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Washington Should Reform Itself First

By Barry W. Poulson

In a May 12 Denver Post editorial, “Reforming Wall Street is Essential,” President Barack Obama makes the case for Senator Chris Dodd’s financial reform bill (what the president calls “Wall Street reforms”). The president argues that the financial crisis was caused by irresponsible practices on Wall Street, that the Dodd bill will end too big to fail bailouts of financial institutions and that the cost of this financial market regulation will be paid for by financial institutions, not taxpayers.

But the president’s arguments are based on several myths surrounding both the financial crisis and financial market reform. The financial crisis was not due to irresponsible practices on Wall Street, but rather the result of flawed governmental institutions and financial market policies.

What we really need is some Washington, D.C. reform.

The origin of the financial crisis can be traced to government policies encouraging unqualified borrowers to assume risky mortgages, and to government mandates that financial institutions extend loans to these borrowers. The Federal Housing Authority loosened standards applied in non-prime lending. Through the Community Reinvestment Act, and Department of Housing and Urban Development, the government pressured lending institutions to extend credit to unqualified borrowers.

We must end the myth of affordable housing. As Thomas Sowell has argued, an affordable house is a house you can afford. This means restoring traditional market criteria for mortgage lending: meeting strict income standards to qualify for a loan, and requiring a minimum down payment from creditworthy borrowers.

The financial crisis was exacerbated by the quasi-governmental institutions, Fannie Mae and Freddie Mac. These institutions created a moral hazard by implicitly guaranteeing mortgages. By the time they collapsed in 2008, they together held $5 trillion in mortgages and mortgaged backed securities. They continue to incur billions in losses, requiring government bailouts. The Dodd bill does nothing to reform these institutions.

The solution to this problem is instead to end government conservatorship of Fannie Mae and Freddie Mac, as proposed by Senator John McCain. Over the next decade these institutions would have to liquidate their assets and go into receivership.

The mortgage bubble was also exacerbated by the cheap money policies pursued by the Federal Reserve System under Greenspan. Following the recession in 2001, the Fed reduced the federal funds rate to 1 percent. This easy money policy fueled an unsustainable growth in liquidity, ending in the credit market collapse.

We must end the cheap money policies pursued by the Fed. Discretionary monetary policy should be replaced by a rules based monetary policy, such as that proposed by Stanford University’s John Taylor.

The Dodd bill would greatly expand the resolution authority of the Federal Deposit Insurance Corporation (FDIC). The FDIC would have the discretion to take over financial institutions, using the orderly liquidation fund. In fact, the bill provides for unlimited bailouts of financial institutions. The funding for these bailouts would come from assessments levied on financial institutions. But in reality, American citizens invested in the market would ultimately pay for these bailouts through higher costs on financial transactions and fees levied by these financial institutions.

The FDIC should not be given this greatly expanded power to regulate financial markets because it creates too much uncertainty. What is required is a rules-based, law-based process for dealing with failing financial institutions. Private markets are best at signaling when financial institutions are insolvent or illiquid, and a new bankruptcy code is the best way to address failed financial institutions.

A shorter version of this article originally appeared in the Denver Post on May 23, 2010.