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  • Dodd-Frank, Obamacare grew out of same faulty reasoning

    Posted by Kevin Villani on March 6th, 2017 (All posts by )

    The current partisan war over the Dodd-Frank Act is just one dispute in a broader ideological divide about the government’s role in industry. This dispute, which has deep historical roots, includes a similar battle over Obamacare. The common disagreement at issue with both laws — now in the cross hairs of a GOP-controlled Washington — is the extent to which politicians should subsidize their constituents indirectly through regulation of private companies.

    The Affordable Care Act governing health insurers was about 1,000 pages, and Dodd-Frank governing most other financial institutions was more than twice that. Both stopped short of nationalizing their respective industry, instead generating more than 10 pages of regulation for every one page of legislation, although many view nationalization as an eventual but inevitable consequence, particularly for health care.

    The distinction between public control and public ownership is the primary distinction between the competing mid-20th-century ideologies of fascism and communism. In contemporary terminology, this distinction is between crony capitalism and nationalization, neither of which can be reconciled with competition and freedom of choice.

    The serious threats to market competition in the U.S. came well after World War II. In the 1960s, the U.S. had the most competitive financial system globally, a higher rate of homeownership than at present and the best medical care. National health insurance was a high school debating topic, implemented by many western democracies in the wake of the devastation of World War II. Many nations also nationalized other industries.

    But the U.S. took a different approach, attempting to maintain the benefits of private ownership and competition. Most consumer-oriented firms — savings and loans, health and life insurers — were mutually owned, eliminating conflicts among stakeholders. Commercial bank shareholders and management were restrained by competition and market discipline. Health and homeowner subsidies were provided directly to the needy.

    The first major exception was the introduction of federal deposit insurance to protect “small savers” during the Great Depression, requiring sufficiently prudential regulation to prevent moral hazard, i.e., excessive risk-taking. But public insurance schemes fail (as all state deposit insurance systems have failed) where private schemes succeed because politicians sometimes excessively favor constituent customers, e.g., savers, borrowers or the insured, over shareholders or taxpayers. There are only a few ways financial institutions can respond to policies favoring politically designated customers. First, those with monopoly power can cross-subsidize — charge some borrowers more to cover the added costs of favoring others. Second, they can take on more risk in the hope of greater returns.

    These perverse incentives saw their heyday in the 1990s and leading up to the financial crisis.

    Under the Clinton administration, the 1995 National Homeownership Strategy promised homeownership to millions of households that had neither the traditional down payment nor sources of sufficient income, without budgeting explicit subsidies. But the subsidies were there. The costs of lower interest rates were offset by employing extreme leverage facilitated by deposit insurance — thereby increasing public risk in the interest of private profit for money-center banks — and by the implicit government backing of Fannie Mae and Freddie Mac.

    At the peak of this policy’s effect, the combined unbudgeted tax and insurance subsidies for the insured banks were in the tens of billions of dollars annually (and the same for Fannie and Freddie). This and other policies like it were guaranteed to fail, requiring a bailout.

    Obamacare took a similar view of the role of government subsidies. The ACA promised to maintain or improve health care while making coverage universal. Past political attempts to do this had always failed due to the expense and “moral hazard” of people taking greater health and/or financial risks. The ACA ignored or glossed over these concerns, mandating participation at multiples of a competitive market premium to generate sufficient cross subsidies and expensive coverage not paid for by the beneficiaries by fixing prices across all risk classes.

    Authors of the law simultaneously avoided the major source of increasing costs by deferring reform of medical malpractice torts, saying it was politically unpalatable. Knowing in advance that premiums would skyrocket after enactment of the law, the law’s proponents incorporated a bailout scheme into the ACA. The big health insurers became essentially “too big to fail” or dropped out of the system. Most of the smaller nonprofit insurers failed.

    To be clear, this is not “free” national health insurance, which would obviously lead to huge taxpayer expense for what would be a lower-quality product. But the alternative of crony capitalism is worse than budgeted subsidies because it massively undermines market competition and freedom of choice while imposing greater costs on the public.

    The solutions for health insurance and financial services are the same: either bite the bullet and nationalize, or restore competitive markets. Democrats tried to get the former for health insurance, but failed. Meanwhile, commercial banks were temporarily “nationalized” — forced to issue shares to the government during the crisis.

    Well before Dodd-Frank, there are plenty of examples of past banking reform efforts that resulted in horrible incentives.

    The 1989 Financial Institutions Reform, Recovery and Enforcement Act promised to end the systemic (political) risk of mortgage lending, but exacerbated it by bringing the banking and mortgage lending systems closer together.

    The 1994 Riegle-Neal Act allowed banks to branch and merge across state lines. But by limiting interstate approval to banks with high Community Reinvestment Act ratings, the law indirectly induced commercial banks to allocate more credit; making more loans was a road map to branching out across state lines. Public disclosure of CRA ratings empowered community action groups to extract $4 trillion in commitments. Fannie and Freddie’s regulator issued a directive to the same end. Underwriting guidelines and down payment requirements were weakened.

    The Gramm-Leach-Bliley Act of 1999 that repealed the Depression-era Glass-Steagall Act separating commercial from investment banking should have strengthened TBTF banks. But by then all the conservative investment banking partnerships had been converted to corporate casinos gambling for their own account. The riskiest tranches of mortgage securities were their most speculative bet.

    Sufficiently high capital requirements would have prevented a bubble from developing, but the congressional committees responsible for the safety of the financial system rejected higher capital requirements explicitly to help homeowners. When the resulting bubble was finally burst in 2008, the deferred default costs caused a global financial crisis and recession. After millions of households suffered foreclosure, the U.S. homeownership rate has returned to the level prior to the Clinton housing initiative, but the financial system and economic recovery remain fragile.

