Financial "Reform" thoughts; bubble

I've written a few notes on the housing bubble, but things have changed. We are adopting a financial reform bill which relies on increased discretionary power for regulators, to deal with bubbles and crashes on a case-by-case, company-by-failed-company basis. Broad discretion for case-by-case regulation is the traditional recipe for encouraging regulatory capture, so I'm agin it. Besides that, I have a problem. Our regulators have a really bad track record for interpreting bubbles and crashes. As Matthew Yglesias » The Fed and the Housing Bubble says, Greenspan

essentially spent this period egging the bubble on, touting ARMs, downplaying the possibility of a national bust, etc. Similarly, Ben Bernanke’s 2006 Economic Report of the President specifically considered and rejected the possibility of a housing bubble. The point, to my mind, isn’t merely that these guys were wrong. Nor is it that their wrong analysis led to bad policy. It’s that their wrong statements and absence of accurate ones themselves helped egg the bubble on.

In my mind, at least, our regulators have seriously downgraded credibility. You may want to say their actual impact on the bubble (and crash) was quite small, and I disagree but that disagreement is tentative. If, on the other hand, you want to say that their actions and announcements show them to be trustworthy bubble-crash handlers; in that case I disagree much more strongly and much less tentatively.

Bubbles will happen, but this is how I would limit the next housing bubble: I would define a "standard mortgage", a low-risk mortgage, as requiring the traditional 20% down, and also requiring that the originating bank (or whoever) has contracted to retain a minimum 20% of the mortgage value. Then I would say that Federal financing can't be used to support any non-standard mortgages.

That doesn't rule out 0% down mortgages as totally private transactions, and anyway you could still borrow the 20% down from your parents (or your credit card if you're totally insane). I would just make it a constraint on Federal (or agency) action, e.g. FDIC insurance can only apply to banks which apply these constraints to any mortgages or MBSs or loans to mortgage-holders they may have; similarly, Fannie and Freddie (if they continue to exist) can't touch mortgages which don't have those properties; similarly, the Federal Reserve can only buy mortgage-backed securities based on mortgages respecting these constraints, and so on. It's all about incentives and risk and leverage -- and speculation. Liar loans would be harder because the originating bank would have to hold on to a significant chunk of each. Prices would not rise as fast or as far; we would no longer see mortgages used as rent-with-option-to-buy-if-the-price-goes-up, or at least the taxpayer would not be on the hook for losses if we did. That way, even when a future Greenspan or Bernanke (or Frank, as legislator) makes the stupidly optimistic bubble-encouraging remarks that the past Greenspan and Bernanke and Frank did make, there will be limits on the damage that people can do by following them. And even in a downturn few houses would be underwater, so labor mobility would not be much damaged.

I would do other things too, personally: I would say Fannie and Freddie can't take new business, I would say that no new mortgages shall have interest-deductibility, I would get the government out of the business of having those who own a home subsidized by those who don't, I would stop pushing home-ownership on those who really can't afford it. (I don't think subprime mortgage push does any favors for the recipients.) And so on. But all that is secondary; I would start with the "standard mortgage".

I claim this would work (unless I'm wrong, as usual); I also claim this won't happen because it's more profitable for political contributors to have a complex set of relationships with regulators where the regulators have lots of discretion so that regulatory capture will gradually set in, and then the taxpayers will bail them out on a case-by-case basis because Too Big To Fail is embedded in the legislation. It seems to me that that's what we're getting. The guys who brought us the bubble and crash have won, and we lost.