Monday, January 02, 2012

Lesson of the Financial Crisis: Too Many "Dumb" Regulations. We Need "Smarter," Not More Regs

University of Chicago libertarian-leaning finance professor John Cochrane is now blogging at The Grumpy Economist, here's an excerpt from his excellent post today
I am often asked, "doesn't the financial crisis mean we need more regulation?" It's one of those maddening questions, because the answer is "that's the wrong question," which gets you nowhere.

For regulation is not "more" or "less," something you just pour into a cup until you've had enough like a good beer. Regulation is most of all "smart" or "dumb." Dumb regulations produce the opposite of their intended effects, have all sorts of unintended consequences, or get used for fully intended but pernicious consequences like driving out competition. Smart regulations don't.

The main lesson of the financial crisis is not that we did not have "enough" regulations -- we had hundreds of thousands of pages of regulation. The lesson of the financial crisis is that most of those were "dumb" regulations. Their massive unintended consequences led to a fragile financial structure. Yes, we need financial regulation, but "smarter," not necessarily more."
MP: For examples of "smarter" financial and banking regulations, we can look north to our Canadian neighbor.  While our historically fragile banking system lead to 9,000 bank failures during the Great Depression, about 3,000 bank failures during the S&L crisis, and 427 bank failures from 2008-2011 from the "Great Recession," Canada experienced almost no bank failures during any OF those periods.  What's so "smart" about Canada's regulations that allowed it to avoid the thousands of bank failures that occurred in the U.S.?
 
1. Canada never restricted branch banking the way the U.S. did until 1994.  By forcing banks to operate in a single state, they were forced to generally be small and non-diversified in their loan portfolios.  This was an especially important factor in the 9,000 U.S. bank failures during the 1930s when Canada had none.   
 
2. Canada's underwriting standards for home mortgage lending are much more conservative than the U.S. and capital requirements for banks are much higher.
 
3. Canada doesn't have an equivalent to our GEE-sponsored secondary mortgage market (no Fannie or Freddie), so the Canadian banks that originate home mortgages typically keep most of those loans on their own balance sheets, which is another factor that keeps underwriting standards much more conservative than in the U.S. In the U.S. there's more of an incentive to originate mortgages and then sell them in the secondary market, which then allows the banks to lend more.

4. Mortgages in Canada are full recourse loans, meaning that the homeowner/borrower is responsible for their mortgage debt even if they lose their home through foreclosure.  In most U.S. states, homeowners can live in their home for several years or more without making payments, walk away following foreclosure, and then are not held responsible for the deficiency.  Not so in Canada.  The banks there will follow you forever, and even garnish your wages.  
 
5. Most mortgages in Canada generally require a 20% down payment, and there are no 30-year fixed rate mortgages.  Canadian banks will issue 25-year or 30-year mortages, but interest rates are adjusted every five years, like a 5-year ARM. If a borrower in Canada can't come up with the 20% down payment, they have to purchase mortgage insurance from a private insurance company and pay the full premium up front.  And the private mortgage insurance company has to approve the property appraisal before the deal can go through.  
 
Related: See my article "Due North: Canada's Marvelous Mortgage and Banking System."   

27 Comments:

At 1/02/2012 6:58 PM, Blogger PeakTrader said...

When regulations benefit banks at the expense of homeowners, then of course banks will be stronger.

 
At 1/02/2012 7:01 PM, Blogger Mark J. Perry said...

When regulations benefits borrowers at the expense of banks, then of course you can expect a fragile banking system, thousands of bank failures, recurring financial/banking crises, recessions, depressions, etc.

 
At 1/02/2012 7:06 PM, Blogger PeakTrader said...

In 2006, the average square footage of a U.S. house was about 2,500 square feet and the average footage of a Canadian house was around 1,800 square feet.

 
At 1/02/2012 7:10 PM, Blogger Mark J. Perry said...

Even with its pro-lender regulations, Canada's homeownerhip rate is actually higher than the U.S.

 
At 1/02/2012 7:15 PM, Blogger Mark J. Perry said...

Peak: That's just more evidence of American "excess" due to "dumb" regulations that encouraged unsustainable, excessive rates of home ownership, and excessive "size."

 
At 1/02/2012 7:16 PM, Blogger randian said...

I believe you meant to say "Mortgages in Canada are full-recourse loans".

