What Was Just Watered Down in Basel's Liquidity Requirements?

Jan 8, 2013Mike Konczal

Let’s say you were trying to make a personal budget. We can imagine two reasonable ideas you would want to incorporate into this budget. The first is that you want to make sure you can pay your bills if your income suddenly freezes up or you suddenly need cash. You want to make sure your savings are sufficiently liquid in case there is an emergency.

Another rule is that you want your time horizon of your debts to match what you are buying with those debts. You don’t want a 4-year mortgage and a 30-year auto loan; you want a 4-year auto loan and a 30-year mortgage. And for our purposes, you really don’t want to buy either on a credit card, since the payment terms can fluctuate so often in the short term.

These two ideas are behind two of the additional special forms of capital requirements designed by the Basel Committee on Banking Supervision in Basel III. The first is a “Liquidity Coverage Ratio” (LCR), which is designed to make sure that a financial firm has sufficiently liquid resources to survive a crisis where financial liquidity has dried up for 30 days. The second is a “Net Stable Funding Ratio,” which is designed to complement the first rule and seeks to incentivize banks to use funds with more stable debts featuring long-term horizons.

Basel has just introduced some changes into their final LCR rule, so let’s take a deep dive into this capital requirement rule. Before we introduce some headache-inducing acronyms, remember that the basics are simple here. Banks have a store of assets and they have obligations that they have to make. Or, at the simplest level, banks have a pile of money or things that can be turned into money and people and firms who are demanding money. So any watering down of the rule has to impact one of those two things.

Remember that in a crisis it is hard to sell assets to get the cash you need to make your payments. Also, crucially, others will want to take out more from the bank if they are worried about the bank’s assets, like in a bank run. So both of these items are stressed in the rule to get numbers sufficient to survive a crisis. Banks would prefer to count riskier kinds of things as those safe assets, and assume that firms would want to take less in times of crisis. Each allows them to have to hold less high-quality capital.

There are three major changes announced. The first is that the requirements will be slowly phased in each year for the next several years, fully online by 2019. This is to avoid putting additional credit stresses on the financial system right now. There's also a clarification that assets can be drawn down in times of crisis. But how will these regulations look when they are online? The other two changes are the way the actual mechanisms are calculated.

Let’s chart out those last two changes that were just introduced:

Originally there were just two levels of assets, level 1 and level 2. The second change is to create a new level of assets, called “Level 2B.” Level 1 is unchanged, as well as the old Level 2, which is now Level 2A. Level 2B will be no more than 15 percent of total assets, but it will include lower rated corporate debt (BBB- or above) and, more shockingly, equity shares. Equity is not what you want as a liquidity buffer, as its value will plummet and volatility will skyrocket during crises. In a crisis all correlations go to 1, and that’s especially true in a financial crisis. The fact that it might have done well in the 2008 crisis is no excuse because, as Economics of Contempt pointed out on this topic, there were massive government bailouts and interventions in the market, which is what we want to avoid.

On the plus side, rather than just putting equities in “Level 2,” they created a separate bucket with harsher penalties. Equities will receive a 50 percent haircut toward qualifying, much larger than the 15 percent haircut Level 2A assets get.

The third change is the lower outflow rate for liquidity facilities, corporate deposits as well as other sources of outflows. To get a sense of this, stable deposits with a serious system of deposit insurance – think of your FDIC savings account – originally had a 5 percent outflow. A bank would have to be prepared for 5 percent of its deposits to leave during this financial crisis. That has been reduced to 3 percent in the new rule.

These changes are particularly large for liquidity facilities. Instead of the assumption that firms will go gunning for any emergency liquidity that they can find, and as such use up most of these outlines, there are much more financial-friendly outflow estimates. In fact, many of these rates have been cut by more than half, with Basel now estimating that liquidity facilities, for instance, will only be drawn down 30 percent instead of 100 percent.

These are dramatic reductions. If they are predicated on more closely aligning with 2008 numbers, backstopping the entire liquidity of the financial markets was the whole point of the bailouts and the Federal Reserve’s emergency interventions. The numbers should be much worse in this case.

There is finally a global rule declaring a necessary, but not sufficient, minimum level of liquidity in financial firms. Liquidity does nothing if a firm is insolvent, but it by itself can generate panics. However these rule changes almost all entirely benefit the financial system, and call for less liquidity than in the first drafts. Undercounting the liquidity facilities, as well as letting more of the HQLA consist of assets like stocks and MBS, is a major change from the previous version.

The Basel committee notes that its Liquidity Coverage Ratio is an absolute minimum rate, and that “national authorities may require higher minimum levels of liquidity.” Authorities within the United States should take this seriously. Dodd-Frank calls on regulators to put in sufficient liquidity regulations for large financial firms. Basel III provides a baseline, but regulators could go further by themselves if necessary via their Dodd-Frank mandate. Understanding why the outflow assumptions have so dramatically changed will be one point to follow.

Follow or contact the Rortybomb blog:

  

Let’s say you were trying to make a personal budget. We can imagine two reasonable ideas you would want to incorporate into this budget. The first is that you want to make sure you can pay your bills if your income suddenly freezes up or you suddenly need cash. You want to make sure your savings are sufficiently liquid in case there is an emergency.

Another rule is that you want your time horizon of your debts to match what you are buying with those debts. You don’t want a 4-year mortgage and a 30-year auto loan; you want a 4-year auto loan and a 30-year mortgage. And for our purposes, you really don’t want to buy either on a credit card, since the payment terms can fluctuate so often in the short term.

These two ideas are behind two of the additional special forms of capital requirements designed by the Basel Committee on Banking Supervision in Basel III. The first is a “Liquidity Coverage Ratio” (LCR), which is designed to make sure that a financial firm has sufficiently liquid resources to survive a crisis where financial liquidity has dried up for 30 days. The second is a “Net Stable Funding Ratio,” which is designed to complement the first rule and seeks to incentivize banks to use funds with more stable debts featuring long-term horizons.

Basel has just introduced some changes into their final LCR rule, so let’s take a deep dive into this capital requirement rule. Before we introduce some headache-inducing acronyms, remember that the basics are simple here. Banks have a store of assets and they have obligations that they have to make. Or, at the simplest level, banks have a pile of money or things that can be turned into money and people and firms who are demanding money. So any watering down of the rule has to impact one of those two things.

Remember that in a crisis it is hard to sell assets to get the cash you need to make your payments. Also, crucially, others will want to take out more from the bank if they are worried about the bank’s assets, like in a bank run. So both of these items are stressed in the rule to get numbers sufficient to survive a crisis. Banks would prefer to count riskier kinds of things as those safe assets, and assume that firms would want to take less in times of crisis. Each allows them to have to hold less high-quality capital.

There are three major changes announced. The first is that the requirements will be slowly phased in each year for the next several years, fully online by 2019. This is to avoid putting additional credit stresses on the financial system right now. There's also a clarification that assets can be drawn down in times of crisis. But how will these regulations look when they are online? The other two changes are the way the actual mechanisms are calculated.

Let’s chart out those last two changes that were just introduced:

Originally there were just two levels of assets, level 1 and level 2. The second change is to create a new level of assets, called “Level 2B.” Level 1 is unchanged, as well as the old Level 2, which is now Level 2A. Level 2B will be no more than 15 percent of total assets, but it will include lower rated corporate debt (BBB- or above) and, more shockingly, equity shares. Equity is not what you want as a liquidity buffer, as its value will plummet and volatility will skyrocket during crises. In a crisis all correlations go to 1, and that’s especially true in a financial crisis. The fact that it might have done well in the 2008 crisis is no excuse because, as Economics of Contempt pointed out on this topic, there were massive government bailouts and interventions in the market, which is what we want to avoid.

On the plus side, rather than just putting equities in “Level 2,” they created a separate bucket with harsher penalties. Equities will receive a 50 percent haircut toward qualifying, much larger than the 15 percent haircut Level 2A assets get.

