When President Trump was campaigning, one of his talking points was to “dismantle” Dodd-Frank. And after a couple of weeks in office, it seems that it’s next on his “to do” list. While many are already touting the move as controversial and partisan, the reality is that it’s a bipartisan issue. Even Barney Frank was seen on CNBC this past Sunday admitting that his namesake legislation needs reform (video.cnbc.com/gallery/?video=3000590611). Reforming Dodd-Frank will make housing great again.
Dodd-Frank is the nickname for Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The purpose, as described in its title, was to “To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.”
Dodd-Frank changed the housing industry dramatically. Besides altering the process of financing and buying homes, critics have claimed that the legislation has also restricted lending.
Dodd-Frank created the Consumer Financial Protection Bureau; which creates and enforces rules and regulations for consumer financial markets. Besides adding new home buyer and seller disclosures as well as timelines, the “Know Before You Owe” rule changed the home buying process by creating a new level of bureaucracy embedded within the mortgage lending process.
Many critics of the CFPB also claim that it has too much power with little oversight, and point to last year’s Appellate opinion on PHH Corp v. Consumer Financial Protection Bureau as confirmation for necessary reforms., where Judge Kavanaugh wrote:
“…the Director of the CFPB possesses enormous power over American business, American consumers, and the overall U.S. economy. The Director unilaterally enforces 19 federal consumer protection statutes, covering everything from home finance to student loans to credit cards to banking practices. The Director alone decides what rules to issue; how to enforce, when to enforce, and against whom to enforce the law; and what sanctions and penalties to impose on violators of the law…That combination of power that is massive in scope, concentrated in a single person, and unaccountable to the President triggers the important constitutional question at issue in this case.”
One of the unintended consequences of Dodd-Frank was the restricted lending atmosphere in the mortgage industry. Besides the overwhelming increase in rules and regulations as a result of Dodd-Frank, there has also been insufficient private portfolio and securitization of mortgages; which further limits access of funding to many home buyers.
Prior to the financial crisis, private mortgage securitization was prevalent; which provided a multitude of lending products, including “Alt-A” and subprime. The wide access to private mortgage funding contributed to the homeownership rate to peak close to 70 percent (The most recent homeownership rate reported by the US Census was 63.7 percent, a forty year low). Since the crisis, a majority (estimates were as high as 95 percent) of mortgages are insured or purchased by the government.
Before the financial crisis, Alt-A and subprime mortgages were widely available to give home buyers options to finance their homes, especially when they didn’t fit the underwriting guidelines for a conventional loan. Many of these home buyers were self-employed or small business owners, whose financial picture was outside of the box of the requirements for a conventional mortgage.
Of course, FHA is an alternative to conventional mortgages. FHA has lenient underwriting guidelines, like subprime mortgages; but is insured by the government. However, the upfront and annual mortgage insurance premiums can be hefty. Alt-A and subprime can seem more attractive when purchasing a home beyond the FHA loan limits, and/or when documentation becomes onerous.
Back in 2001, Federal Reserve Board Economist Liz Laderman wrote about the growth of subprime through the 1990’s (Subprime Mortgage Lending and the Capital Markets; FRBSF Economic Letter; December 28, 2001).
“An increase in access to the capital markets through loan securitization also contributed to growth in subprime lending in the 1990s. Securitization is the repackaging, pooling, and reselling of loans to investors as securities. It increases liquidity and funding to an industry both by reducing risk—through pooling—and by more efficiently allocating risk to the investors most willing to bear it. Investors had already become comfortable with securitized prime mortgage loans, and subprime mortgage loans were among various other types of credit, such as multifamily residential mortgage loans, automobile loans, and manufactured home loans, that began to be securitized in the 1990s. Through securitization, the subprime mortgage market strengthened its links with the broader capital markets, thereby increasing the flow of funds into the market and encouraging competition.”
Of course, Dr. Laderman also points out that the increased competition in the subprime market was a concern due to reported abusive lending practices. However, she concluded:
“…subprime mortgage lending grew rapidly in the 1990s to become an important segment of both the home purchase and home equity mortgage markets. Evidence pertaining to securitization and pricing of subprime mortgages also suggests that the subprime market has become well linked with the broader capital markets, an important first step in the development of a fully competitive environment.”
A 2006 article by The Evolution of the Subprime Mortgage Market; Federal Reserve Bank of St. Louis Review; Vol. 88, No. 1) described the history of subprime mortgages. The authors stated:
“..Because of its complicated nature, subprimelending is simultaneously viewed as having greatpromise and great peril…”
Through it’s history, subprime lending has had crises where this lending sector took pauses to reflect on missteps.
Private mortgage funding isn’t entirely Alt-A or subprime mortgages, although there’s a place for responsible Alt-A and subprime lending. Prior to the growth in securitizing these types of mortgages, banks and financial institutions privately held (portfolio) these loans which increased their institutional risk and provided incentive for originating performing loans.
How can Dodd-Frank be reformed? One only has to look back to the S&L crisis of the 1980’s and listen to William K. Black. Black was the Director of Litigation for the Federal Home Loan Bank Board in the aftermath of the S&L crisis. His conclusions included a list of “Lessons not Learned.” The focus of his list was fraud and ethics. Black discussed curbing “control fraud” (fraud perpetrated by CEOs as well as those who are in power) and other types of fraud. He wrote The Best Way to Rob a Bank is to Own One: How Corporate Executives and Politicians Looted the S&L Industry first published in 2005, but was recently updated.
Not surprisingly, Mr. Black reemerged after the financial crisis to provide testimony to Congress, including testimony in 2010 to the Committee on Financial Services United States House of Representatives regarding “Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner.” In a 2010 interview with Bill Moyers (pbs.org/moyers/journal/04232010/transcript1.html), Black discussed CDO’s (collateralized debt obligations), fraud, and their role in the recent crisis. And although many, including the Financial Crisis Inquiry Commission, cited failures in the financial system as cause for the financial crisis; they all fall short in seeing William K. Black’s “control fraud” in action – Fraud was the vehicle that drove the unrelenting greed in the CDO and mortgage markets.
With regard to housing, there is much potential for reform within Dodd-Frank. However, maybe begin with SEC. 941 “Regulation Of Credit Risk Retention” of Dodd-Frank. SEC.941 requires a securitizer of residential mortgages to have skin in the game by retaining some of the risk of any asset or mortgage backed security that is sold, transferred, or conveyed. Additionally, the securitizer is prohibited from hedging or transferring their credit risk. Exceptions to this section include federal programs insuring or guaranteeing mortgages; which includes FHA and VA mortgages, as well as mortgages from institutions supervised by the Farm Credit Administration (including the Federal Agricultural Mortgage Corporation). However, Fannie Mae and Freddie Mac are not exempt.
The President can make housing great again by incentivising private investment in the mortgage industry either through increasing portfolio and/or private securitization in the mortgage markets – along with reducing fraud (and control fraud) while ensuring responsible lending practices. Private investment in mortgage funding will open the doors for many home buyers and increase homeownership rates.
Copyright © Dan Krell
Disclaimer. This article is not intended to provide nor should it be relied upon for legal and financial advice. Readers should not rely solely on the information contained herein, as it does not purport to be comprehensive or render specific advice. Readers should consult with an attorney regarding local real estate laws and customs as they vary by state and jurisdiction. Using this article without permission is a violation of copyright laws.