Monday, April 26, 2010

In search of fairy tale regulators

Arnold Kling echoes my skepticism of regulation:
Kevin Drum writes,
From a systemic point of view, the real issue is that predatory lending on a large scale helped to massively inflate the housing/credit bubble of the aughts. If the home loan market had been regulated stringently enough to keep mortgage lending relatively sober, the bubble most likely would have been half the size it ended up at...
Well, yes, if a regulator had stepped in and required 10 percent down payments, the bubble would have been much smaller. That is excellent hindsight. But in the real world, with real politicians, there is no way that a regulator would have done that. The result would have been to drive first-time homebuyers, particularly minorities, out of the market. That was an inconceivable policy decision in 2004 or 2005.

One of the assumptions about the "markets fail, use government" folks is that government always knows what it's doing. I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one.
For the record, I think a regulation requiring larger down payments would be the most effective way of preventing future housing bubbles, but of course none of the politicians want to go down that route. Quite the opposite, they're actively encouraging 3.5% down payments and $8,000 tax credits (which can be used toward the down payment).

Hat tip to an anonymous commenter for the second link.


  1. As of April 19th, your government now requires you to put a 20% down payment toward any rental/investment home purchases and of course for owner-occupied homes you'll still only be required to put down 5%...that is, if YOUR government happens to be the Canadian government.

  2. Skin in the game -- or the lack there of created this mess.

    Home buyers could buy with tiny or zero down payments -- no skin in the game.

    Lenders, loan officers, the ones making the loans were just skimming fees and selling the debt to someone else -- no skin in the game.

    With nothing to lose, what the heck, buy baby buy.


  3. I'm coming around to your opinions on human regulators when you put in automatic rules as a substitute. I still, however, believe that human regulators should have a certain amount of fluctuation power within the rules. If we mandate a percentage of the home's value as down payment, then a human regulator should be able to mandate higher percentages for riskier loans but not lower ones, that way we can at least set those regulations at reasonable levels to be able to get people into homes.

    A person making enough to more than enough to cover mortgage payments but hasn't had the opportunity to save for the down payment shouldn't be locked out of home ownership, but somebody just barely making enough who wants a home can be made to put more down initially.

  4. Look, its politically difficult to get politicians to do anything. But that's not reason to poo-poo people who point out what effective policy should look like, as Kling seems to do. Its a cop out equivalent to "well, that looks hard so lets do nothing". And saying "I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one" is just stupid. There are clear fundamental financial issues which allow large bubbles and we know what they are. Many knew what they were before the recent crisis. These include excessive leverage (by individuals with too little skin in the mortgage game and investment banks investing in CDOs), ratings agencies being paid by those selling securities, excessive short term profit incentives for players at all levels, fraud, lack of transparency in the shadow banking system etc etc. These are systemic problems which we can fix.

    Now, unfortunately, the current financial reform bill doesn't solve many of these problems. I agree that regulators aren't likely to recognize (or at least have the balls to stop) a bubble in progress. So we need hard rules on things like down payment size, leverage ratios, open exchanges for derivatives. Laws and procedures that act automatically to inhibit bubbles and risk. These things may not happen, but educated voices should be pushing for them instead of dismissing them.

  5. I just really disagree with the premise that larger downpayments are necessary to curb future bubbles. Weather a borrower puts $1K or $10K of their own money into a deal has little impact on wheather or not they are going to pay the mortgage if times get tough. I'm in the industry on the front lines. What's needed is quite simply effective underwriting and less expansion of debt to income ratios. An effective balance needs to be struck between curbing undue price escalation and supporting a vibrant market. Keeping downpayment requirements low for otherwise well qualified borrowers will support a healthy housing market while it will not fuel unwarranted price escalation as long as these borrowers can TRULY AFFORD the monthly payment. It is much more important in my view to require a certain level of cash reserves than it is to require a large downpayment.