The third change is the lower outflow rate for liquidity facilities, corporate deposits as well as other sources of outflows. To get a sense of this, stable deposits with a serious system of deposit insurance – think of your FDIC savings account – originally had a 5 percent outflow. A bank would have to be prepared for 5 percent of its deposits to leave during this financial crisis. That has been reduced to 3 percent in the new rule.

These changes are particularly large for liquidity facilities. Instead of the assumption that firms will go gunning for any emergency liquidity that they can find, and as such use up most of these outlines, there are much more financial-friendly outflow estimates. In fact, many of these rates have been cut by more than half, with Basel now estimating that liquidity facilities, for instance, will only be drawn down 30 percent instead of 100 percent.

These are dramatic reductions. If they are predicated on more closely aligning with 2008 numbers, backstopping the entire liquidity of the financial markets was the whole point of the bailouts and the Federal Reserve’s emergency interventions. The numbers should be much worse in this case.

There is finally a global rule declaring a necessary, but not sufficient, minimum level of liquidity in financial firms. Liquidity does nothing if a firm is insolvent, but it by itself can generate panics. However these rule changes almost all entirely benefit the financial system, and call for less liquidity than in the first drafts. Undercounting the liquidity facilities, as well as letting more of the HQLA consist of assets like stocks and MBS, is a major change from the previous version.

The Basel committee notes that its Liquidity Coverage Ratio is an absolute minimum rate, and that “national authorities may require higher minimum levels of liquidity.” Authorities within the United States should take this seriously. Dodd-Frank calls on regulators to put in sufficient liquidity regulations for large financial firms. Basel III provides a baseline, but regulators could go further by themselves if necessary via their Dodd-Frank mandate. Understanding why the outflow assumptions have so dramatically changed will be one point to follow.

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Lifestyles of the Rich and Frustrated: How Much is Enough to Make a Banker Happy?

Jan 4, 2013John Paul Rollert

Greg Smith's tale of exile from Wall Street shows that even the rich can feel inadequate compared to the super-rich.

Greg Smith's tale of exile from Wall Street shows that even the rich can feel inadequate compared to the super-rich.

Last winter, Bloomberg published a much-discussed account of belt-tightening in the brave new economy. Notable for featuring Wall Streeters, not Walmart greeters, the suffering depicted was sepia-toned. One poor soul described driving all the way to outer Brooklyn to buy discounted salmon, another the indignity of doing his own dishes, and a third dismissed his Porsche 911 Carrera 4S Cabriolet as “the Volkswagen of supercars.”

Among the lingering calamities of the financial crisis, the sorrows of young bankers don’t exactly cry out for remedy. This is not Les Miserables but the hardships of the haute bourgeoisie. Yet the afflictions of affluence are afflictions nonetheless, and this particular one can teach us an awkward but essential truth in the ongoing debate over income inequality—if we can only bear to listen.

Consider the inadvertent testimony of Greg Smith. Doubtless you have heard of Smith, who vaulted to fame last March with an op-ed in The New York Times published the day he parted ways with his long-time employer, Goldman Sachs. The piece reads like the précis for some revelatory work. During his 12 years at Goldman, Smith says he had seen the interests of the customer “sidelined” in favor of an approach that sees the bank “ripping their clients off.” Their trust is taken advantage of, their naïveté exploited, their ignorance scorned. Goldman is no longer the client-centered institution Smith joined after college, and blame is placed at the feet of the bank’s leadership, whom he accuses of having “lost hold of the firm’s culture on their watch.”

Given the anger directed at Goldman in the aftermath of the financial crisis, Smith knew that his op-ed would be greeted with some interest. Here was an insider who affirmed the bank’s bad behavior and promised to illustrate it, at length, if given the opportunity.

He was, of course—in the form of $1.5 million book deal. Published at the end of October, the attempted tell-all was widely panned for falling short of its promise. The criticism is not unfair, though the publisher shares blame for rushing to print a work that would have benefited from sharper focus and the self-criticism of sustained introspection. Why I Left Goldman Sachs is Greg Smith’s first book, and its 250+ pages were written in less than seven months. If it feels like a first draft, that’s almost certainly because it is, and all parties (except Goldman, perhaps) would have benefited from the careful editing that made the original op-ed an astonishing success.

But that does not mean the book doesn’t have an intriguing story to tell, if one that is also unintended. The chronicle form lends itself to the task of writing an inevitably personal book on extremely short notice, and while Smith might have done without the convenience, preferring instead to dwell on the conflicts of interests he spends too little time on in the book, he ends up presenting a timely self-portrait of a rich man in a much richer man’s world.

When he left Goldman Sachs, Greg Smith had been making in the ballpark of $500,000 for at least six years, and the book provides ample evidence of the consolations afforded the young bachelor by his considerable income. There are the fine restaurants Smith frequents (“we went to the Frisky Oyster in Greenport”), the premier sporting events he attends (“I was lucky to be courtside in Paris to see Rafael Nadal beat Roger Federer for his sixth French Open title”), and the fashionable neighborhood he moves into when he transfers to London (it “had become trendy because Gwyneth Paltrow and Chris Martin (of Coldplay) had moved there”). There is even the 30th birthday dinner he throws for himself and his then-girlfriend (“at Freeman’s, a place with a vintage speakeasy vibe”) for which Smith graciously picks up the tab (“[t]he bill came to over $3,000, but I was happy to do it—I like treating people”).

Smith never reveals how much he has salted away for hard times, but it is not enough to stave off a minor panic when the financial crisis hits. Faced with the possibility of post-Goldman penury, he describes not one but two instances of taking public transportation, noting as an aside that “[m]any Wall Streeters can spend north of $10,000 a year on taxis alone.” The accounts are rueful—“I saved sixty bucks”—but juxtaposed with his birthday largesse, which is subsequent to these accounts and conspicuously so, a central preoccupation of the book comes into relief. The problem is not having money, but not having nearly enough.

If you take a step back, this seems absurd. From the vantage point of most Americans, not to mention the broader world, Greg Smith is rich. Indeed, according to the U.S. Census Bureau, the median household income between 2006-2011 was in the range of $50,000, or roughly one tenth of what Smith was making during that time. But Smith is not most people, and he doesn’t have the luxury of stepping back without also stepping beyond his social world. That world includes people who are not only making double or triple what Smith made, but also individuals like Gary Cohn, the president of Goldman, who made just over $53 million in 2006, or more than 100 Greg Smiths.

As a financial matter, being rich in a much richer man’s world has a tendency to bury you in what Cornell economist Robert Frank calls an expenditure cascade. In a paper he co-authored with Adam Seth Levine, Frank starts from the curious fact that “aggregate savings rates have fallen even though income gains have been largely concentrated in the hands of consumers with the highest incomes.” He explains this by showing that that wealthy scale their consumption not by the expenditures of the broader public—a benchmark that would leave their bank accounts flush—but by the people at the very top of their social group. This is the time-honored tradition of keeping up with the Joneses, but when the Joneses can afford 100 times what you can, the race can lead you right of a cliff. 

Still, while Smith’s need to make more money occasionally announces itself by way of some pressing financial concern—on same day the stock market bottoms out, Smith splits with his long-time girlfriend who had been “adamant that she didn’t want to work when she had kids”—he is well aware that his frustration has less to do with how much he actually makes than what that number says about him. Reflecting on the significance of “bonus day,” the day in December on which bankers meet with their bosses to discover the full amount they will make for the year, Smith admits that there is “an absurd amount of emphasis placed on these meetings. For many people, the session determined a person’s entire self-worth.” And yet, he continues, “however arbitrary the number handed down by the partner might be, there was also a real poignancy to the bonus meeting. Many people had spent the year working eighty-five-hour weeks, killing themselves for the firm. They expected something in return.”

