the Fed also drove the spread between short- and long-term borrowing to historic heights. This created irresistible incentives for households and companies to borrow short — sometimes as short as overnight — and lend long. Many households chose adjustable-rate mortgages that would later reset as interest rates rose, increasing monthly payments. For banks, this spread provided an opportunity for handsome profits by simply speculating on the yield curve.

Avoiding the issue of loose monetary policy may well be the result of Congress's possessing almost no understanding of it. The first obvious step toward building such an understanding would be to have the GAO audit the Fed's monetary policy. Yet Congress continues to ban the GAO from examining the issue. It is as if Congress does not even want to understand the causes of the crisis.

Nor has there been any discussion in Congress about removing the tax preferences for debt. Washington subsidizes debt, taxes equity, and then acts surprised when everyone becomes extremely leveraged.

Until Washington takes a long, deep look at its own role in causing the financial crisis, we will have little hope for avoiding another one. And the Dodd-Frank legislation, sure to be heralded as strong medicine for perfidious financiers, is actually not even a modest step in the right direction.