Dodd-Frank works well, so financial elites hate it
Dodd-Frank created the Consumer Financial Protection Bureau that prevents the finance industry from ripping off its customers. More importantly, Dodd-Frank saves homeowners and taxpayers from another painful housing bust.
In the past, whenever home affordability became a problem, lenders would come up with some
innovative toxic loan product, allowing people to buy homes they really couldn’t afford, renewing the cycle of Ponzi lending and borrowing. During the bubble from the late 80s, adjustable-rate interest-only loans became common, and prices rose to the limit of affordability these products created. During the housing bubble of the 00s, prices reached a ceiling in late 2003, but lenders “innovated” again and originated and securitized option ARMs, pushing prices up to unsustainable levels.
To prevent the deflation of that housing bubble, the federal reserve engineered low mortgage rates by first lowering the federal funds rate to zero then printing money to buy mortgage-backed securities to push mortgage rates down from 6.5% to 3.5%. In the process they made stupid bubble-era prices affordable—which is where we stand today.
The difference today is that lenders must now deal with the Dodd-Frank restrictions of qualified mortgage rules and the ability-to-repay rules. These two rules effectively ban the toxic mortgage products used in the past to make unaffordable house prices temporarily affordable. Dodd-Frank effectively bans affordability products, but it necessarily inhibits transaction volumes and rapid home price appreciation, two features realtors, lenders, and homeowners covet dearly.
Back in January of 2013 I wrote that the new mortgage regulations will prevent future housing bubbles, and later I wrote that new mortgage regulations change how real estate markets work. Based on the evidence — declining sales caused by higher prices — I believe are witnessing the end to the cycles of boom and bust in real estate. Perhaps I succumb to my own optimism bias, but I want to believe people finally want to stop the madness.
Well, at least some of us want to to stop the madness. The financial elites who profit from fees and transactions want to party once again.
Speaking at the American Bankers Association’s Government Relations Summit in Washington, Committee Chairman and Texas Republican Rep. Jeb Hensarling alternately described Dodd-Frank as “regulatory waterboarding,” “a monument to the arrogance and hubris of man” and “a modern-day Tower of Babel.” He vowed that he “will not rest until Dodd-Frank is ripped out by its roots and tossed on the trash heap of history.”
“Listen to that world famous economist Bono [of rock band U2], who said: ‘In dealing with poverty here and around the world, welfare and foreign aid are a Band-Aid. Free enterprise is a cure,'” Hensarling said, suggesting less government oversight and regulation ultimately would benefit the domestic economy and society as a whole. “Not a fan of the band U2? Then how about Kanye West, who recently reminded us: ‘The only true freedom is economic freedom.'”
West’s quote, pulled from one of the rapper’s recent tweets about his personal debt, isn’t quite verbatim, though the message is still largely the same. Hensarling believes the U.S. economy would be better off without the extra controls and regulations introduced by Dodd-Frank, suggesting it is foolish to think that the “answer to incomprehensible complexity and government control is yet more incomprehensible complexity and more government control.“
Hensarling is so full of shit that it’s difficult to take him seriously, but I give him points for creativity in his endless posturing and pontification on behalf of his political campaign donors. The only thing that would improve from a rollback of the Dodd-Frank protections is the bottom line of the financial elites donating to Hensarling’s reelection campaign.
“Seriously, if rock stars and rappers get it, why can’t Washington elites? You can’t have the benefits of capitalism without capital. It is that simple,” Hensarling said. “Washington’s regulatory waterboarding is drowning community banks and small businesses and sinking the hopes and dreams of millions of low- and middle-income Americans.”
With any regulation, there is fear that it will either be changed or enforcement will be lax. Jeb Hensarling, a meat puppet for Wall Street, is certainly doing everything he can to destroy Dodd-Frank. While it’s still possible future generations may forget the folly of the last decade, it’s unlikely our generation will, so Hensarling’s efforts may play well for his donors, but it won’t change anything.
Dodd-Frank is here to stay.
A far larger concern is the lack of enforcement and oversight. And if the issue were left up to bureaucrats, that would still be a big concern, but that’s not where enforcement will come from. Civil lawsuits from future homeowners decrying their inability to repay the loans is what will keep lenders in line.
What would inflate another bubble?
Housing bubbles inflate for one of a few reasons:
- Unstable loan products with rising payments allow borrowers to increase their loan balances beyond what their incomes can support. This usually happens in response to rising prices when borrowers want to raise their bids to obtain a better property but they can’t qualify using an amortizing loan. Interest-only and Option ARMs are Ponzi loans doomed to fail at some point in the future.