By late 2011, Smith had come to expect more from Goldman than Goldman was willing to give him. At his last bonus meeting, he requested a promotion to Managing Director and a million dollar payout. Both requests were denied.

Smith does not disclose these details in his book—they were leaked by Goldman to discredit him in advance of its release—but they come as no surprise to anyone who reads it. They merely underscore the salient psychological fact of Greg Smith’s experience and the essential lesson of income inequality among the economic elite. Namely, that beauty is in the eye of the beholder, but wealth is a matter of whom you behold.

John Paul Rollert teaches business ethics and leadership at the Harvard Extension School.

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What Does the New Community Reinvestment Act (CRA) Paper Tell Us?

Dec 11, 2012Mike Konczal

There are two major, critical questions that show up in the literature surrounding the 1977 Community Reinvestment Act (CRA).

The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis?
 
There's a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an "I told you so!" by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second.
 
Where is the literature on these two questions? One starting point is the early 2009 research of two Federal Reserve economists, Neil Bhutta and Glenn B. Canner, also summarized in this Randy Kroszner speech. On the first question Kroszner summarizes research by the Federal Reserve, the latest being from 2000, arguing that "lending to lower-income individuals and communities has been nearly as profitable and performed similarly to other types of lending done by CRA-covered institutions." The CRA didn't cause changes to banks' portfolios, but instead required them to find better opportunities. More on this in a minute.
 
What about the second question? Here the Bhutta/Canner research notes that only six percent of higher-priced loans (their proxy for subprime loans) were extended by CRA-covered lenders to lower-income borrowers or CRA neighborhoods. 94 percent of these loans were either made by non-traditional banks not covered by the CRA (the "shadow banking system"), or not counted towards CRA credits. As Kroszner noted, "the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis."
 
How did those loans do? Here the research compared the performance of subprime and alt-A loans in neighborhoods right above and right below the CRA's income threshold, and found that there was no difference in how the loans performed. Hence the idea that a CRA-driven subprime bubble isn't found in the data. (The FCIC's final report, starting at page 219, has more on this and other research.)
 
So what does this new research do? It takes banks that were undergoing a normal examination to see if they were in compliance with the CRA, and thus under heightened regulatory scrunity, and compares their loan portfolios with banks that were not undergoing a CRA examination. It finds that the CRA exam increases loans 5 percent every quarter surrounding the event and those loans default 15 percent more often, under the idea that those banks were ramping up their loans to pass the CRA exam.
 
But this is question 1 territory. 94 percent of higher priced loans came outside CRA firms and outside CRA loans, and this research doesn't really change that. Since we are talking about regular mortgages - more on that in a second - that higher default isn't that scary. To put that in perspective, loans made in the quarter following the initiation of a CRA exam in a non-CRA tract are 8.3 percent more likely to be 90 days delinquent. That sounds scary, but it is an increase of 0.1, from 1.2 percent to 1.3 percent. In the CRA tract it is 33 percent more likely to default, going from 1.2 percent to 1.6 percent. FICO scores drop 7 points from 713.9 to 706.9. That's an increase I wouldn't want in my portfolio, but it is light-years away from 25%+ default rates, and very low FICO scores, on actual subprime.
 

This research, if anything, pushes against movement conservative CRA arguments. In light of the evidence in question 2, many conservatives argue that regulators used CRA to push down lending standards, which then impacted other firms. But this paper finds that extra loans aren't more likely to have higher interest rates, lower loan-to-value, or be balloon/interest-only/jumbo/buy-down mortgages, although there is a slight increase in undocumented loans. And their borrowers aren't more likely to have risky characteristics themselves. The authors conclude that "this pattern is consistent with banks’ strategic attempts to convince regulators that the loans they extend that meet CRA criteria are not overtly risky."

Read that again. The authors argue, from their empirical evidence, that regulators were trying to make sure these loans had high standards, and CRA banks tried to comply with that as best they could on the major, visible risks of their loans. This is the opposite argument made by people like John Carney, who believes the CRA "encourag[ed] lenders to adopt loose standards for mortgages." It also pushes against people like Peter Wallison, who, in his FCIC dissent, argued that CRA loans were more likely to have subprime characteristics or riskier borrowers in ways not captured by a higher-price variable. Not the case.

It also finds that loan volume and risk increases the most during 2004-2006, and points to the private securitization market as an important channel. This, along with characteristics above, pushes back against the idea that the CRA primed a subprime pump in the late 1990s and early 2000s, another favorite of movement conservative finance writers. If anything, banks undergoing CRA exams were caught up in the same mechanisms that were causing the housing bubble itself.

I'm not sure I buy all of the research. If CRA banks take on too many loans during examination, why wouldn't they just loan less afterwards, balancing out? The paper jumps to argue the opposite, as it is worried that "adjustment costs may cause banks to keep elevated lending rates even after the CRA exam is formally completed." This is meant to establish their results as a lower-bound, rather than an upper-bound. But really? They managed to ramp up their lending in enough time during this time. Either way it would throw a very different set of interpretations on their research. I'm interested in seeing how other researchers react to these problems. But for now these results don't change the way we approach the financial crisis.

 

Follow or contact the Rortybomb blog:
  

 

There are two major, critical questions that show up in the literature surrounding the 1977 Community Reinvestment Act (CRA).

The first question is how much compliance with the CRA changes the portfolio of lending institutions. Do they lend more often and to riskier people, or do they lend the same but put more effort into finding candidates? The second question is how much did the CRA lead to the expansion of subprime lending during the housing bubble. Did the CRA have a significant role in the financial crisis?
 
There's a new paper on the CRA, Did the Community Reinvestment Act (CRA) Lead to Risky Lending?, by Agarwal, Benmelech, Bergman and Seru, h/t Tyler Cowen, with smart commentary already from Noah Smith. (This blog post will use the ungated October 2012 paper for quotes and analysis.) This is already being used as the basis for an "I told you so!" by the conservative press, which has tried to argue that the second question is most relevant. However, it is important to understand that this paper answers the first question, while, if anything, providing evidence against the conservative case for the second.
 
Where is the literature on these two questions? One starting point is the early 2009 research of two Federal Reserve economists, Neil Bhutta and Glenn B. Canner, also summarized in this Randy Kroszner speech. On the first question Kroszner summarizes research by the Federal Reserve, the latest being from 2000, arguing that "lending to lower-income individuals and communities has been nearly as profitable and performed similarly to other types of lending done by CRA-covered institutions." The CRA didn't cause changes to banks' portfolios, but instead required them to find better opportunities. More on this in a minute.
 
What about the second question? Here the Bhutta/Canner research notes that only six percent of higher-priced loans (their proxy for subprime loans) were extended by CRA-covered lenders to lower-income borrowers or CRA neighborhoods. 94 percent of these loans were either made by non-traditional banks not covered by the CRA (the "shadow banking system"), or not counted towards CRA credits. As Kroszner noted, "the very small share of all higher-priced loan originations that can reasonably be attributed to the CRA makes it hard to imagine how this law could have contributed in any meaningful way to the current subprime crisis."
 
How did those loans do? Here the research compared the performance of subprime and alt-A loans in neighborhoods right above and right below the CRA's income threshold, and found that there was no difference in how the loans performed. Hence the idea that a CRA-driven subprime bubble isn't found in the data. (The FCIC's final report, starting at page 219, has more on this and other research.)
 
So what does this new research do? It takes banks that were undergoing a normal examination to see if they were in compliance with the CRA, and thus under heightened regulatory scrunity, and compares their loan portfolios with banks that were not undergoing a CRA examination. It finds that the CRA exam increases loans 5 percent every quarter surrounding the event and those loans default 15 percent more often, under the idea that those banks were ramping up their loans to pass the CRA exam.
 
