Too Big To Fail?

Rep. Ed Royce (R-Calif.), and James Gattuso, senior research fellow at the Heritage Foundation, discussed the pitfalls in Connecticut Sen. Chris Dodd’s (pdf) financial regulatory reform bill during the Tuesday, April 27, Bloggers Briefing in Washington D.C.

As of Wednesday, Dodd, the Chairman of the Senate Banking Committee, and Richard Shelby (R-Ala.) the ranking Republican on the Banking Committee, agreed to take the debate of the bill to the Senate floor on Thursday, after Republicans won what concessions they could get from the Democrats. Among them, the removal of the $50 billion bailout fund for large financial institutions.

Royce, a member of the House Financial Services Committee, said that for much of his tenure, he’s had a running battle with the majority of the members on the committee over  the question of “whether or not we should have the kind of government intervention in the marketplace that increases moral hazard and that removes market discipline.” He believes that the government’s use of Fannie Mae and Freddie Mac as government sponsored enterprises was one of the causes of the recent financial crisis.

In 1992, Congress passed the Federal Housing Enterprise Financial Safety and Soundness Act (GSE Act) that gave Fannie Mae and Freddie Mac incentives to give loans to people who could not make any down payment on a house, would not qualify for a home loan, or who would be considered to be a high credit risk, in order to improve access to affordable housing to low- and moderate-income families.

“The GSE Act calls on Fannie Mae and Freddie Mac [the two largest GSEs] to devote a large share of their business (a combined $1.5 trillion in mortgage assets purchased in 2007), to ‘underserved’ groups,” Neil Bhutta, an economist at the Federal Reserve said in his 2009 published analysis, GSE Activity and Mortgage Supply in Lower-Income and Minority Neighborhoods: The Effect of Affordable Housing Goals.   

Royce said that “in that act, Congress put certain mandates on the GSEs and established certain goals that had to be achieved. Ultimately, those goals led to the GSEs over leveraging at a rate of 100-to-1, and building up a portfolio of $1.5 trillion in mortgage backed securities that they carried. One half of that portfolio was in subprime and Alt-A loans. That was by design; that was an attempt by Congress in order to get the public into housing.

“The Federal Reserve came to the Congress in 2003-2004, and they were concerned about the systemic risk that this posed to the financial system, globally, because there was the possibility of losing $1 trillion in the housing market.

“Politicians had muscled the system so that we had gone from a traditionally 20 percent down, to 3 percent down, and ultimately, 0 percent down on loans; and we had created a market for Countrywide and other forms of junk mortgages. Since one half of the mortgage portfolio held by the GSEs had to be in the subprime and Alt-A loans, we were in fact creating this market.

“But Congress was doing something else equally damaging,” he added. “By creating a dualopoly, by giving Fannie Mae and Freddie Mac the implied support of the government, the implied government backstop, and the implied bailout, they sent a message to the market; and so the cost of capital for the GSEs was lower than their competition. They [Fannie Mae, Freddie Mac] were able to push their competition out of business. They were able to leverage much more than any private institution would have been able to leverage. The upshot was that we lost $1 trillion in the housing market; this is where the collapse began.”

During an interview with Don Irvine, chairman of Accuracy In Media, Royce elaborated on his concerns about the Dodd bill.

“ …what we’re doing here is a permanent bailout authority, as one of my Democratic colleagues refers to this legislation. And I think the consequences of that is to increase the amount of moral hazard, as the economists tell us, and sort-of guarantee additional problems that are going to come as a result of giving this government the right to decide which firms are too big to fail and which are too small to save.

“By having the government so designate a firm, or having the power to do that, the difference in the competitive advantage is that your cost of capital is going to be about 1 percent less if you manage to be too big to fail. And so you’ll be able to do what Fannie Mae and Freddie Mac did against their competition, when they had that implied government backstop, they were able to force them out of business, because their cost of capital was so much lower, and their cost of borrowing was so much lower. We’ve allowed the government to not only pick winners and losers in this, but in the future, if a firm goes down, the government can decide which creditors are paid off.”

Gattuso, a senior research fellow in Regulatory Policy in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation, spoke to Irvine about his recently published web memo on financial markets, Senator Dodd’s Regulation Plan: 14 Fatal Flaws.

One of the many problems Gattuso found in Dodd’s bill is that it contains a provision to create a new Bureau of Consumer Financial Protection that he believes will “limit credit availability [to consumers] and their ability to get the financial services they want. Rather than consumer protection, it actually is consumer limitation,” he said.

Gattuso highlights the fact that “the bill would give the government resolution authority to shut down firms it believes are failing, and will be able do so with limited judicial review.”

The memo also cites provisions in the bill that would, “No. 9, enriching trial lawyers by authorizing consumer regulators to ban arbitration agreements [thus] reducing the use of streamlined dispute resolution procedures, more consumers and businesses would be forced to pay the costs of litigation—to the benefit of trial lawyers; and No. 13, allow activist groups to use the corporate governance process for issues unrelated to the corporation or its shareholders.”

In regard to GSEs, he said that the bill “essentially ignores the role Fannie Mae and Freddie Mac played in the financial crisis, and the massive bailout they received from taxpayers.”

Melissa Barnhart is an intern at the American Journalism Center, a training program run by Accuracy in Media and Accuracy in Academia.