    Indeed, Dodd-Frank has been a continuance of this faulty reasoning. With more government control over private-company decisions, the economic recovery has been the weakest on record, and even many Democrats agree that insufficient lending to small and medium enterprises — the bread and butter of smaller banks — continues to be a major drag. The effects of the Consumer Financial Protection Bureau, created by Dodd-Frank, have been to drive mortgage lending and other lines of business to government-sponsored lenders and big banks that can afford the compliance burden.

    What should a Dodd-Frank repeal-and-replace effort include? First and foremost, capital requirements should be sufficiently high and immutable. Second, TBTF firms should lose their subsidies. Third, the prohibitions on the Federal Reserve bailouts of insolvent firms should be strengthened and enforced. Fourth, no prudential regulator should have conflicting social objectives. Fifth, the FDIC as insurer should be the primary regulator for all insured institutions and held accountable for protecting its insurance fund. Sixth, proprietary trading and other games of chance should remain in private casinos, not universal TBTF banks.

    The history of government-subsidized health care and financial “reform” efforts provide a lesson on what policymakers should avoid. Hopefully, the Republicans will take heed and restore market competition in the financial services and health insurance industries.

    —-
    Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is an economic and financial consultant and a principal of University Financial Associates LLC.

    Originally published on American Banker.

     

    10 Responses to “Dodd-Frank, Obamacare grew out of same faulty reasoning”

    1. Mrs. Davis Says:

      Dodd-Frank, Obamacare grew out of same faulty reasoning

      Yeah, Deomcrats’. SarBox too. All three have done a lot to kill the economy.

    2. Grurray Says:

      The purpose of Dodd-Frank was to cement the Too Big To Fail banks’ takeover of the econony in a ‘never let a good crisis go to waste’ maneuver. The cover of the financial crisis was the opportunity of the century to finally clear out any regional competition and dissent. It put the fox in charge of the hen house (and my most respectful regards to Sgt Mom and humblest hopes that vileness such as this would never befall your brood).

      The main result is that the victims of the financial crisis, the American people, are being punished for the crimes of the very crooks now sanctioned to run the economy by Dodd-Frank. Hanlon’s razor only explains so much. These people are at war with Americans.

    3. Mike K Says:

      “had always failed due to the expense and “moral hazard” of people taking greater health and/or financial risks”

      There is a long history of moral hazard and I have lived some of it. I was a medical student when Medicare passed and was enacted into law. I saw some behavior by doctors that should have been a warning.

      The best combination would, in my opinion, have been a combination of the big public hospitals for the poor and a free market system for the rest. In the Depression, the LA County hospital, then new, was enough temptation for middle class in distress that doctors derided the hospital to patients in fear of competition.

      Medicaid, in California MediCal, would not pay for care at the County hospital and this resulted in serious deterioration, later compounded by illegals.

      Johnson and the Democrats were determined that everyone would have “mainstream care.” This led to terrible abuses.

      Long story.

    4. PenGun Says:

      Your long experiment with unbridled capitalism has not produced a great result. Please continue with this, as I am interested in how it pans out. I expect pain. ;)

      One could make a case that Trump was elected because of it’s failures.

    5. Mike K Says:

      “Your long experiment with unbridled capitalism ”

      You are keeping me entertained Penny.

      What “long experiment with unbridled capitalism?'”

      You mean the one that ended in 1928 ?

    6. Lexington Green Says:

      If only we really could have a long experiment with unbridled capitalism, in particular where crony businesses were not insulated from competiont and where risks were not socialized while benefits were kept by the insiders.

      The heavily regulated areas of the economy benefit the repeat players: banking, health insurance, education.

      A bracing dose of unbridled capitalism in each of those areas would do wonders.

    7. pointsnfigures Says:

      Yesssss. Can we Flight 93 all Federal Regulation and start with a clean slate?

    8. Grurray Says:

      Our long experiment has been in bureaucratic crony capitalism. It’s the regulations, either unintentionally misguided or intentionally malignant, that cause us to lurch from one crisis to the next. Tyler Cowen writing about Dodd-Frank last fall explained the bill didn’t improve anything and probably made things worse. Bureaucrats can’t foresee what the next problems will be, and they’re dumb solutions cause other problems

      It’s a common economic prescription that regulation should insist that banks carry high levels of capital to withstand losses in bad times. But although Dodd-Frank raised statutory capital requirements, it may have drained banks of some of their true economic capital by regulating and sometimes prohibiting valuable banking activities. The ratio of market price to book value has declined for the biggest banks, and that is one sign of falling values for true economic capital, even though banks have met the letter of law by increasing capital as the regulations specified. Sarin and Summers note that measures of bank capital, as defined by regulators rather than the market, have little predictive power for bank failures.

      The economic crash was a liquidity crisis caused by a weakened banking system, but Dodd-Frank keeps the system weak, or probably weaker considering fewer banks are left, making the system even more vulnerable to illiquidity

      The core problem is this: The franchise value of banks fell after the crisis, which pushed banks closer to insolvency. As recovery proceeded, however, Dodd-Frank pushed down the value of banks once again. If your reaction to this problem is, “Regulation needs to be tougher yet,” that’s going to worsen the dilemma by bringing banks that much closer to insolvency. Maybe it was factors separate from Dodd-Frank, such as lower interest rates, that have had the biggest role in reducing the value of banks. Still, that means regulation isn’t addressing the most significant threats to bank solvency.

    9. dearieme Says:

      It’s often a good move to distinguish capitalism from free markets, just as you might distinguish a republic from a democracy.

    10. ErisGuy Says:

      Too often people look for a man on horseback to use bit and bridle as tools to trample the people.

      Like evolution, which has no General Secretary to master it, nor Zampolit to guide it, I’ll take the people, unbridled.