But this is question 1 territory. 94 percent of higher priced loans came outside CRA firms and outside CRA loans, and this research doesn't really change that. Since we are talking about regular mortgages - more on that in a second - that higher default isn't that scary. To put that in perspective, loans made in the quarter following the initiation of a CRA exam in a non-CRA tract are 8.3 percent more likely to be 90 days delinquent. That sounds scary, but it is an increase of 0.1, from 1.2 percent to 1.3 percent. In the CRA tract it is 33 percent more likely to default, going from 1.2 percent to 1.6 percent. FICO scores drop 7 points from 713.9 to 706.9. That's an increase I wouldn't want in my portfolio, but it is light-years away from 25%+ default rates, and very low FICO scores, on actual subprime.
 

This research, if anything, pushes against movement conservative CRA arguments. In light of the evidence in question 2, many conservatives argue that regulators used CRA to push down lending standards, which then impacted other firms. But this paper finds that extra loans aren't more likely to have higher interest rates, lower loan-to-value, or be balloon/interest-only/jumbo/buy-down mortgages, although there is a slight increase in undocumented loans. And their borrowers aren't more likely to have risky characteristics themselves. The authors conclude that "this pattern is consistent with banks’ strategic attempts to convince regulators that the loans they extend that meet CRA criteria are not overtly risky."

Read that again. The authors argue, from their empirical evidence, that regulators were trying to make sure these loans had high standards, and CRA banks tried to comply with that as best they could on the major, visible risks of their loans. This is the opposite argument made by people like John Carney, who believes the CRA "encourag[ed] lenders to adopt loose standards for mortgages." It also pushes against people like Peter Wallison, who, in his FCIC dissent, argued that CRA loans were more likely to have subprime characteristics or riskier borrowers in ways not captured by a higher-price variable. Not the case.

It also finds that loan volume and risk increases the most during 2004-2006, and points to the private securitization market as an important channel. This, along with characteristics above, pushes back against the idea that the CRA primed a subprime pump in the late 1990s and early 2000s, another favorite of movement conservative finance writers. If anything, banks undergoing CRA exams were caught up in the same mechanisms that were causing the housing bubble itself.

I'm not sure I buy all of the research. If CRA banks take on too many loans during examination, why wouldn't they just loan less afterwards, balancing out? The paper jumps to argue the opposite, as it is worried that "adjustment costs may cause banks to keep elevated lending rates even after the CRA exam is formally completed." This is meant to establish their results as a lower-bound, rather than an upper-bound. But really? They managed to ramp up their lending in enough time during this time. Either way it would throw a very different set of interpretations on their research. I'm interested in seeing how other researchers react to these problems. But for now these results don't change the way we approach the financial crisis.

 

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How to Strengthen Financial Reform in the Next Four Years

Nov 16, 2012Mike Konczal

As part of our series "A Rooseveltian Second Term Agenda," an outline of what needs to be done to build upon and safeguard Dodd-Frank.

As part of our series "A Rooseveltian Second Term Agenda," an outline of what needs to be done to build upon and safeguard Dodd-Frank.

One of the Obama administration’s biggest vulnerabilities when it comes to its first term policy legacy was that the roots of the legislation it ushered through wouldn’t take hold until around 2014. Thus if a Republican president took office in 2013, there was a real chance that he could dismantle, or at least strongly interfere with, the new framework for health care and financial regulations. And it was clear by 2010 that movement conservatives would make the repeal or collapse of both bills a litmus test for all Republicans in office.

But with President Obama’s victory last week, the core framework of Dodd-Frank, the financial reform bill he signed in 2010, will become the law of the land. The question now is how to best push it forward in the coming months and years.

The most sensible, immediate reform would be to give regulators the adequate resources necessary to do their jobs. The CFTC had its funding cut by both parties last year in a move that will make their crucial work even harder to accomplish. The GOP is aiming to remove the independent funding stream for the CFPB. Without decent resources, it is unlikely that financial reform will be carried out effectively.

The next goal will require new reforms to draw some lines on the issues that haven’t been implemented well after the initial passage of the law. The Volcker Rule continues to be a mess while rules are being written. There isn’t a clear vision for what important new offices like the Office for Financial Research will set out to accomplish. These are major pieces of the legislation and are essential to creating fair, accountable, and transparent markets.

Fleshing out the post-Dodd-Frank agenda is also crucial. What should the proper regulations, if any, of high-frequency trading look like? Is breaking up the banks necessary for eliminating Too Big To Fail and the power of the financial firms over the markets, as a larger chorus of experts is starting to argue? How important is the government in preserving middle-class access to a 30-year fixed interest rate mortgage loan?

Fighting off a bi-partisan effort to make Dodd-Frank more industry-friendly will continue to be a full-time battle. But even though we don’t have to worry about the party in power repealing what has already been put into place, there’s no excuse for neglecting to articulate a vision for a financial sector that serves the greater interests of the real economy.

Mike Konczal is a Fellow at the Roosevelt Institute.

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Keep Calm and Get Excited About the Rolling Jubilee

Nov 15, 2012Mike Konczal

Occupy has created a Strike Debt wing, which has a new project: a Rolling Jubilee. There will be a livestream of the Debt Jubilee fundraiser tonight, starting at 8pm ET, that you can access from their webpage. It features Janeane Garofalo, Jeff Mangum from Neutral Milk Hotel, Lee Ranaldo of Sonic Youth, Lizz Winstead, and many more. You should check it out.

Occupy has created a Strike Debt wing, which has a new project: a Rolling Jubilee. There will be a livestream of the Debt Jubilee fundraiser tonight, starting at 8pm ET, that you can access from their webpage. It features Janeane Garofalo, Jeff Mangum from Neutral Milk Hotel, Lee Ranaldo of Sonic Youth, Lizz Winstead, and many more. You should check it out.

To give you a sense why I find this new project fascinating, I'll quickly review three random projects I've been working on recently, all of which are related to this new project.

The first is on what bankruptcy law professor Ronald Mann refers to as the "sweat box" model of consumer debt and bankruptcy. Mann argues that the 2005 bankruptcy amendments benefit creditors "by slowing the time of inevitable filings by the deeply distressed and allowing issuers to earn greater revenues from those individuals" and functions as a windfall for creditors because it "enable[s] issuers to profit from debt servicing revenues paid by distressed borrowers who are not yet in bankruptcy." More broadly, the distressed debt markets allow debt collectors the right to make huge profits by "sweating" debtors through assessing fees, raising rates, and inflating the debts owed while debtors struggle to pay the debts back over long periods of time. At the distressed end, debts aren't about recovering what is owed or making sure loans that aren't being paid turn into good debts that have reliable payments, but instead about the option to harrass small payments indefinitely. Debt collectors don't want these loans to work. (The same distorted incentives might be in play with those who have missed a mortgage payment.)

Another is focused on student debt, particularly about how the collapse of public higher education has been a planned political project. Rather than student debt levels being the result of individual greed or cost inflation driven by productivity levels, they result from a specific project to shift costs for public education onto the individual that has been consciously planned. This is part of a larger project to dismantle the access and mobility inherent in the centuries-old public higher education system in this country.

The final one is arguing that one explanation for why our recovery is so slow has to do with a debt overhang. Rather than forcing the losses of our housing bubble onto creditors, we've left them to stagnate, dragging down aggregate demand. Or we've solved it through foreclosures, which have huge costs for communities and municipalities. The financial sector itself understands that these loans aren't worth much and are fighting among itself over who will eat the losses, but this knowledge hasn't spread to homeowners or the country at large.

Rolling Jubilee

Explaining these issues and how they connect is difficult, but it is now easier with Strike Debt and its Rolling Jubilee project. What is the Rolling Jubilee? "Banks sell debt for pennies on the dollar on a shadowy speculative market of debt buyers who then turn around and try to collect the full amount from debtors. The Rolling Jubilee intervenes by buying debt, keeping it out of the hands of collectors, and then abolishing it."

