Financial Regulation Imperfections Are Worth Fixing

Among the early actions announced to reduce regulatory burdens is a theme that targets the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) enacted in July 2010. Dodd-Frank authorized federal agencies to institute extremely broad regulatory controls over banks, mortgage issuers, insurance companies, hedge funds, stock brokerages and financial advisors. The intent was to prevent a repeat of the 2008 Great Recession which resulted in public bailouts of some private sector businesses.

There was a need for some regulatory action because leading up to the Great Recession some mortgage issuance practices made loans to people whose income was inadequate to handle the mortgage payments. Some banks held collateralized mortgage securities consisting of those toxic mortgages. That left banks with an undermined capacity to withstand bad debts. That in turn posed a risk to consumer’s bank deposits.

Many automobile finance loans fell into arrears and several automotive manufacturers wobbled on the edge of bankruptcy until they were bought out or bailed out by the government. Banks and insurance companies were further exposed to dubious loans through a massive amount of credit default swaps. The swaps spread default potential beyond the original borrowers and lenders, widening the financial stresses, leading banks to become reluctant lenders, and making it difficult for many businesses to obtain routine financing they needed to operate. Unemployment reached about 10% and the labor force participation rate fell as people could not find a worthwhile job. A repeat of these problems is worth avoiding.

Congress reacted to the Great Recession with a recovery package of infrastructure investment stimuli, an automobile industry takeover, bailout loans for some banks and passage of the Dodd-Frank act to address many issues in the financial sector. The infrastructure investments were not stimulative in the short run. The economy and employment slowly recovered and bailout loans were repaid, but wage rates remained low. The Dodd-Frank authority to regulate may have resulted in suitable regulations, but in other instances the regulations were off the mark.

Among the Dodd-Frank regulations that directly affect consumers are changes to mortgage issuance. One regulation allows a 43% maximum ratio of your debt payments to your income. Forty-three percent leaves little money for the other expenses a family incurs. It may allow circumstances to prevent you from moving when today’s 4% mortgage rates increase to 6% or 8% levels a decade hence. Your current mortgage payment will main constant, but if you attempt to refinance your current home or attempt to move to a home of similar value you will again need to qualify at the 43% hurdle. Since a new mortgage at 8% has a payment almost double the payment of a new mortgage at 4%, you could be stuck in your current home unless you have doubled your income. There is no elegant fix for the 43% hurdle, but reducing the hurdle to a lower percentage would make the issued mortgage more secure for the lender and perhaps protect the borrower in the out years. On the other hand, decreasing the hurdle rate would push people toward higher down payments or lower priced homes. There is a cost to prudence.

Under Dodd-Frank, mortgages for the self-employed are more difficult to obtain and even with high equity, a squeaky clean financial record and a FICO score above 800, you can be denied for reasons unrelated to the risk you pose to the lender. Regulators put their thumb on the scale in some strange places. The new mortgage regulations are ostensibly crafted to protect the lender from default, but that goal is undermined by regulations that allow a mere 3% of sales price as a down payment, a reversion to political agendas that were partly to blame for high rates of mortgage default.

Two genuine improvements coming from Dodd-Frank in mortgages are the requirement that issuers must retain some of the mortgage loan on their books, and the requirement for the lender to provide meaningful evidence of income. The requirement for an issuer to keep a stake in each mortgage sharpens their incentive to carefully underwrite the risk involved. In the pre-2008 period, some mortgage issuers offered “low documentation” loans, which they then securitized into large blocks of bonds and sold to others. Low doc loans were popular with speculators and they were also known as liar’s loans. Low-doc loans were more likely to fall into default.

Other Dodd-Frank related regulations being considered for amendment are the Volker Rule and the correct level of banking reserves. The Volker Rule precludes banks from owning more than 3% of a hedge fund or private equity fund. Prohibiting banks from investing their own money in some hedge funds diverts capital from the pool used as equity or loans for other businesses. Those types of investments are considered high risk by some regulators, and by limiting the potential for loss, they increase the chances of avoiding another public bailout. On the other hand, the Volker Rule precludes banks from having a role in some kinds of legitimate financing.

A requirement for excessive bank reserves diverts capital from being used as loans to consumers and businesses. At one time, some bank reserves were as low as 3%, perhaps too low. Today the requirement is closer to 10%, perhaps too high. High reserve requirements chip away at the amount of capital that can be loaned to individuals and businesses.

Not in the Dodd-Frank thicket, but under consideration with other financial regulations is a Labor department rule requiring financial consultants to act in the client’s best interest, i.e. act as fiduciaries when they advise workers on financial preparation for retirement. The rule is intended to protect workers from advisors whose motivation is merely to earn the highest fees. The way the rule is crafted has the effect of limiting consumer investment choices, and increasing compliance costs by 31 billion over 10 years.

If you have ever faced the stolid, low yield 401(k) investment choices in most employee retirement plans, you will see how the lack of choice undermines retirement readiness. Many suites of 401(k) investment options reveal an extreme aversion to lawsuits instead of a focus on building a meaningful nest egg for retirement. This regulation needs fine tuning.

A rethink of good and bad regulations is certainly worthwhile. Dodd-Frank regulations sometimes harm consumers. Consumers deserve to have faulty regulations adjusted and now is a good time to start.