Nick Schulz, who I’ve had the pleasure to have a few email exchanges with, steps into the anti-Consumer Protection arena with Protecting Consumers Against Another Failure of Government. He tries to find ways that the government can step out of the financial protection business to help even things up for them. I think he’s wrong here, but it is a good faith try. Two things of note:
For starters, Congress should support counter-cyclical loan-to-value ratios — that is, more stringent loan requirements during boom times and relaxed requirements in down times. This will be difficult for Congress because it means making the purchase of a home more difficult at times…
Last, the government needs to bury forever the government-sponsored enterprises that helped fuel the boom…To best help consumers, Congress should learn from this mistake by de-politicizing the housing market, starting with Fannie and Freddie.
So having Congress try and go counter-cyclical with minimum housing requirements would politicalize the mortgage process beyond anything Fannie and Freddie have done. Indeed I’m not sure how Congress would do this. Beyond all the hype about the government loosening standards, the only weapon in the arsenal without getting new powers is the definition of the conforming loan that Fannie/Freddie uses, and trying to get Congress to spin that counter-cyclically strikes me as asking for a disaster.
If he’s just concerned about LTV, the interest rate takes care of that by itself. In boom (bust) times, as the interest rate goes up (down), the NPV of a loan goes down (up); this encourages borrowers to either decrease (increase) the principal by paying more down payment or taking a smaller loan out (the opposite of that), making the LTV go down (up). The market is already on the case.
Should the terms of a vanilla loan adjust with the business cycle? No. The vanilla loan should serve as a floor of consumer protection, not as a means of trying to adjust the terms of credit lending during a credit cycle.
The three major ratings agencies amount to a government-sponsored cartel. And therein lies the problem: Large institutional investors who are forced by law to rely on the agencies are harmed when there is no competition…But these ratings agencies were the only game in town – large institutional investors could not rely on securities analysis from competitor agencies to make their decisions.
This is a good point, and I’m not sure what should be done about it. Alternatives I’ve heard, from backing out implied ratings information from cds and bond spreads to letting a thousand ratings agencies bloom all have their strengths and weaknesses. One thing that is worth noting is that nobody was unaware of the conflict of the ratings agencies, yet everyone was still taken by surprise. Everyone including international institutional investors, who aren’t subject to US government impositions. Perhaps it was a matter of the instruments in question being too complicated by the underlying mortgages in them.
Now note if we have a vanilla mortgage option, with a few alternative mortgage packages, CDOs could be structured in a way that used these mortgage options as building blocks. “This CDO is 95% vanilla”, is different than “This CDO is 95% prime” – and people would trade accordingly. That vanilla rating would be stamped by lenders under penalty of law. For all the talk about “subprime” it was obviously difficult to tell the actual performance of the mortgages in question, indeed what was even a subprime loan.
This is what Elizabeth Warren was getting at when she said: “While anyone with a bathtub and some chemicals could be a drug manufacturer a century ago, Carpenter points out that drug companies were willing to invest far more in research and development to bring good drugs to the market once FDA regulations drove out bad drugs and useless drugs. Good regulations support product innovation.” There’s an obvious informational asymmetry in underlying products; if we are going to continue to try and structure consumer debt to keep a capital markets banking system alive, having the government work to hurdle this asymmetry strikes me as very important. And providing floors on the quality of loans, with clear signals to buyers of packaged mortgages, may be worthwhile for both consumers of loans and the people who will ultimately end up holding them.
There’s a lot of talk about protecting consumers, but a Consumer Financial Protection Agency also ends up protecting those who end up on the ultimate other end of packaged consumer debt, be it pension funds in Denmark, a school board in Wisconsin, etc. Lord knows those people need protection too, and they may be against any type of innovation if these informational problems aren’t addressed.