- Debt-to-income ratios get out of line. During the 1970s, lenders allowed very high debt-to-income ratios because both they and their borrowers assumed the borrower would obtain 10% or better raises every year due to inflation. A 60% debt-to-income ratio becomes affordable after three or four years of 10% yearly raises. In the 1990s, lenders allowed borrowers to stretch again, and they underwrote many interest-only loans which took the debt-to-income ratio to unsustainable heights.
- Another way housing bubbles can get inflated is to abandon underwriting standards altogether. Obviously, in the Great Housing Bubble lenders did everything they did wrong from the first two bubbles and added negative amortization, teaser rates, and liar loans to boot.
It all comes down to borrower leverage. If borrowers are not allowed to take on debts they cannot successfully service and repay, housing bubbles will not occur—which is one of the main arguments against a bubble today. Wall Street might believe residential mortgages are the best investment available again, but without interest-only mortgages, Option ARMs, seconds, and HELOCs to pump money into those mortgages in an unstable way, housing bubbles won’t inflate.
How do we prevent another housing bubble?
Let’s review my recommendations for preventing future housing bubbles from The Great Housing Bubble:
Loans for the purchase or refinance of residential real estate secured by a mortgage and recorded in the public record are limited by the following parameters based on the borrower’s documented income and general indebtedness and the appraised value of the property at the time of sale or refinance:
- All payments must be calculated based on a 30-year fixed-rate conventionally-amortizing mortgage regardless of the loan program used. Negative amortization is not permitted.
- The total debt-to-income ratio for the mortgage loan payment, taxes and insurance cannot exceed 28% of a borrower’s gross income.
- The total debt-to-income of all debt obligations cannot exceed 36% of a borrower’s gross income.
- The combined-loan-to-value of mortgage indebtedness cannot exceed 90% of the appraised value of the property or the purchase price, whichever value is smaller except in specially sanctioned government programs.
The new regulations specifically ban interest-only and negative amortization loans, so #1 was implemented.
The debt-to-income ratio limits are not as low as I proposed, all loans, including jumbos, now have a maximum allowable debt-to-income ratio of 43%. The standard today set by the GSEs is 31% of gross income, and since all attempts at higher limits failed, it’s unlikely this will go up. So provisions #2 and #3 were enacted.
There is the risk that second mortgages and HELOCs may rise back to 100% of value or higher, but given the magnitude of the losses on these loans from the bubble, it will be a while before lenders start making those stupid loans again. Plus, with rising future interest rates, demand for HELOCs and second mortgages will diminish from the bubble when lower rates allowed borrowers to refinance larger sums with the same payments.
Any sums loaned in excess of these parameters do not need to be repaid by the borrower and no contractual provision is permitted that can be interpreted as limiting the borrower’s right to exercise this right, make the loan callable or otherwise abridge the mortgage agreement.
This last statement is the most critical. This is how the enforcement problem can be overcome. Regulators are pressured not to enforce laws when times are good, and decried for their lack of oversight when times are bad. If the oversight function becomes a potential civil matter policed by the borrowers themselves, the lenders know exactly what their risks and potential damages are. Any lender foolish enough to make a loan outside of the parameters would not need to fear the wrath of regulators, they would need to fear the civil lawsuits brought by borrowers eager to get out of their contractual obligations.
Given the legal environment favoring homeowners in response to the collapse of the bubble (loan modification entitlements, Homeowners Bill of Rights, and so on), lenders will not be eager to stick their necks out and make loans outside the parameters of a qualified mortgage—and that’s a good thing.
Imagine what will happen if they do. Let’s say a lender makes a loan with a debt-to-income ratio that makes the loan unaffordable to the borrower. At the first sign of trouble, the borrower will petition for a loan modification. If they are denied, they will find an attorney to bring suit to force the lender to favorably modify the mortgage, and they will win because the loan is outside the “safe harbor” of a qualified mortgage.
The threat of future lawsuits from borrowers — lawsuits the lenders know they will likely lose — will prevent them from loaning outside the parameters of a qualified mortgage. If lenders don’t loan outside those parameters, borrowers will be able to afford their mortgages, and a housing bubble and associated collapse will not occur. While some may consider the inhibition of poor lending practices a bad thing, as a taxpayer who will undoubtedly be called upon to fund the next bailout, I think it’s great the Dodd-Frank is protecting my interests over those of the financial elites.