Regulation did not address the fundamental causes of the crisis

Article Highlights

  • Dodd-Frank is probably responsible for the weak recovery we have had thus far

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  • Dodd-Frank did not address the causes of the financial crisis. Unnecessary regulation can't be good

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  • Fannie Mae and Freddie Mac set the low mortgage underwriting standards that caused the crisis. Dodd-Frank does fails to resolve this.

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Editor's note: The following is from a symposium of views around the question:"Is regulation, or the lack thereof, risking a second great financial crisis?"

The question of whether the Dodd-Frank Act is good or bad is easily resolved once it becomes clear that it did not address the causes of the financial crisis. Unnecessary regulation can’t be good.

By June 2008, before the financial crisis began in earnest, there were more than thirty-two million subprime and otherwise weak mortgages in the U.S. financial system, about 58 percent of the fifty-five million American mortgages then outstanding. Of this thirty-two million, 75 percent were on the books of the U.S. government agencies, principally Fannie Mae and Freddie Mac. This was the result of a set of policies adopted by Congress in 1992, which required Fannie and Freddie, when they bought loans from banks and other originators, to meet a quota of loans that had been made to borrowers at or below the median income of their communities. Between 1992 and 2008, the U.S. Department of Housing and Urban Development increased this quota seven times, from 30 percent in 1992 to 50 percent in 2000 and 56 percent in 2008.

Because it was difficult for Fannie and Freddie to find prime loans among borrowers below the median income, they had to reduce their underwriting standards over this period, accounting for the large number of sub-prime loans on their books in 2008. Fannie and Freddie were the key players in the U.S. housing market, setting the standards for their suppliers—the lenders—in the primary market. For this reason, their underwriting standards, initially intended for low-income borrowers, spread to the wider market. After all, who wouldn’t want a 3 percent or a zero downpayment if it was on offer?

The large sums that Fannie and Freddie were pouring into the housing market over a sixteen-year period, and the leverage their low credit and collateral standards produced, built the largest housing bubble in U.S. history. By 2007, when it began to flatten out, it was about nine times larger than any previous bubble. The sharply rising housing prices in the United States, and the high yields on sub-prime mortgages, attracted investors in the United States and around the world, most apparently believing that “this time it’s different.”

When the bubble finally collapsed, it generated unprecedented numbers of mortgage defaults. Investors fled the market for mortgage-backed securities, and mark-to-market accounting required the financial firms that were holding these instruments to write them down, making these firms look unstable or insolvent. When Lehman was allowed to go bankrupt, a full-scale panic ensued.

The Dodd-Frank Act is probably responsible for the weak recovery we have had thus far. The fact that it didn’t address at all the true causes of the crisis just makes it that much worse.

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