The project relentlessly emphasizes the social conditions for the creation of debt: "We believe people should not go into debt for basic necessities like education, healthcare and housing." Debt in our country evolves in a system of institutions where publicly provided goods are missing or being dismantled in real-time, with private systems designed to benefit the few replacing them, and that is something that can be resisted. And the Jubilee also emphasizes that these specific debts that they are buying no longer reflect something that's owed, as they were written to zero on a balance sheet a long time ago. These are debts whose real value consists of a harrassment option to try and collect more than the pennies on the dollar that they were bought for.

Strike Debt can only purchase so much debt. What can it do going forward? There's the obvious ability to use this to highlight how bad debts actually play out in our country and expose the ins-and-outs of this system.

I'd personally like people to make the connection between random groups of people doing this and the government doing this itself through eminent domain. Right now southern California, for instance, is a battlefield between municipalities looking to prevent destructive foreclosures and the financial industry, which is looking to do a capital strike. Other cities are turning to eminent domain to buy mortgage debt at its real value, write it down, and save their communities. It would be great for them to say, "Hey, if cultural studies icon Andrew Ross and some Occupy kids are capable of doing this, certainly we, with our legal powers of eminent domain and power to tax, could do the same!"

And I'm already hearing about people proposing a form of "debt-holder activism" akin to the idea of shareholder activism: exposing wrong-doing, suing debt traders for selling debt without proper documentation, etc. It might be far-fetched, but it is worth exploring.

Critiques

There are reasonable criticisms of this project. But I'll start with some that I don't find convincing.

Doug Henwood, for instance, believes that this is generated by activists' uncritical populism, or the anarchist anthrology of David Graeber's Debt, or the reification of Bowles-Simpson's debt talk. But this is putting the carriage before the horse. A little over a year ago, I wrote some code that went through the We are the 99% Tumblr and parsed it for clues about what was motivating the people submitting their stories. And even I was shocked at how much student debt, medical debt, and debt overall were factors in those people's misery. It is how they identify the challenges they face, and this was equally so at Occupy sites.

It's fun to imagine people writing hostile comments on that 99% tumblr saying that all these people's misery is not useful to the cause because it focuses on the sphere of circulation instead of the sphere of production. But this is what is behind young people's suffering and it is an important project to address it as such. Linking it to a larger project of broad-based propserity is the work of others, and I believe the Strike Debt people are trying to do so.

Henwood also argues that Strike Debt can't buy in sufficiently large amount to buy up all the debt. That's true, but hardly the goal. He also brings up the idea that bankruptcy is a universal solvent here and should be emphasized over other projects. I disagree. To go back to Ronald Mann's "sweat-box" theory of bankrutpcy, the fees, waiting period, and other charges involved in post-2005 bankruptcy means that the legal DNA of bankruptcy code, while very useful, amplifies these problems. You can see it in the academic research that finds a spike in bankruptcy filings after people get tax rebates, because they finally have the resources to declare bankruptcy. You also see it in this random We Are the 99% tumblr entry, which notes, "I have been trying for the last 4 years to save $2000 to file bankruptcy for $5000-$10000 medical debt. It still hasn’t happened."

There are other worries that I find to be more important.

First, it's a big problem that it isn't clear yet whether those whose debt will be forgiven are stuck with a tax bill. Blogs are going back and forth on this issue, though the IRS should have given a comment already. That there aren't, say, tax attorneys Occupy can direct people to is a problem. It's funny that, given Marcel Mauss' influence on David Graeber and many in Occupy, the tax issue might hinge on being able to legally define what a "gift" is.

Another worry is whether or not this will build a community of people committed to the cause going forward. According to a Strike Debt spokesperson, when they forgive debts they send certified mail containing the Debt Resistor's Operation Manual and a notice explaining what the Debt Jubilee is. Contrast it with foreclosure activism,  where there is a lot of work that goes into building up the person in their community and making sure the person has the strength and the resources to both fight and contribute back. I've debated whether or not this is an actual problem, but it is certainly not sufficient to keep me from being excited. The people contributing are more energized than I had expected to see, which means you many see a community of people vested on the donation end as well.

The last issue is debt itself. As Jacob Hacker and Nathaniel Loewentheil argued in the Boston Review forum on debt, "[B]y focusing so much on debt...the challenge of reform appears both smaller and larger than it really is. Smaller because providing write-downs for households with underwater mortgages, while valuable, would not be enough...[yet a debt focus sets] sights higher than necessary... [W]e do not have to change people’s conception of debt or personal responsibility... [A] broad coalition will be based more on effective organizing than on consciousness-raising or cultural change around debt."

I think in the long-run Hacker is right, which is why I'm happy that the Strike Debt coalition has worked to link its concerns back to larger ones of public health care, free education, and a more robust safety net. Weaving these concerns with broader ones is precisely the work that needs to be done.

Last year, Suresh Naidu sent me the following chart, which is an evolution of different tactics during the civil rights movement, 1955-1962, charted by frequency of occurrences:

This chart is taken from Tactical Innovation and the Pace of Insurgency by the sociologist Doug McAdam. Tactists will come and go. What is necessary to keep in mind are the goals and the spirit of experimentation. I hope you check out the telethon tonight and follow the Strike Debt news to see if this is a wave of experiments worth following in the months ahead.

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Live at Boston Review with a Forum on Debt Relief

Nov 13, 2012Mike Konczal

I'm live with a forum on debt relief at Boston Review. Here's my lead essay, along with responses from Jacob S. Hacker and Nathaniel Loewentheil, Dean Baker, Tamara Draut, Robert Hockett, Barbara Fried, Mark Calabria and more. My piece summarizes much of the work done at this blog over the past several years, especially focused on balance-sheet recessions, bankruptcy, implications of "you didn't build that," and the battle between debtors and creditors. The respones afterwards were very informative. (Plus, Fried is the author of one of my favorite books, so I was really psyched to see her participate.) I hope you check it out!

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I'm live with a forum on debt relief at Boston Review. Here's my lead essay, along with responses from Jacob S. Hacker and Nathaniel Loewentheil, Dean Baker, Tamara Draut, Robert Hockett, Barbara Fried, Mark Calabria and more. My piece summarizes much of the work done at this blog over the past several years, especially focused on balance-sheet recessions, bankruptcy, implications of "you didn't build that," and the battle between debtors and creditors. The respones afterwards were very informative. (Plus, Fried is the author of one of my favorite books, so I was really psyched to see her participate.) I hope you check it out!

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Three Election Thoughts: The Failed All-In Repeal Strategy, Warren, and Three-Strikes

Nov 7, 2012Mike Konczal

The Consequences of the Conservative All-In Repeal Strategy: The attacks on Nate Silver have been fun to watch, but David Frum took the most heat for calling how this would all play out back in 2010. I really hope his Waterloo post, which made the case, will be on the radar of academics studying this era decades from now. Frum:

The Consequences of the Conservative All-In Repeal Strategy: The attacks on Nate Silver have been fun to watch, but David Frum took the most heat for calling how this would all play out back in 2010. I really hope his Waterloo post, which made the case, will be on the radar of academics studying this era decades from now. Frum:

Conservatives and Republicans today suffered their most crushing legislative defeat since the 1960s. It’s hard to exaggerate the magnitude of the disaster...Legislative majorities come and go. This healthcare bill is forever. A win in November is very poor compensation for this debacle now...No illusions please: This bill will not be repealed. Even if Republicans scored a 1994 style landslide in November, how many votes could we muster to re-open the “doughnut hole” and charge seniors more for prescription drugs? How many votes to re-allow insurers to rescind policies when they discover a pre-existing condition? How many votes to banish 25 year olds from their parents’ insurance coverage? And even if the votes were there – would President Obama sign such a repeal?

