Are we serious about regulating banking?

When the sub-prime crisis hit in 2007, we were all bombarded with stories about how this showed the effects of deregulation run amok.  Never mind that the housing and banking industries are heavily regulated, the crisis showed we had the wrong kind of regulation.  Or perhaps it showed that the Bush administration never had their heart in regulation, so they let the banks get away with murder.  I think it’s a bit more complicated than that (Bush did try to rein in Fannie and Freddie) but obviously Bush wasn’t keen on discouraging banks from making housing loans.  Just the opposite, he wanted to create an “ownership society.” 

As a card-carry libertarian I am always a bit skeptical of the notion that “deregulation” is the cause of each and every economic problem that crops up.  But I am also aware than many existing regulations (FDIC, TBTF, etc) encourage excessive risk taking by banks, so it’s possible that some regulations might work as second best policies.  And it seems to me there was one obvious regulation that would have prevented the sub-prime fiasco:


That’s the sine qua non of regulatory responses to the crisis.  If we can’t even do what the Canadians and Danes do, make it tough to get a mortgage without at least 20% down, then I don’t see how anyone can say we are serious about regulating the banking industry.  Indeed, a minimum 20% down-payment would actually address two market failures; the tendency of banks to takes excessive risks, caused by the bank insurance discussed above, and also the tendency for Americans to save far too little, caused by dozens of tax and subsidy programs that systematically discourage saving and encourage consumption.

So how is the (pro-regulation) Obama administration doing so far?  Here’s how Robert Pozen describes their attempt to prevent another subprime bubble:

A few weeks ago, President Barack Obama signed legislation extending an $8,000 tax credit for first-time home buyers. The refundable tax credit, available even if a family has no taxable income, will enable many more buyers to close on a home. But it also could bankrupt the Federal Housing Administration (FHA) and, by doing so, damage an already weak housing market.

This can’t be; Pozen makes it seem like Obama is trying to inflate a new housing bubble, by stimulating a new round of sub-prime mortgages.  But perhaps there is some requirement that borrowers put down at least 20% of their own money.  Unfortunately, the minimum seems a bit lower than the 20% I had in mind, indeed 20% lower:

Here’s how the credit allows buyers to avoid putting their own money at risk. Suppose a couple making $60,000 annually buys a home worth $200,000. They can get an FHA-insured loan if they put down 3.5% of the purchase price, about $7,000. The couple will also need to come up with another $1,000 in closing costs, for a total of $8,000. The couple can either dip into savings or borrow that money from relatives or somewhere else on a temporary basis.

After closing, the couple can quickly obtain the $8,000 refundable tax credit to pay off their temporary loan (or replenish their savings). In effect, they will have bought a home without putting any of their own money at risk. Owners who don’t sink their own money into a house are much more likely to default on the mortgage.

Say it ain’t so.  I can’t believe that after everything we have heard from the left about the sins of Bush-era deregulation, we are again trying to shovel government money to homebuyers with no income and no money for a down-payment.  Surely this is the “re-regulation” we were told was necessary?  I may have misinterpreted the Pozen article.  Feel free to educate me, as I am no export on mortgage lending.

BTW, because I started my blog in February I never had a chance to bash Bush for all his policy errors.  So just to show my liberal readers that I am fair and balanced, let me add that Obama’s attitude toward the “War on Drug using Americans” is a vast improvement over the Bush administration.  It has even led other nations in Latin America to liberalize their drug laws.  That’s “deregulation” that both liberals and libertarians can believe in.  And this policy change has occurred in an area that is far more consequential than banking reform.



21 Responses to “Are we serious about regulating banking?”

  1. Gravatar of William William
    27. November 2009 at 18:54

    …we are again trying to shovel government money to homebuyers with no income and no money for a down-payment

    “In 2005, the peak year of the subprime boom, the study found that borrowers with decent credit scores got more than half – 55 percent – of all the subprime mortgages that were ultimate packaged into securities and sold to investors. By the end of 2006, it was 61 percent.”

    “Using loan origination data obtained pursuant to the Home Mortgage Disclosure Act (HMDA), we find that in 2005 and 2006, independent nonbank institutions””institutions not covered by the CRA””accounted for about half of all subprime originations. (See Table 1.) Also, about 60 percent of higher-priced loan originations went to middle- or higher-income borrowers or neighborhoods, populations not targeted by the CRA.”

    If you accept this narrative then “no income and no money” as well as “shovel government money” may not be accurate (I can’t tell how much of a hyperbole that is intended to be!)

    Just nitpicking, can’t help myself.

