Dodd-Frank: Solving a government-created problem with more bad government

Peter Wallison of the American Enterprise Institute explains in Hillsdale College’s Imprimis why the Dodd-Frank financial reform legislation represented the wrong response to the 2008 financial crisis.

… [T]he crisis was not caused by insufficient regulation, let alone by an inherently unstable financial system. It was caused by government housing policies that forced the dominant factors in the trillion dollar housing market—Fannie Mae and Freddie Mac—to reduce their underwriting standards. These lax standards then spread to the wider market, creating an enormous bubble and a financial system in which well more than half of all mortgages were subprime or otherwise weak. When the bubble deflated, these mortgages failed in unprecedented numbers, driving down housing values and the values of mortgage-backed securities on the balance sheets of financial institutions. With these institutions looking unstable and possibly insolvent, a full-scale financial panic ensued when Lehman Brothers, a large financial firm, failed.

Given these facts, further regulation of the financial system through the Dodd-Frank Act was a disastrously wrong response. The vast new regulatory restrictions in the act have created uncertainty and sapped the appetite for risk-taking that had once made the U.S. financial system the largest and most successful in the world.

What, then, should have been done? The answer is a thorough reorientation of the U.S. housing finance system away from the kind of government control that makes it hostage to narrow political imperatives—that is, providing benefits to constituents—rather than responsive to the competition and efficiency imperatives of a market system. This does not mean that we should have no regulation. What it means is that we should have only regulation that is necessary when the self-correcting elements in a market system fail. We can see exactly that kind of failure in the effect of a bubble on housing prices. A bubble energizes itself by reducing defaults as prices rise. This sends the wrong signal to investors: Instead of increasing risk, they tend to see increasing opportunity. They know that in the past there have been painful bubble deflations in housing, but it is human nature to believe that “this time it’s different.” Requiring that only high quality mortgages are eligible for securitization would be the kind of limited regulatory intervention that addresses the real problem, not the smothering regulation in Dodd-Frank that depresses economic growth.

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