It should be pointed out that whether a mortgage is non-recourse in the US is state-specific. It is often said that California is one of them, but that's only for purchase-money mortgages, and only for non-judicial foreclosures. A California lender can enforce a deficiency judgment, but because judicial foreclosures take more time and cost more money lenders generally do not bother.

 
At 1/02/2012 7:17 PM, Blogger PeakTrader said...

The U.S. homeownership rate was higher when the housing market peaked in 2006, and Canada's homeownership rate is only slightly higher today, even after years of deep depression in the U.S. housing market.

 
At 1/02/2012 7:21 PM, Blogger PeakTrader said...

Dr. Perry, it's a bubble only if it bursts.

The U.S. housing boom lasted over 10 years, from 1995-06, and it didn't have to collapse.

 
At 1/02/2012 7:34 PM, Blogger Mark J. Perry said...

I think the bank failure statistics speak for themselves. USA: more than 12,000. Canada: Zero (or very close to zero).

 
At 1/02/2012 7:43 PM, Blogger PeakTrader said...

That's what happens after government fails to slow a housing boom (in 2004), tips the country into a severe recession (in 2008), and implements weak and expensive stimulus policies (from 2009 to today).

 
At 1/02/2012 7:56 PM, Blogger Craig said...

When regulations benefit banks at the expense of homeowners, then of course banks will be stronger.

But Canadian regulations most certainly do not benefit the banks at the expense of homeowners. Homeowners have absolutely nothing to do with banking regulations.

It's people who are attempting to buy homes with money borrowed from the bank who are regulated.

 
At 1/02/2012 8:00 PM, Blogger PeakTrader said...

Craig, if banks don't benefit lending for smaller houses, and homebuyers don't benefit for borrowing for smaller houses, then who does?

 
At 1/02/2012 8:08 PM, Blogger Larry G said...

anyone have a comment on this:

" The Commodity Futures Modernization Act of 2000 (CFMA) is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton. It clarified the law so that most over-the-counter (OTC) derivatives transactions between “sophisticated parties” would not be regulated as “futures” under the Commodity Exchange Act of 1936 (CEA) or as “securities” under the federal securities laws."

http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

 
At 1/02/2012 8:09 PM, Blogger Larry G said...

This comment has been removed by the author.

 
At 1/02/2012 9:44 PM, Blogger Ed R said...

Canada only has 5 banks of any significance; and, yes, they are held to higher capital requirements than those of the USA. There were many small Canadian banks in in the 1800's and early 1900's. Some did get into trouble but they were merged into the (eventual)'Big 5'.

There were no Canadian bank runs -- and therefore no bank failures -- during the Great Depression because Canada had gone off gold convertibility (to a true fiat currency) in early 1929 before fears of currency devaluations swept the financial world in the early 30's.

The above reasons may not fit well with the Austrian view of economics but they do explain why Canada has had a more stable banking system -- less competition and more flexible currency.

 
At 1/03/2012 1:42 AM, Blogger Expected Optimism said...

A lack of failing companies in an industry isn't necessarily a sign of a healthy industry. I'm not sure if it's still true, but in 2009, the Canadian government became the world's largest holder of subprime mortgages. When just five banks have a combined market share of over 90%, "too big to fail" takes on a whole new meaning.

Moreover, anyone who believes in Schumpeterian creative destruction should be worried about an industry with zero failures.

 
At 1/03/2012 2:58 AM, OpenID johnberkowitz said...

Even I agree with you division on good and bad regulations, I disagree about the Canada as a good example of country where it works. Canadian and US mortgage markets are completely different models. US government was not the main cause of the subprime crisis, but with bad regulation/deregulation, it didn´t protect us enough. Canada was not affected that much, but right now, their own bubble is becoming a serious problem.

 
At 1/03/2012 3:20 AM, Blogger PeakTrader said...

Johnberkowitz, the financial crisis was caused by a giant government unfunded social program that the government assumed it didn't have to fund.

It created so much "moral hazard" that the entire U.S. financial system was on the verge of collapse:

What Caused the Financial Crisis
November 16, 2010

"Starting in the late 1990s, the government, as a social policy to boost homeownership, required Fannie Mae and Freddie Mac to acquire increasing numbers of "affordable" housing loans. (An "affordable loan" is made to people who normally would not qualify.)

By 2007, 55 percent of all loans made by Fannie and Freddie had to be "affordable." By June 2008, there were 27 million subprime housing loans outstanding (19.2 million of them directly owed by government or government-sponsored agencies), with an unpaid principal amount of $4.6 trillion."