  2. Gravatar of ssumner ssumner
    27. November 2009 at 19:34

    William, I am sure your evidence is accurate, but don’t quite see how it makes my point inaccurate. I am talking about 2009, not 2005-06.

  3. Gravatar of Thorfinn Thorfinn
    27. November 2009 at 22:32

    The congressman with the highest donations from the financial sector was Rahm Emanuel, so I have doubts that the Democrats will really act on financial sector reform.

    But if the Democrats have sold out; I don’t know what the Republicans are doing. Even without donations from Big Finance, they remain opposed to government interventions in finance.

  4. Gravatar of Simon K Simon K
    28. November 2009 at 00:03

    “Sub-prime” as such really meant fully-private-sector lending to people with FICO scores below 680, and usually little or no downpayment. That doesn’t really happen any more. It was only really possible before because of ever-rising home-prices. The FHA has largely stepped in to fill the gap, and can do so because the government insures the loans, so if they default, the lender gets their money back, even if the collateral turns out not to be worth the principal. Unfortunately the FHA’s insurance fund is running a tad low …

    William’s data is interesting because it implies a lot of sub-prime loans were made to people who didn’t need them. Its possible those people were defrauded by their mortgage brokers, but its also quite possible they were taking advantage of a good deal with the intent to refinance later. Its possible a lot of FHA borrowers are doing the same thing down – not putting in their own money because they don’t want to risk it.

  5. Gravatar of Doc Merlin Doc Merlin
    28. November 2009 at 00:18

    1) The “deregulation” story is just partisan BS, to try to blame the republicans for the mess. Bush pushed for regulation of Fanny and Freddy as did their regulator, but the democrats blocked it.

    2) Good regulation doesn’t leave room for legislators getting support from scared/rent_seeking institutions.

    3) The most important rule of regulatory politics: “Good law is a public good, bad law is a private good.” This fairly succinctly sums up why attempts at good regulation don’t work.

  6. Gravatar of Carl Lumma Carl Lumma
    28. November 2009 at 02:20

    > indeed 20% lower:

    Cute, but I think “100% lower:” would be clearer.

  7. Gravatar of StatsGuy StatsGuy
    28. November 2009 at 09:37

    I think William’s point is that while bad loans were made, many people who did not deserve to be punished were caught up in the mess.

    Arguably, the primary mechanism for fixing this ought to be through restructuring of loans – except that banks have taken a ridiculously hard line against all homeowners (refusing to recognize losses) – and the courts/federal system has generally not been helpful. There are _many_ cases of individuals who have slight negative equity (or close to zero equity) that are unable to refinance from an 8% rate to a 5% rate, even though that makes the difference between the mortgage being affordable or not.

    In a sense, this ties back to the issue of govt. as a coordinating mechanism for setting expectations of prices in the future, and stabilizing perceptions of long term risk (as well as real risk). Partly, this could operate through NGDP targeting (to stabilize house price levels implies reducing default risk by increasing recovery rates). Partly this could act via direct subsidies to restructure existing loans (or just buying them outright). The notion being that if you buy enough loans, you pump enough money back into the system (and prevent enough foreclosures which helps stabilize prices) that we escape underutilization and the macro effect actually _reduces_ the risk of default.

    Small banks, operating independently, can’t unilaterally affect the macro variables. Govt can – either through policy or directly (in theory).

  8. Gravatar of TGGP TGGP
    28. November 2009 at 13:58

    Stan Liebowitz argues that the problem was with adjustable rate mortgages (ARMs) rather than sub-primes.

  9. Gravatar of ssumner ssumner
    28. November 2009 at 14:57

    Thorfinn, Even worse, the Republicans favored those interventions that make the problems worse (FDIC, TBTF, etc) but oppose interventions to clean up the mess created by those distortions. I’ll bet most republicans would oppose 20% down payment minimums

    Both parties are hopeless in this area. We have a neighbor to the north that has had a well-functioning financial system during each of our major crises, so its not like we can claim we don’t know what to do. We just don’t want to do it. Neither party does.

    Simon K, OK, technically they aren’t subprime, let’s just say that zero down, no income verification mortgages were the sort of mortgage that created this crisis, and whatever you call them the Obama adminstration is trying to create more of them.

    Doc Merlin, Yes, I mentioned that Bush tried to regulate the federally-sponsored entities.

    Carl, OK, 20 percentage points lower.

    Statsguy, I agree with your NGDP commnets, but remember that the US government is extraordinarily inefficient, even by the standards of national governments. It’s way too big. Could the Danish government help sort out a mortgage mess where mutually advantageous trades are going unmade? Perhaps. Could Uncle Sam? I doubt it.

