Download BankThink Dodd-Frank, Obamacare grew out of same faulty reasoning

BankThink Dodd-Frank, Obamacare grew out of
same faulty reasoning
By Kevin Villani
March 03 2017
The current partisan war over the Dodd-Frank Act is just one dispute in a broader ideological divide about the
government’s role in industry. This dispute, which has deep historical roots, includes a similar battle over
Obamacare. The common disagreement at issue with both laws — now in the cross hairs of a GOP-controlled
Washington — is the extent to which politicians should subsidize their constituents indirectly through
regulation of private companies.
The Affordable Care Act governing health insurers was about 1,000 pages, and Dodd-Frank governing most
other financial institutions was more than twice that. Both stopped short of nationalizing their respective
industry, instead generating more than 10 pages of regulation for every one page of legislation, although many
view nationalization as an eventual but inevitable consequence, particularly for health care.
The distinction between public control and public ownership is the primary distinction between the competing
mid-20th-century ideologies of fascism and communism. In contemporary terminology, this distinction is
between crony capitalism and nationalization, neither of which can be reconciled with competition and freedom
of choice.
The Affordable Care Act, signed into law March 2010, along with Dodd-Frank are examples of how the government
subsidizes consumers through regulation to the detriment of market choice and competition. Bloomberg News
The serious threats to market competition in the U.S. came well after World War II. In the 1960s, the U.S. had
the most competitive financial system globally, a higher rate of homeownership than at present and the best
medical care. National health insurance was a high school debating topic, implemented by many western
democracies in the wake of the devastation of World War II. Many nations also nationalized other industries.
But the U.S. took a different approach, attempting to maintain the benefits of private ownership and
competition. Most consumer-oriented firms — savings and loans, health and life insurers — were mutually
owned, eliminating conflicts among stakeholders. Commercial bank shareholders and management were
restrained by competition and market discipline. Health and homeowner subsidies were provided directly to the
needy.
The first major exception was the introduction of federal deposit insurance to protect “small savers” during the
Great Depression, requiring sufficiently prudential regulation to prevent moral hazard, i.e., excessive risk-
taking. But public insurance schemes fail (as all state deposit insurance systems have failed) where private
schemes succeed because politicians sometimes excessively favor constituent customers, e.g., savers, borrowers
or the insured, over shareholders or taxpayers. There are only a few ways financial institutions can respond to
policies favoring politically designated customers. First, those with monopoly power can cross-subsidize —
charge some borrowers more to cover the added costs of favoring others. Second, they can take on more risk in
the hope of greater returns.
These perverse incentives saw their heyday in the 1990s and leading up to the financial crisis. Under the Clinton
administration, the 1995 National Homeownership Strategy promised homeownership to millions of households
that had neither the traditional down payment nor sources of sufficient income, without budgeting explicit
subsidies. But the subsidies were there. The costs of lower interest rates were offset by employing extreme
leverage facilitated by deposit insurance — thereby increasing public risk in the interest of private profit for
money-center banks — and by the implicit government backing of Fannie Mae and Freddie Mac.
At the peak of this policy’s effect, the combined unbudgeted tax and insurance subsidies for the insured banks
were in the tens of billions of dollars annually (and the same for Fannie and Freddie). This and other policies
like it were guaranteed to fail, requiring a bailout.
Obamacare took a similar view of the role of government subsidies. The ACA promised to maintain or improve
health care while making coverage universal. Past political attempts to do this had always failed due to the
expense and “moral hazard” of people taking greater health and/or financial risks. The ACA ignored or glossed
over these concerns, mandating participation at multiples of a competitive market premium to generate
sufficient cross subsidies and expensive coverage not paid for by the beneficiaries by fixing prices across all
risk classes.
Authors of the law simultaneously avoided the major source of increasing costs by deferring reform of medical
malpractice torts, saying it was politically unpalatable. Knowing in advance that premiums would skyrocket
after enactment of the law, the law’s proponents incorporated a bailout scheme into the ACA. The big health
insurers became essentially “too big to fail” or dropped out of the system. Most of the smaller nonprofit insurers
failed.
To be clear, this is not “free” national health insurance, which would obviously lead to huge taxpayer expense
for what would be a lower-quality product. But the alternative of crony capitalism is worse than budgeted
subsidies because it massively undermines market competition and freedom of choice while imposing greater
costs on the public.
The solutions for health insurance and financial services are the same: either bite the bullet and nationalize, or
restore competitive markets. Democrats tried to get the former for health insurance, but failed. Meanwhile,
commercial banks were temporarily “nationalized” — forced to issue shares to the government during the crisis.
Well before Dodd-Frank, there are plenty of examples of past banking reform efforts that resulted in horrible
incentives. The 1989 Financial Institutions Reform, Recovery and Enforcement Act promised to end the
systemic (political) risk of mortgage lending, but exacerbated it by bringing the banking and mortgage lending
systems closer together.
The 1994 Riegle-Neal Act allowed banks to branch and merge across state lines. But by limiting interstate
approval to banks with high Community Reinvestment Act ratings, the law indirectly induced commercial
banks to allocate more credit; making more loans was a road map to branching out across state lines. Public
disclosure of CRA ratings empowered community action groups to extract $4 trillion in commitments. Fannie
and Freddie’s regulator issued a directive to the same end. Underwriting guidelines and down payment
requirements were weakened.
The Gramm-Leach-Bliley Act of 1999 that repealed the Depression-era Glass-Steagall Act separating
commercial from investment banking should have strengthened TBTF banks. But by then all the conservative
investment banking partnerships had been converted to corporate casinos gambling for their own account. The
riskiest tranches of mortgage securities were their most speculative bet.
Sufficiently high capital requirements would have prevented a bubble from developing, but the congressional
committees responsible for the safety of the financial system rejected higher capital requirements explicitly to
help homeowners. When the resulting bubble was finally burst in 2008, the deferred default costs caused a
global financial crisis and recession. After millions of households suffered foreclosure, the U.S. homeownership
rate has returned to the level prior to the Clinton housing initiative, but the financial system and economic
recovery remain fragile.
Indeed, Dodd-Frank has been a continuance of this faulty reasoning. With more government control over
private-company decisions, the economic recovery has been the weakest on record, and even many Democrats
agree that insufficient lending to small and medium enterprises — the bread and butter of smaller banks —
continues to be a major drag. The effects of the Consumer Financial Protection Bureau, created by Dodd-Frank,
have been to drive mortgage lending and other lines of business to government-sponsored lenders and big banks
that can afford the compliance burden.
What should a Dodd-Frank repeal-and-replace effort include? First and foremost, capital requirements should
be sufficiently high and immutable. Second, TBTF firms should lose their subsidies. Third, the prohibitions on
the Federal Reserve bailouts of insolvent firms should be strengthened and enforced. Fourth, no prudential
regulator should have conflicting social objectives. Fifth, the FDIC as insurer should be the primary regulator
for all insured institutions and held accountable for protecting its insurance fund. Sixth, proprietary trading and
other games of chance should remain in private casinos, not universal TBTF banks.
The history of government-subsidized health care and financial “reform” efforts provide a lesson on what
policymakers should avoid. Hopefully, the Republicans will take heed and restore market competition in the
financial services and health insurance industries.
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is an economic and financial consultant and
a principal of University Financial Associates LLC.