"What we know is that almost 50 percent of all mortgages outstanding in the United States in 2008 were subprime or otherwise deficient and high-risk loans.

The fact that two-thirds of these mortgages were on the balance sheets of government agencies, or firms required to buy them by government regulations, is irrefutable evidence that the government's housing policies were responsible for most of the weak mortgages that became delinquent and defaulted in unprecedented numbers when the housing bubble collapsed.

The tragedy is that the financial crisis continues because Congress misdiagnosed the problem and came up with a 2,000-page "solution" that will only make matters worse."

******

Bush Administration Tried to Reform Freddie and Fannie Five Years Ago
CBS News
February 19, 2009

Karl Rove, “We were briefed as far back as 2001 about the problems with Fannie and Freddie; in fact, we moved aggressively in 2004 to regulate Fannie and Freddie, actually got a bill through the Senate Banking and Finance Committee only to have it filibustered by [Sen.] Chris Dodd.”

Rove said Fannie Mae and Freddie Mac “accelerated their imprudent behavior after we attempted to regulate them. They bought almost as much mortgage debt from 2005 through 2008” as they bought in their first 30 years of their existence.

“In fact, in 2003, when we sent our first members of the Cabinet up to talk about this on Capitol Hill, Barney Frank had a hearing in which they basically beat up everybody we sent up there in pretty vociferous language.

 
At 1/03/2012 12:24 PM, Blogger Hydra said...

We Need "Smarter," Not More Regs

=================================

I imagine that if we had smarter regs, there would be more demand for more of them.

Thats why I have proposed writing more regs that have feedback mechanisms built into them: think of market based regulations as one way to have smarter regs.

 
At 1/03/2012 12:26 PM, Blogger Hydra said...

In 2006, the average square footage of a U.S. house was about 2,500 square feet and the average footage of a Canadian house was around 1,800 square feet.

================================

might have something to do with heating costs in Canada. I suspect you find US homes in New England and Wisconsin run smaller than averge, too.

 
At 1/03/2012 12:28 PM, Blogger Hydra said...

Canada's homeownership rate is only slightly higher today,

================================

And the average age of canadian homeowners is much higher, meaning they have less time for the (somewhat marginal) benefits of home ownership to accrue.

 
At 1/03/2012 7:45 PM, Blogger VangelV said...

What's so "smart" about Canada's regulations that allowed it to avoid the thousands of bank failures that occurred in the U.S.?

You missed one important fact about the Great Depression. There was no Canadian central bank to create a massive inflationary boom during the 1920s as there was in the US. Since there was not as much irrational exuberance and since there was geographical diversification in Canada, the bust was much more manageable.

 
At 1/03/2012 9:42 PM, Blogger Jon Murphy said...

Kind of to your point, Prof. Perry is the fact that Canada doesn't have a securities regulatory body like WE DO (The SEC). In that case, it's clearly not the amount of regulations but the quality.

 
At 1/03/2012 10:15 PM, Blogger PeakTrader said...

Hydra says: (much smaller houses in Canada) "might have something to do with heating costs in Canada. I suspect you find US homes in New England and Wisconsin run smaller than averge, too."

You'd think Canada would have large houses from all that space (almost the entire U.S. housing boom from 1995-06 took place in new neighborhoods and the expansion of newer neighborhoods):

10 states with the biggest houses
October 27, 2011

Six of the 10 states with the biggest homes are in the West, based on the median square footage of homes for sale on Realtor.com in September.

The six Western states among the top 10 with the largest homes are: Utah, Colorado, Wyoming, Montana, Idaho and Washington. Three of the states are in the South: Texas, Georgia and Maryland. One Midwest state is on the top 10 list: South Dakota.

 
At 1/03/2012 10:26 PM, Blogger PeakTrader said...

And, it should be noted, "the subprime crisis" was not only caused by low income earners buying houses they couldn't really afford, but also by higher income earners buying more expensive houses they couldn't really afford.

 
At 1/03/2012 10:31 PM, Blogger PeakTrader said...

It's more accurate to say "homebuilding boom" than "housing boom:"

"Almost the entire U.S. housing boom from 1995-06 took place in new neighborhoods and the expansion of newer neighborhoods."

 
At 1/04/2012 6:08 PM, Blogger Hydra said...

Utah, Colorado, Wyoming, Montana, Idaho

==============================

Pretty much blows my theory about heating bills.

 

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