    TGGP. The problem isn’t that people can’t afford to repay mortgages, rates are very low. The main problems are:

    1. Falling housing prices, which gives people an incentive to default.

    2. Severe recession, which lowers disposible incomes.

    3. Many people put less than 20% down. I’ll bet default rates are much lower where people put at least 20% down.

    I see the ARMs as a minor factor. Interest rates have not risen more than expected. People can’t re-finance because they are underwater.

  10. Gravatar of StatsGuy StatsGuy
    28. November 2009 at 15:56


    Liebowitz’ argument is fondly adopted by those seeking to blame the debacle squarely on programs designed to expand homeownership to minorities. I hear it a lot from my conservative friends – even tho Bush II aggressively advocated these programs in his 2004 campaign (and took credit for them in his 2004 nomination speech).

    “Thanks to our policies, home ownership in America is at an all- time high.

    Tonight we set a new goal: 7 million more affordable homes in the next 10 years, so more American families will be able to open the door and say, “Welcome to my home.”

    What I find strange about the Liebowitz argument is the unforgiving attitude toward government programs combined with an accommodating stance to all the other agents that were complicit in the crisis (banks only reluctantly went along… kicking and screaming).

    It was the markets, after all, that priced the risk. One can blame Fannie/Freddie only to a limited degree; but many private banks were buying this risk.

    Once we get through the “it was our foolish attempts to be nice to minorities” argument (and certainly there are nuggets of truth there), the second part of the article – the “it was the speculators” part – aligns very closely with a lot of data. Indeed, his own data…

    Loans were extended to minorities from ’92 onward – but we don’t seen the rapid spike in prices until 2003 to 2005. Moreover, this spike was concentrated heavily in FOUR states:

    California, Arizona, Nevada, and Florida

    So, of course, were the defaults.

    Scroll down to the foreclosure rates by state. Now, look at the RED bars. These were the states where the crisis started. Later on, the crisis spread (reflected in the blue bars).

    This correlates very well with the Sunbelt states that were experiencing a massive population influx, BUT correlates weakly with minority population. For example:

    While those four states had high minority populations, other states had even higher minority populations and lower than national average default rates in the initial wave (including Texas, the Mississippi delta states, the carolinas)… Moreoover, loans in these states were largely financed by private entities. At no point did the purchasers of CDO type securities waver in their hunger to acquire AAA rated tranches.

    Then toward the end he moves on to argue that it wasn’t so much the minorities, but rather the entry of speculators who took advantage of the relaxed lending standards, then abruptly fled the market.

    In other words, the real problem was the failure to distinguish between minorities (who, in fact, did not cause price explosion prior to 2002) and the speculators who flooded the market in 2003-2005. How, exactly, did this failure materialize? (There are many reasons, but they do not reflect well on either the private sector or their alleged regulators in an Administration where regulators were demonized and punished.)

    Liebowitz spends no time on this, since he spent most of the article arguing that if the government had just avoided programs to help the poor, none of this would have happened. There is truth in the article, but it’s a rather one sided truth.

  11. Gravatar of StatsGuy StatsGuy
    28. November 2009 at 16:01

    “the US government is extraordinarily inefficient, even by the standards of national governments. It’s way too big.”

    Many programs are inefficient because they were deliberately handicapped by politicians that opposed them but lacked the political power to cut them. To argue that the current, Bush-structured administration is inefficient is different from arguing that the US must, by necessity, be inefficient.

    There is a circularity here. If it’s broken, should we not fix it?

  12. Gravatar of Scott Sumner Scott Sumner
    29. November 2009 at 14:12

    Statsguy, I don’t know what you mean by the current Bush-structured administration. Are you referring to the deregulation that occurred under Clinton? Or the housing subsidy program signed into law by Obama? Bush is to blame for part of this mess, but surely not the issue I addressed in this post.

    I agree that more than 50% of the failure was do to private banks. But there is a reason why I focus on the role of government. It is easy to abolish Fannie and Freddie. But we can’t just abolish private banks. We’d like them to behave more responsibly, but it is not as easy as just abolishing bad government programs. And note that I have advocated more regulation of private banks, such as restrictions on mortgages with less than 20% down-payments.

  13. Gravatar of Simon K Simon K
    29. November 2009 at 18:47

    There’s another problem with Liebowitz’s argument, in addition to the weakness of the case that the real root of the problem was the CRA, Fannie and Freddie, and that’s that his demonstration that sub-prime loans weren’t the issue, but ARMs were is itself flawed.