What's interesting to me is how the conservative movement followed an "all-in repeal" strategy since summer 2010. The think tanks didn't prioritize the parts of Obamacare and Dodd-Frank that they wanted to see removed and replaced with something else, and political agents didn't try to force changes in exchange for concessions on other priorities.

It was almost as if they didn't accept that the laws were the actual laws of the land. The major conservative think tanks all focused on either the unconstitutionality of the bills, hoping the Supreme Court would save them (this goes for Dodd-Frank as well), or wrote only in terms of repeal. During the primaries, every Republican presidential candidate promised to repeal Dodd-Frank and repeal Obamacare, and almost nobody said anything about what would go in their places. Romney famously was vague about how he'd replace Dodd-Frank and Obamacare. As such, there's been no signaling or mobilization on priorities for how conservatives should try to change these laws.

Part of this is a function of how the movement has been mobilizing itself. If Obamacare is an Ayn Rand horror story of socialists nationalizing the health-care industry, well, 10 percent less socialist horror is still a nightmare. If Eric Cantor went and, say, offered Obama a debt ceiling raise or a second stimulus in exchange for putting the CFPB's budget under Congress's control or pulling back parts of Obamacare, he'd likely have his head ripped off by the base. This also might be because the conservative movement is out of ideas, something that has become painfully obvious in its responses to the Great Recession.

But either way, Obamacare and Dodd-Frank will be here for a generation now.

More Reasons to Celebrate Elizabeth Warren: Besides all the other reasons to be happy about Elizabeth Warren winning her Senate seat, there are two additional policy reasons to consider. Conservatives and lobbyists are focused on removing the CFPB's funding, single directorship, and sole focus on consumer financial protection. Republicans have explicitly stated that they'll block any director until these changes are made. Warren, who came up with the idea for the agency and fought for its creation, will understand how important the mission and the legal structure for how the agency is funded and organized are, and fight for that as well.

Another important financial reform issue is that people are still nervous about how resolution authority, or the FDIC forcing a major financial firm to fail, will work in practice. Warren is one of the major experts on bankruptcy law -- she's the third most cited scholar on bankruptcy law in the country -- and also would like to see Too Big To Fail ended, so I believe she can work productively with FDIC to implement a resolution regime best capable of handling the problem.

California Overwhlemingly Votes to Ease Three-Strikes Law, Other States Legalize Marijuana18 years after it was first passed, California looks to ease its three-strike law by a 20-point margin. When people study how the United States differs from the rest of the world in terms of incarceration policy and how we manage to have a significantly higher prison population than other countries, mandatory penalties for those who have a prior (recidivists) is a major driver.

As the University of San Francisco School of Law’s Center for Law and Global Justice wrote in their report, “Cruel and Unusual: U.S. Sentencing Practices in a Global Context,” all of the major policy differences between the United States and other countries -- "life without the possibility of parole, 'three strikes' laws, consecutive sentences, mandatory minimums, juvenile justice laws, dual sovereignty, and non-retroactive application of ameliorative law" -- are all anti-rehabilitation policies.

Let's go to the section of that report on three-strikes laws:

The most infamous example of a stringent habitual offender law is California’s three strikes law, which provides a sentence of 25 years to life for anyone convicted of a felony who has committed two prior serious or violent offenses. While the public pushes for “the worst of the worst” to be taken off the streets, the reality is that most third strike convictions are for non-violent felonies: fifty-four percent of third strike commitments under California’s three strikes law were for drug, property, and other non-violent crimes...

Virtually all of the countries surveyed for this report provided some type of increased penalty for recidivists. What distinguishes the United States from the rest of the world, however, is the lack of judicial discretion in sentencing schemes aimed at recidivists and the length of sentences that result...This leaves only 21% of countries, including the United States, that require a mandatory increased punishment for an offender with prior convictions.

For fun, what are those other countries that also have three-strike like laws?

Not the best company. Remember, these laws were designed to limit the power of judges and increase the power of prosecutors, a core part of the conservative assault on liberalism in the space of incarceration policy. This is a major change, likely to impact many other states for the better.

Meanwhile, Colorado and Washington voted to legalized and regulate marijuana use. As of right now, Attorney General Eric Holder has not publicly stated if the Feds will try to interfere with these new laws, like they threatened to do to California's proposal (which failed to pass). President Obama and Holder have a real opportunity to let states experiment with ending the failed War on Drugs as we know it, or an opportunity to keep a moral crime going indefinitely by federal preemption. Nicole Flatow has an excellent overview of the legal issues at Think Progress.

 

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What Explains Wall Street's Shift Away From Obama: Fat Cat Comments or Dodd-Frank?

Nov 1, 2012Mike Konczal

In an interesting column on President Obama as the last of the "New Democrats" presidents, Michael Lind brings up the idea that the financial sector has permanently moved away from Democrats. "In 2012, most Wall Street donors, offended by Obama’s mild criticism and alarmed by the support shown by many Democrats for Occupy Wall Street, have swung their support away from the Democrats to the Republicans. It is unlikely that most of them will ever come back.

In an interesting column on President Obama as the last of the "New Democrats" presidents, Michael Lind brings up the idea that the financial sector has permanently moved away from Democrats. "In 2012, most Wall Street donors, offended by Obama’s mild criticism and alarmed by the support shown by many Democrats for Occupy Wall Street, have swung their support away from the Democrats to the Republicans. It is unlikely that most of them will ever come back. In the aftermath of the Great Recession, moderate as well as progressive Democrats are going to emphasize deficit reduction through tax increases far more than even moderate Republicans...Any such reform will cut deeply into the incomes of many Wall Street rentiers whose 'progressivism' extends only to cost-free support for gay rights and abortion rights."

It'll be interesting to see if the political coalitions permanently shift in this manner. One reason for a shift is if Wall Street is leaving President Obama less for rhetorical reasons and more for economic and regulatory ones, especially when it comes to Dodd-Frank, which Democrats will continue to defend and Republicans will look to overturn.

When people discuss why Wall Street has turned against President Obama, it is usually a story about personalities and ego. Obama once said, “I did not run for office to be helping out a bunch of fat cat bankers on Wall Street,” and that particularly stung them. Or maybe Obama is terrible with fundraising and managing the egos of rich donors. Or maybe it runs deeper psychologically. As an investor who voted for Obama in 2008 told Gayle Tzemach Lemmon, "There is just this feeling across the financial services community, across the business community, that this guy hates us."

There is a lot to the lost feeling of proper stewardship over the economy, but as Matt Yglesias points out, it likely goes beyond the fat cats line. These conversations almost always put Dodd-Frank in the far background, even though it is a major reform of the financial sector that will reduce Wall Street's power and profits. Let's look at a few reforms.

Derivatives. One of the goals of Dodd-Frank is to bring transparency and standardization to the derivatives markets by requiring derivatives to go through a clearinghouse with pricing transparency. According to the FT's Michael Mackenzie and Tracy Alloway in "Swaps profits threatened by Dodd-Frank," "Analysts at Standard & Poor’s expect an annual drop in revenues for large dealers of between $4bn and $4.5bn once rules that include...mandatory central clearing of OTC swaps are fully implemented... But for smaller broker dealers and others, the future looks brighter as competition potentially opens across the OTC arena."

In the article, CFTC chairman Gensler recognizes "all [the] benefit[s] from the lower costs and greater pricing information of a more transparent, accessible and competitive swaps market.” But not everybody actually does. Those who cornered the market pre-reform lose out on rents they were collecting from dominating the information in the market. Dodd-Frank is tackling the market in a way that expands access and transparency and reduces the pricing power of powerful incumbents. That's fantastic, unless you are one of those incumbents who will lose billions of dollars.

