Financial Reform Bill Passes House, Misses Point

On Wednesday, June 30th, the House of Representatives passed the Financial Reform Bill by a vote of 237-192. Next step: the Senate later this month.

According to CNNMoney, the focus of the bill is to "strengthen consumer protection, shine a light on complex financial products and establish a new process for shutting down giant financial firms in trouble." These reforms make sense in light of the mainstream narrative of the crisis. Regardless of one's opinion on the desirability of these items, the policy reveals an ignorance to the factors of the Great Recession.

The first phase of this recession was rooted in the subprime mortgage market. The second, more severe, phase can be blamed on the Federal Reserve. Any financial reform bill should focus solely on the first stage. In this regard, the Financial Reform Bill lacks the two most important and relevant reforms.

Limits on Subprime Loans

First, the problem with subprime mortgages was the ability for a borrower to take a loan out on a house with little to no downpayment. Why worry too much about whether or not loan payments are feasible when there is little to lose from defaulting? The upside, having a nice house, far outweighed the downside of walking away without suffering a significant financial loss. Other practices and policies shielded the lenders from risk as well. This atmosphere led to an overly-risky subprime mortgage market.

The practical solution to this problem is simple: mandate a minimum downpayment, in the neighborhood of 15-20%. As long as banks are allowed to take big gambles without worrying about suffering big losses, the government must limit their risk-taking. A 15-20% minimum would move substantially in that direction.

This is a policy suggestion in the spirit of Canada's tougher rules toward subprime loans. The United States' neighbors to the north were able to largely prevent the spread of subprime loans. According to the CBC News, in 2007, 20% of U.S. mortgages were subprime, whereas this figure was only 5% in Canada. Avoiding subprime mortgages allowed Canada to weather the beginning stages of the Global Financial Crisis in significantly better shape than the United States. Learning from Canada on this issue would be a wise decision. Unfortunately, the current bill, as well as rhetoric from Washington, indicate the resumption of the status quo.

Deal with Fannie Mae and Freddie Mac

Of even greater importance, the bill currently mentions nothing of significance in regards to Fannie Mae and Freddie Mac. These two government-sponsored enterprises were largely responsible for the creation and growth of the subprime market. For decades, the government used Fannie and Freddie to spread home-ownership to people with lower and lower incomes. While a seemingly good-hearted mission, the consequences were severe.

Heavily guided by the government's hand, these two quasi-private corporations acted as the main purchasers of subprime mortgages. Most recently, the Bush Administration used Fannie and Freddie as tools to spread the "American Dream" to people who could not afford his version of the dream. The plan backfired. Having semi-private corporations control the direction of the housing market, while enjoying an implicit, now explicit, guarantee of a bailout does not make for a stable housing market. It appears this lesson has not been learned.

Abandon the Current Bill and Start Over

It probably took weeks and months of hard work to contemplate, discuss, and write this Financial Reform Bill. Sadly, the fruits of this labor were a failure. Strengthening consumer protection may or may not be desirable, but it certainly has nothing more than a tangential relationship to the subprime crisis. Creating a process for shutting down large financial firms can be debated, but it will not magically remove the moral hazard problem. When the next financial crisis hits, will the "too-big-to-fail" firms believe they will not receive a bailout? Politicians can say whatever they want now, but it will take an enormous dose of fortitude to deny these powerful firms a bailout in the future. Finally, adding transparency to the derivative market may also have its own merits, but not in relation to this current crisis. The problems occurred in the sub-prime market, not the derivatives market.

The goal of regulating banks looks appealing in theory; however, it has seldom worked well in practice. This sounds defeatist, but policy must be crafted in light of reality. There are examples around the world of how to regulate a banking sector, such as Canada. However, Congress continues to ignore the lessons from Canada. Congress would be wise to support reforms similar to the two mentioned in this article. Regardless, society must temper their expectations when it comes to regulating complex systems.

Sources:
Jennifer Liberto, "House OKs Wall Street Reform Bill." CNNMoney.com

"The U.S. Subprime Mortgage Meltdown." CBC News.