    His graphs look convincing, but that’s because they show percentages of numbers that, themselves, vary hugely during the time interval under consideration. In 2006, 13.5% of mortgages were sub-prime. In 2000, only 2% were. So when he shows 3% of sub-prime loans in default in 2000, thats 0.06% of total mortgages were sub-prime loans in foreclosure. In late 2006, partially by Liebowitz’s own numbers, 0.3% of mortgages were sub-prime loans in foreclosure! That a 5x difference, but on Liebowitz’s graph, the latter number looks smaller than the former, because the shere number of sub-prime mortgages grew enormously during that time period. Even correcting for that understates the impact on the housing market, because the total number of homes with a mortgage of some kind grew during that time period too.

    And if we’re trying to determine the impact of sub-prime on the housing market, its surely the number of sub-prime foreclosures as a proportion of total mortgages that we’re interested in, not the perfomance of sub-prime loans. We’re not considering an investment here, but trying to diagnose a crisis. Its debatable even that what Liebowitz claims to show here is true – he asserts that sub-prime loans “performed just as well” as prime, but his own graphs show that at the peak of the bust, 3.5% of sub-prime loans were in foreclosure, compared with only 0.4% of prime loans.

    A similar problem almost certainly exists with his graphs showing that ARMs were really the problem, although I don’t have numbers to hand. Almost all sub-prime loans were ARMs, where the number of prime ARMs varies with the interest rate environment. Its likely that the proportion of prime ARMs increased during 2003-06, as the number of sub-prime loans shot upwards, as they tend to be a good idea if interest rates are expected to fall prior to the first reset.

  14. Gravatar of StatsGuy StatsGuy
    29. November 2009 at 19:37


    “Are you referring to the deregulation that occurred under Clinton? Or the housing subsidy program signed into law by Obama?”

    No, to the general gutting of administrative capacity by appointing unqualified (but loyal) political hacks into positions that require technical expertise. (Something very un-Singaporean.) Although I only tracked this anecdotally, it looks like there are those who tracked it full time:

    BTW, even though high level political appointees are usually in high demand, the markets apparently agree with my opinion about the qualify of Bush’s appointees:

  15. Gravatar of ssumner ssumner
    29. November 2009 at 20:19

    Thanks Simon, I’m no expert here, but I find your views very plausible.

    Statsguy, You might want to check out that first link more closely. It seems to be from some pretty nutty groups. People like Rice, Powell, Rumsfeld, Chao and Thompson weren’t qualified? By what standard? Compared to the Obama appointee who thought 9/11 was a Bush conspiracy? Sure Rumsfeld made some poor decisions. But as we learned with Kennedy’s “best and brightest,” qualifications don’t necessarily translate into good decisions.

    Anyway if there is one thing I am sure of, it is that the subprime fiasco has absolutely nothing to do with the quality of Bush appointees. (Which I am not defending, BTW, he had some real duds.) If Bush had tried to stop the sub-prime boom, there is no way Congress would have let him. They wouldn’t even let him rein in Fannie Mae. So let’s not kid ourselves that this was a Katrina-type situation.

  16. Gravatar of StatsGuy StatsGuy
    29. November 2009 at 22:06


    “the subprime fiasco has absolutely nothing to do with the quality of Bush appointees”

    I don’t think I ever claimed that the appointees caused the subprime crisis… That would imply that the expansion of subprime mortgages was not in line with the core Bush agenda (and with the Democratics in Congress as well, although the Republicans controlled Congress for a majority of Bush’s tenure).

    My contention was that you cannot make arguments about the efficacy of US federal agencies based on how they performed between 2001-2008; agencies were deliberately handicapped (because it was too politically difficult to kill them outright). From 1993-2000, it’s much easier to find examples of agencies that were semi-effective even as they were being reduced in headcount (and charged with regulating a growing economy).

    For example, consider Christopher Cox… The man who essentially decided that the SEC’s role was to get out of the way.

    This after William Donaldson was deemed too independent.

    [This reminds me of the removal of Christine Todd Whitman (who turned out to be a reasonable EPA administrator) and the eventual appointment of Steven Johnson who routinely overruled his staff on technical reports to Congress.]

    [As to the quality of the nutjob link – sorry, but by definition, anyone who devotes that much time to tracking/attacking Bush is going to be as far on the left as Matt Drudge is on the right.]

  17. Gravatar of Scott Sumner Scott Sumner
    1. December 2009 at 06:54

    Statsguy, Again, I don’t want to defend the quality of all of Bush’s appointees. Because Democrats believe in governmnet, I think they have a bigger talent pool to draw from.

    But didn’t many of the famous corporate scandals (Enron, Worldcom, etc) start developing before Bush took office? I seem to recall that the scandals broke in 2001, but involved behavior that had occurred earlier. Is that right?