Interchange. Even the little things challenge the power of the financial sector over the real economy. Take interchange, the fees the financial sector charges to the real economy for using debit and credit cards. That now resembles a public utility after Dodd-Frank, which rationalizes the system in much the same way that personal checks were rationalized by the Federal Reserve in the early 20th century. S&P estimates that "the Durbin Amendment's immediate financial impact for the banking industry is a $6.5 billion to $7 billion annual reduction in debit card-related revenue... Bank of America, JPMorgan Chase, and Wells Fargo have absorbed the majority of these losses, considering the size of their debit card businesses relative to peers." This balances the playing field between the real economy and the financial sector while taking away a powerful set of contracts the banks were using to squeeze merchants.

CFPB. Meanwhile, consumer financial protection used to be the orphan mission of 10 different agencies, a number that encourages race-to-the-bottom regulatory arbitrage, none of which had the incentives to build expertise in this area or directly fight for consumers over other mission priorities. Now that mission is squarely placed in the CFPB, an agency whose funding and organizational structure is designed to prevent capture. The CFPB is already successfully going after illegal and deceptive practices at places like American Express, Discover, and Capital One, winning damages in the hundreds of millions of dollars. The financial sector is noticing that there is now an agency designed to enforce accountability.

(One might note that hedge funds don't fall under these requirements, yet they are very mad. Some of that is the result of the push to remove special tax breaks, which is a direct economic issue. Some might be the result of other financial regulations.)

These are just items with visible price tags, so it doesn't include things like the Volcker Rule, extra-prudential regulations of larger and riskier firms, trying to tackle the ratings agencies, the presumption that the FDIC will need to resolve and liquidate large firms and will require those firms to prepare for that event, and the other new regulations of the financial sector. With billions of dollars a year in profits on the line in repealing Dodd-Frank (and with those who benefit from regulation dispersed across the entire economy), it isn't surprising that we are seeing a lot of donations go to those saying they will substantially weaken reform. And the GOP is specifically targeting these kinds of reforms.

Notice that though these regulations have a large price tag, they aren't "soak the rich" or "let's get the fat cats" regulations. They are all designed to make the financial markets run better by bringing transparency, a level playing field, and accountability to the system. We haven't seen how they'll be fully implemented, and a lot is still at risk even without a Republican victory in the presidental election. But right now there are billions of reasons Wall Street should want to stop the Democratic Party and Dodd-Frank beyond hurt feelings.

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Angry cat image via Shutterstock.com.

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Worried About TBTF Banks? Ignore Romney's Attacks in the Debate.

Oct 5, 2012Mike Konczal

The big question is not whether to dismantle Dodd-Frank, but whether it gets implemented correctly.

Wednesday's presidential debate had a relatively detailed discussion of the Dodd-Frank financial reform bill. From a transcript, this is how President Obama described what the bill does:

The big question is not whether to dismantle Dodd-Frank, but whether it gets implemented correctly.

Wednesday's presidential debate had a relatively detailed discussion of the Dodd-Frank financial reform bill. From a transcript, this is how President Obama described what the bill does:

We said you've got -- banks, you've got to raise your capital requirements. You can't engage in some of this risky behavior that is putting Main Street at risk. We've going to make sure that you've got to have a living will so -- so we can know how you're going to wind things down if you make a bad bet so we don't have other taxpayer bailouts. [...] And, you know, I appreciate and it appears we've got some agreement that a marketplace to work has to have some regulation. But in the past, Governor Romney has said he just want to repeal Dodd- Frank, roll it back.
 
And so the question is: Does anybody out there think that the big problem we had is that there was too much oversight and regulation of Wall Street? Because if you do, then Governor Romney is your candidate. But that's not what I believe.
The sleepy delivery aside, this is a good description. I would have liked to seen a reference to the CFPB ("cops on the beat protecting consumers") and derivatives reform ("making sure our financial markets are transparent"), since they are both under serious attack from conservatives. But it's not bad for a high-level overview.
 
What was Mitt Romney's critique of Dodd-Frank?
One is it designates a number of banks as too big to fail, and they're effectively guaranteed by the federal government. This is the biggest kiss that's been given to -- to New York banks I've ever seen. This is an enormous boon for them....We need to get rid of that provision because it's killing regional and small banks. They're getting hurt.
 
Let me mention another regulation in Dodd-Frank. You say we were giving mortgages to people who weren't qualified. That's exactly right. It's one of the reasons for the great financial calamity we had. And so Dodd-Frank correctly says we need to have qualified mortgages, and if you give a mortgage that's not qualified, there are big penalties, except they didn't ever go on and define what a qualified mortgage was.
 
It's been two years. We don't know what a qualified mortgage is yet. So banks are reluctant to make loans, mortgages. Try and get a mortgage these days. It's hurt the housing market because Dodd-Frank didn't anticipate putting in place the kinds of regulations you have to have. It's not that Dodd-Frank always was wrong with too much regulation. Sometimes they didn't come out with a clear regulation.

First off, as Adam Levitin notes, the reason that we don't have a QM definition is because that requires having a CFPB director. And who has been blocking a CFPB director consistently from the beginning? Senate Republicans. President Obama had to recess appoint a director in order to get this rule started, much to the chagrin of Republicans. So it is a bit much to block the nominee necessary to start the agency and then complain the agency isn't getting things done.

That said, there are two major complaints here. The first is that Dodd-Frank's "resolution authority" and regulations for systemically important financial institutions (SIFI) are a "wet kiss" to the banks, and the second is that qualified mortgages are holding up the financial market. Let's take them in turn.

SIFI and Too Big To Fail

Part of Dodd-Frank's approach involves creating a graduated system of regulatory burdens for risky financial firms, combined with special resolution authority powers housed at the FDIC to resolve these firms when they fail. This gets attacked by conservatives, an attack Mitt Romney reiterated, because, they believe, it has three problems: (1) it picks a handful of winners, (2) protects those winners from competition through regulations that have no teeth, and (3) gives a signal to the market that these firms will be bailed out again in the future.

To address complaint (1), all bank holding companies with $50 billion or more in consolidated assets are included without a necessary designation, and systemically important financial institutions (SIFI) are included as well after a determination process. So it isn't just the top five firms, but instead the 35 plus that are all larger in size. If it were an advantage to be declared systemically important, SIFI financial firms would be fighting to get the designation. By all accounts they are not, and indeed they are fighting against this status.

For (2), it makes sense that they are fighting the designation because Dodd-Frank requires more capital and includes more requirements for riskier firms. Take Sec. 165, which requires "large, interconnected financial institutions" to be subject to "prudential standards...more stringent than the standards and requirements applicable to nonbank financial companies and bank holding companies that do not present similar risks to the financial stability of the United States."

Or Sec. 171, which requires that capital requirements scale with "concentrations in market share for any activity that would substantially disrupt financial markets if the institution is forced to unexpectedly cease the activity." The idea is that if a firm wants to get bigger or engage in riskier activity, the normal prudential requirements to hold more capital and plan for a failure should scale as well.

For (3), the question is whether it will work or whether the market will think there will be endless bailouts. As I've described at length elsewhere, the resolution authority in Dodd-Frank is designed to precommit against bailouts. You need three institutions to approve resolution, who must consider the decision with a bias toward the market and the bankruptcy code. If there's a liquidation, the FDIC has to wipe out shareholders, hit creditors, fire management and board members, and can't buy equity in the firm to keep it alive. The problem we face isn't Dodd-Frank, but Congress and the executive branch passing "TARP: Part Two."

So how is the market reacting? Jennie Bai, Christian Cabanilla, and Menno Middeldorp of the Federal Reserve Bank of New York wrote a great paper recently that used "Moody’s KMV credit default swap (CDS) implied probability of default to gauge changes in the market perception of the risk that senior bondholders will not be completely repaid." (Disclosure: In the past, I worked at Moody’s KMV, a well regarded credit risk firm founded as KMV by three old-school quants, as a financial engineer. As a result, I'm biased towards their probability of default methodologies as a metric.)

