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TAKE 5 are too big to fail. That's the thing that worries me most about the Dodd-Frank Act. It's caused all kinds of other problems, but what troubles me most is the likelihood that when these institutions are designated SIFI [systemically important financial institution] by the FSOC, they will then have funding advantages over smaller institutions . . . . This has the potential to change the entire nature of our financial system, and we have to recognize that and stop. M // The JPMorgan trading loss continues to net criticism from lawmakers in favor of Dodd-Frank. Is talk of regulation making a comeback on Capitol Hill after this controversy? Peter Wallison on Government Housing Policy and Market Regulation Peter Wallison, co-director of financial policy studies at the American Enterprise Institute, wrote the only dissent against the majority report of the Financial Crisis Inquiry Commission in 2009. We take five with the former White House general counsel to talk about market regulation and public spats with Barney Frank. M // You wrote in a recent Wall Street Journal article that calling a financial institution systemically important could grant it favored status. Elaborate on how that works. SMITH // Sure. We know from looking at the bank- ing industry . . . that we have four gigantic banks, and many studies have shown that those banks have lower cost of funds than their smaller com- petitors. And that, of course, is because the market is assuming they are too big to fail and that the government will protect them. So loans to those institutions are less risky than others that might fail. What Dodd-Frank proposes is that the Financial Stability Oversight Council (FSOC) will have the power to declare that nonbank financial institutions are systemically important, by which they mean that those institutions will then be treated as though they 16 | THE M REPORT SMITH // No, not really. There may very well be things that renew interest in the Volcker Rule, but my sense about what is happening—what everyone is beginning to recognize—is that it is very hard to strike the balance in words between something that is a proprietary trade that a bank is engaged in for its own account and hedging our market-making, which are things that they want our banks to do. Although there was a lot of brave talk at the time about JPMorgan Chase, a lot of people said this proves the need for the Volcker Rule. But a lot of other people were saying that we do expect banks to continue engaging in market-making for these various instru- ments and we do expect them to hedge, which is what JPMorgan said it was doing. M // After serving on the Financial Crisis Inquiry Commission, you wrote the only dissent against the majority report, saying that affordable housing policy loosened up mortgage underwriting standards and led to the crisis. Is this narrative gaining traction? SMITH // The interesting thing that every Republican candidate, including Mitt Romney, has said [is] that the financial crisis was caused by U.S. government housing policy. That's my thesis. That's what I wrote in my dissent. He's also saying that we should repeal the Dodd-Frank Act because, in effect, it was il- legitimate, because it was not based on the correct cause of the financial crisis. There are two narratives here—they're basically competing narratives—but you don't hear mine very much in the press. The press has decided that it was the financial sector that caused the crisis. Well, all the Republicans have basically accepted my narrative. They have become convinced that it was government housing policy that caused the financial crisis, and not the private market, which is the Democrats' analysis. As Romney is talking about it, people are going to take a look at whether the financial crisis was caused by govern- ment housing policy. M // Barney Frank once called you an extremist in The Atlantic. Are you happy to see him retire? SMITH // Yes, I am. I am very happy to see him retire. I think what he has done recently with the Dodd- Frank Act has been very destructive. And so for that reason I am happy to see that he will bow out. He was a major backer of Fannie Mae and Freddie Mac and was Horatio at the bridge for them. Whenever there was any criticism of them, he was always ris- ing to their defense. As a result, he did a great deal of damage to our financial system. I caught him in a terrible misstatement—I'll be charitable—but in that exchange that we had, he said that in 2004 he had told the president not to keep adding to the affordable housing requirements for Fannie Mae and Freddie Mac, because he was afraid those afford- able housing requirements would cause trouble in the future. So I have a letter that he wrote along with other Democrats in 2004 that said exactly the opposite—which asked the president to go easy on restrictions for Fannie and Freddie. I've posted that in The Atlantic and there was no comment after that. M // Freddie Mac continues to see year-over- year losses for its mortgage portfolio. When do you think we'll see momentum to take the GSEs off the federal lifeline? SMITH // That's going to depend on the election. It's going to be very hard to close down the GSEs without a Republican House and Senate and a Republican president. One reason—this isn't the most important reason, but it's one of the more important reasons—is that we need to amend the Dodd-Frank Act. It is possible to reduce the limit of conforming loans for Fannie and Freddie, but unless the private sector is more willing to come in and take over, it will hurt the housing market. We need to do two things: amend the Dodd-Frank Act and with- draw Fannie and Freddie from the housing markets. And that will eventually create a private market. M // Implicit federal guarantees for mortgages backed by Fannie Mae and Freddie Mac receive a great deal of criticism from reformers for fixing Uncle Sam's wagon to the GSEs. Others point out that a conundrum is created by removing these guarantees, since investors have come to trust U.S. debt more than any other debt, and invest accordingly. Is a middle ground feasible between these two extremes? SMITH // I think so, certainly. After all, our entire economy is financed without federal guarantees. There are only very few areas in our economy that federal guarantees are important. We know about student loans and we know about housing. Both of them are troubled activities. What you point out is correct in one sense; since the financial crisis, there are many people who want a federal guarantee be- fore they invest in a mortgage-backed security. So it is very hard to create something as good as a federal guarantee. When there is a government guarantee, there is a yield, because taxpayers take risk. So the insurance industry—particularly life insurance, but also the pension industry, which has something like $13 trillion to invest—would be perfectly happy to take the risk on mortgages as long as that risk is paid. What does that mean? It means that mortgages need to attract private investors. That, of course, will raise political problems with the housing complex. The homebuilders, the Realtors, and others press Congress all the time for the cheapest possible rates so they can build more houses and sell more houses. But that's not a healthy situation, because as we see, when a government gets into a business, politics takes over and it's no longer a business—it becomes a political football. We have to move away from a situation where everything becomes a decision for Congress and the president and get back to a situ- ation where mortgages are financed through the private sector.