    I not convinced that something like Madoff slipped by because of Cox. My impression is that those cases go to lower level SEC people, and they passed on the evidence. And although Republicans are anti-regulation, they are surely not in favor of outright fraud, so I doubt ideology can explain a Madoff scandal either. I just think that we expect too much of government. By the way there are plenty of corporate scandals in Europe, despite the fact that countries like France are known to have excellent civil servants.

  18. Gravatar of StatsGuy StatsGuy
    1. December 2009 at 09:33


    “Because Democrats believe in governmnet, I think they have a bigger talent pool to draw from.”

    That’s an interesting argument I had not heard before. If that were true, one might be tempted to conclude that Democrats are more talented but intellectually misguided. But I do not think that explains the pattern of appointments we observe.

    Going into 2001, first term Bush II appointed several moderate republicans with experience. A few examples are listed above, but I think the paramount example is Treasury Sec Snow, who served under Ford.'Neill_(businessman)

    After 9/11, as Bush II consolidated his electoral position, we see rapid turnover and replacement of moderate, capable folks with individuals who were loyal and more ideologically aligned. I suspect that many in the administration (like Dick Cheney) believed their appointments were being co-opted by agencies as they become exposed to the details of their jobs.

    The solution was to appoint individuals who were not encumbered by reliance on facts, but were instead very loyal and ideologically aligned.

    “although Republicans are anti-regulation, they are surely not in favor of outright fraud”

    This view ignores the legislation/administration divide in the US. If you consider the work of various Public Choice theorists (e.g. Terry Moe and such), they offer a theory which does explain 2003-2008 rather well. Simply, if you can’t kill the agency (but you disagree with its mission), then you handicap using political appointments.

    You cite Madoff, which is a hard case to retrospectively consider. The question you need to ask is this: Did the dominant anti-regulatory ideology combined with the ideological political oversight of career agency staff diminish the chances of identifying Madoff earlier? There are strong cases to be made on both sides of that counterfactual, so I don’t think it’s clear cut.

    Or are you instead making a broader argument, that regulatory bodies can _never_ be effective, so we are better off without them because their existence only induces us to put too much trust in their outcomes?

    In that sense, how do you distinguish the SEC function of preventing accounting fraud from the provision of a public police force and court system? Do you think accounting transparency is a private good? Are civil penalties enough when financial agents are moving vast amounts of _other peoples’_ money, and opportunities to stash money offshore and flee across borders are plentiful? I’m skeptical.

  19. Gravatar of Doc Merlin Doc Merlin
    2. December 2009 at 09:10

    “Or are you instead making a broader argument, that regulatory bodies can _never_ be effective, so we are better off without them because their existence only induces us to put too much trust in their outcomes?

    In that sense, how do you distinguish the SEC function of preventing accounting fraud from the provision of a public police force and court system?”

    I am now going to put on my Devil’s Advocate Hat (TM).
    I don’t actually necessarily believe this theory, but I’d like to explore it: Sans police force, people would take revenge on criminals themselves or would set up an informal courts system to do it for them. The mine claim societies in the Old West and the vigilante system in Sicily are a good examples of this. Thus police have been regulatory captured by criminals and end up serving to protect violent criminals from retribution.

    ” Do you think accounting transparency is a private good?”

    Actually it is! Look at businesses that aren’t legally required to have accounting, or auditing: churches for example. They end up getting audited (Disclosure my fiance works for a firm that audits Churches) and having accounting because it allows them to get loans, detect fraud, and generally be safer.

    Southern baptist churches even have sort of ritual associated with accounting transparency. Ushers are selected temporarily from the male laymen of the congregation and it is considered an honor to be asked to usher for a sunday. No usher is ever alone with the money. Immediately after collections are taken up, the Ushers all get together in a room somewhere and count up the money as a group. They then lock it in a strongbox.
    Over the long term, accounting transparency is a private good, because reputation is important.

  20. Gravatar of Scott Sumner Scott Sumner
    3. December 2009 at 06:01

    Statsguy, When I was in grad school I remember being taught that studies showed the SEC had not been successful in helping investors. But then I went to Chicago. So I still have an open mind on the issue, but I don’t consider it a given that good intentions in regulation lead to good results.

    Doc Merlin, I would add that there is a distinction between regulation and enforcement of contracts. Madoff would have been prosecuted even if the SEC didn’t exist. I am not calling for vigilantism

  21. Gravatar of TheMoneyIllusion » We never learn TheMoneyIllusion » We never learn
    11. December 2012 at 08:20

    […] have to take my word for all that.  But not for my 2009 prediction that Obama’s policy of pumping up FHA was another time bomb waiting to go off.  His solution […]

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