What did they find?

Using the results from this regression and the shift in Bloomberg resolution news over our sample, we estimate that the anticipated and actual changes in resolution regime have increased the CDS market’s expectations of default by approximately 20 basis points, which is around a fifth of the average CDS-implied default probability for G-SIFIs in March 2012. While this doesn’t necessarily mean that markets are no longer pricing in any possibility of government support, it does suggest that the new laws have resulted in the CDS market taking into account the view that senior bondholders run a higher risk that they’ll need to share in the costs of bank resolution.

The market is starting to price in the risk that senior bondholders at risky, major financial firms will take hits, and those risks are priced in alongside movements in the resolution authority law. Given that the rules aren't completed yet and that there are additional ways to bolster them, this is a good sign. Mitt Romney's attack on the overall plan embodied in Dodd-Frank isn't the right approach for people serious about tackling Too Big To Fail. The problems we should be worried about are whether there is a good implementation of the law and if it is sufficient for taking down a major firm.

QM

In addition to Adam Levitin's piece, you should read John Griffith and Julia Gordon of Center for American Progress, writing over at Think Progress, who have a piece on the QM issue.

We’re thrilled to hear Romney give such a full-throated defense of the ability-to-repay rule. It’s a welcomed about-face from his recent calls to repeal Dodd-Frank and dismantle the Consumer Financial Protection Bureau, the federal agency that’s responsible for enforcing the rule. That said, Romney has a few key facts wrong.

As Romney points out, the ability-to-repay rule has not yet taken effect as regulators are still defining the “Qualified Mortgage” exemption. But the Republican candidate neglected to mention that the final rule isn’t due until January 2013 — a deadline regulators appear to be on pace to meet. The Consumer Financial Protection Bureau submitted its proposed rule back in April and is currently hashing through public comments.

Romney seems to imply some sort of negligence or malfeasance from the Obama administration that is preventing the rule from being completed. Alas, no scandal here. The Dodd-Frank law is actually quite clear about what type of loan should be considered a “Qualified Mortgage.” The loan must be well-underwritten with verified income, employment, and debt information. Loan payments can’t exceed a certain percentage of the borrower’s net monthly income. The loan can’t contain risky feature like negative amortization, interest-only payments, or balloon payments. The list goes on.

It's a shame the debates didn't include anything on foreclosures or the housing market more generally, but the Dodd-Frank discussion was a pleasant surprise.

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The GOP's Zombie Dodd-Frank Would Lose the Core Logic of Financial Reform

Sep 20, 2012Mike Konczal

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

Republicans might not repeal Dodd-Frank outright, but they'd eliminate the system of rules that make it work.

It was just announced that Tim Pawlenty will become the head of the bank lobbying group Financial Services Roundtable. The powerful financial lobbying group, which represents groups like JP Morgan and Bank of America among other big financial sector players, appears to be aligning itself more closely with the Republican Party and betting on the idea that Republicans will control at least part of Congress. But what do they want? Earlier in the year, I argued in Washington Monthly that they'd like to repeal the core parts of financial reform.

Recently, Phil Mattingly had an article at Bloomberg Businessweek about how the GOP and Mitt Romney would approach Dodd-Frank. This is with a hat-tip to Reihan Salam who notes that this article "has confirmed something I’ve heard from well-informed insiders" and makes additional arguments [1]. So it seems well-sourced.

Mattingly's argument is that it is unlikely that the Republicans will outright repeal Dodd-Frank. "Instead, President Romney would likely try to give the financial industry something it wants more: a diluted financial reform law that would relax restrictions on some of its most profitable—and riskiest—investments but maintain enough government oversight to give the banks cover."

So what would the Republicans try to dilute and remove? Mattingly:

"Wall Street wants to loosen rules governing the swaps market, which generated $7 billion in revenue in the first quarter of 2012, according to government records. The banks would also get rid of restrictions on bank investment in private equity and hedge funds, pare back the power of the new federal consumer protection agency, and block the Volcker Rule, which bars banks from trading with money from their own accounts, a practice that can put customer deposits at risk. [...]

Wall Street doesn’t oppose everything in the law. Banks support the “resolution authority” that spells out how and when the government can seize and wind down struggling banks before they catastrophically fail."

So they want to go after derivatives rules (swaps), the Volcker Rule and the related law on restrictions on hedge fund investments, and also the CFPB. It's important to understand this isn't like removing random parts of the bill, as strict as they may be, but is instead gutting the core logic of the law. It's the equivalent of Republicans saying they'd keep the Obamacare bill, but stop the exchanges, remove the individual mandate, and lose the ban on pre-existing conditions while getting rid of the means-tested subsidies and Medicaid expansion. We'd understand that all of the parts of this system are interconnected and inseparable; the ban requires everyone to be in the market, which requires subsidies and well-developed markets.

Let's make sure we understand how derivatives, the Volcker Rule, and the CFPB all work together. Imagine that we're car engineers, and we want to design a car and road system so that if the car crashes, it does so as safely as possible. There are four things we can do. We can put airbags and seatbelts in the car and other cars so that when it does crash the damage is limited and controlled. We can design the car with things like a brake override system so that if it hits a rough patch the driver can keep control of it and make it less likely to crash.  We can put some speed limits on the road, as well as clear traffic signals to guide cars from running into each other. And we can have some protection for pedestrians, like cops watching for DUIs or barriers to prevent cars from driving into crowds of people. Easy, right?

Now let's think of Dodd-Frank. There are the legal powers that deploy to resolve a firm if it fails, like an airbag, which are called resolution authority. This allows the FDIC to take down a failed financial firm as if it were a bank, subject to serious rules and restrictions.  And, like requiring certain car features, there are specific policies for large, systemically risky financial firms, like enhanced capital requirements, limits to investments in risky hedge-funds, and the Volcker Rule, which are designed to make it less likely for a firm to crash.

Dodd-Frank also introduces speed limits and rules of the road in the financial sector, designed to make the system as a whole less likely to crash or spiral out of control when a panic does happen. One primary place it does that is through derivatives regulations. And "cops on the beat" is the metaphor for the Consumer Financial Protection Bureau.

So there's Dodd-Frank law to allow a firm to fail, law to make it less likely a financial firm fails, laws to prevent the interconnected financial markets from going into crisis if a firm does fail, and law to gives consumers a representative in dealing with the regulatory field. This is like thinking of Dodd-Frank as a system of deterrance, detection, and resolutiion, a related model we've developed elsewhere.

If Wall Street and the Republicans are looking to seriously gut the Volcker Rule, derivatives, and the CFPB, then they're looking to gut the entire logic of the bill. Interestingly, they are less interested in "resolution authority," the legal process to fail a financial firm. This is evidently no problem with everything else removed, perhaps because they believe congressional bailouts will then happen. This should remind us that resolution authority is strengthened and made more credible by other strong regulations, including things not in Dodd-Frank, like size caps or Glass-Steagall. Preventing these diluations is crucial to building a regulatory system for the financial sector that works in the 21st century.

[1] Reihan notes that banks "also understand that [Dodd-Frank] favors incumbents over new entrants, particularly incumbents with the legal acumen and lobbying resources to shape the emerging regulatory regime. My strong preference, very much in line with conservative and libertarian sensibilities, would be for a financial reform that would aim to facilitate rather than stymie entry."

I'd like to see more on how Dodd-Frank as blocking new firm entry works. While this is a generic complaint of regulations in general, I'm not sure in what ways it applies to Dodd-Frank. Parts of Dodd-Frank actually are designed to scale up with size and risk, e.g. Sec. 171 requires capital requirements to scale with "concentrations in market share for any activity that would substantially disrupt financial markets if the institution is forced to unexpectedly cease the activity," which is not for new entries. The idea is to hold larger and riskier firms to tougher standards and higher capital, which is regulation that scales with size.

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