In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act “to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Dodd-Frank was a massive piece of legislation (the Economist quipped that it was too big not to fail). One of the key criticisms was that so much of what Dodd-Frank aspired to do was delegated to rulemaking in the regulatory agencies. Ultimately, whether Dodd-Frank would prevent another financial crisis would depend on the quality and compatibility of some 398 rules.
One of the many targets of Dodd-Frank was the securitization process. In the days of traditional banking, banks financed their loans with deposits and then retained those loans until they matured (the “originate-to-hold” model). Because they had skin in the game, they had incentives to lend only to credit-worthy borrowers. But increasingly, this model was replaced by the “originate-to-distribute” model wherein banks would sell their loans to other parties that would, in turn, pool them and sell shares to investors (the securitization process). The securitization process changed the incentive structure. Lenders no longer had skin in the game and were thus far less interested in the question of whether borrowers could document their ability to meet their obligations.
Of course, a Bootlegger-Baptist coalition of financiers, government-sponsored entities (Freddie and Fannie), and affordable housing advocates succeeded in making the case that standard underwriting standards effectively foreclosed credit markets to moderate and low-income borrowers. They were given cover by two presidential administrations that made increases in homeownership rates central to their social agendas (remember the “ownership society”). Members of Congress—the targets of heavy lobbying, donations, and low-interest loans—worked diligently to promote the weakening of underwriting standards, pushing liquidity into the most fragile part of the market (for examples of how influence was exercised, see the 2012 report by the House Committee on Oversight and Government Reform). The rest is history, and one would imagine a history that is ripe with lessons.
Dodd-Frank correctly sought to change the incentive structure by requiring that banks retain a stake in their products unless the underlying loans were qualified residential mortgages. Regulators, in turn, proposed a simple rule in 2011: a qualified residential mortgage would require a 20 percent down payment and a 36 percent debt-to-income ratio.
As the Washington Post reports, the agencies have retreated from the 2011 proposal in the wake of intense lobbying:
the requirement [20 percent down payment] was quite inconsistent with the interests of a wide range of lobbies — from real estate agents to low-income-housing advocates — which protested that the rule would unduly limit access to credit and kill the housing recovery. The groups swarmed the regulators; hundreds of members of Congress from both parties wrote in support of them. And so, in the dog days of August this year, the regulators backed down, offering a revised rule that requires no down payment at all.
The proposed rule would likely allow a return to some of the securitization practices that contributed to the financial collapse and the Great Recession. The final rule is due in 2014, so there is still time for regulators to return to a more prudent position on qualified residential mortgages. But is there any reason to anticipate that the pressure from the revivified Bootlegger-Baptist coalition will be weakened in an election year?
Perhaps French historian Lucien Febvre was correct: “If history teaches any lesson at all, it is that there are no historical lessons.”