The flawed Dodd-Frank bill was the legislation that arose from the 2008 financial crash and the ensuing recession. This new banking bill comes at an interesting time for Southern California’s economy. The region’s housing market is hitting record-high prices in many areas, meaning prices are back at, or near, their bubble peaks of 2006 and 2007. “The median home price – or price at the midpoint of all 2017 sales — hit $492,000 in Southern California,” the Orange County Register reported.

The state’s unemployment rate is at its lowest point in decades — 4.3 in California in December 2017, with even lower unemployment numbers in Los Angeles County, 4.2 percent, and Orange County, 2.8 percent.

And, of course, the stock market spent much of the last year booming. In this potentially bubbly economic environment, bond investors are looking to rating agencies to warn of possible trouble ahead. But the big three dominant rating agencies continue to suffer from the same conflicts of interest they had during the last financial meltdown.

Credit rating agencies still rely primarily upon an issuer-pays business model, which means banks seeking to issue debt securities pay the rating agencies to evaluate their bonds. The credit rating agencies have financial incentives to give the bond issuers whatever rating they want. The Dodd-Frank financial reforms were supposed to fix this problem but the issuer-pays model remains in place and the U.S. economy remains vulnerable to systemic credit rating errors.

Similarly, Dodd-Frank identified another problem – government agencies using credit ratings in regulations.  Taking rating assessments from private rating agencies and putting them into government regulations gives the opinions of these for-profit companies significant regulatory power that they can monetize.  Congress should insist that regulators complete, and then maintain, the full separation between ratings and regulations that were called for in Dodd-Frank.

This is also an opportunity to encourage innovation in the credit rating industry. Today it is extremely difficult for new companies to enter the ratings market. The Securities and Exchange Commission has set up rules that protect the entrenched interests of existing rating agencies and make it nearly impossible for new companies to compete in the industry. More competition could spur analytical advancements that the status quo is preventing.  The rating agencies have no need to evolve or improve their quality, but with today’s abundant and inexpensive computing power, new credit rating agencies could quickly gather data, analyze large volumes of securities, and potentially develop innovative ways of evaluating financial risks.

The federal government could further lower the cost of entering the credit rating business by updating its archaic systems and migrating financial filings from PDFs to “machine-readable” data formats. Consumers of financial disclosures, such as rating agencies, would have access to large data sets at little or no cost. This reform could be accomplished by the passage of a financial transparency bill sponsored by Rep. Darrell Issa, R-Vista.

By fully divorcing credit ratings from regulations, and then lowering the cost of entering the credit rating business, Congress could reduce the risk that bad credit ratings pose to the financial system and economy.

Adding new voices to the credit rating industry — ideally, voices freed from the conflicts inherent in the issuer-pays model — would increase the chances that investors receive accurate credit analysis, helping avoid the traps of the opaque, poorly understood, toxic debt securities that hammered the economy and home values in 2007. Hopefully, lawmakers don’t need another global financial crisis to finally fix the credit rating system.

This column first appeared in the Orange County Register

The post As housing and stock markets boom, has Congress learned from the last crash? appeared first on Reason Foundation.

The payday lending industry’s success has been accompanied by a backlash from politicians, consumer groups and many journalists who accuse the industry of taking advantage of vulnerable individuals and targeting certain populations in order to extract their wealth. The result is that regulation of payday lending has grown almost as fast as the industry itself.

The industry responds to its critics by saying that it provides a needed service to people underserved by banks and credit unions, allowing them access to credit they would not otherwise have so that they may make it through periods of financial difficulty. Who is right? On closer inspection, many of the criticisms of the payday lending industry turn out to be based on myths:

• Payday Lending Myth #1: Excessive Fees. Critics note that typical payday loan fees range from $15 to $30 per $100 loaned over a two-week term. If one were to project the costs out over a one-year period, would translate to an APR of 390 percent to 780 percent. However, it simply does not make sense to project payday loans out over a whole year when they are intended to be repaid in two weeks. What’s more, the short-term alternatives to payday loans – like overdrafts, bounced checks, late credit card payments, and utility reconnect fees – will often prove even more costly.
• Payday Lending Myth #2: The Debt Trap. Critics charge that payday lending companies trap their customers in a cycle of debt. This is contradicted by empirical evidence, however, which suggests that payday lending bans result in worse outcomes for consumers – in the form of more bounced checks, increased rates of bankruptcy, and so on. Ultimately, the debt cycle theory seems to get the causality of payday lending behavior backwards: people use payday loan services because they face financial emergencies, not the other way around.
• Payday Lending Myth #3: Lenders Target the Poor and Minorities. The evidence suggests that while payday lenders are more likely to locate in markets with relatively low household incomes, they are not more likely (after controlling for income) to locate in markets with disproportionate minority populations. To the extent that payday lenders do aim their services at those with low incomes, this may be: (a) an effort to tap an underserved market; and (b) a reflection of the fact that payday customers tend to be those in financial distress. In other words, there is a greater need and natural customer base for payday lending in relatively low income areas.
• Payday Lending Myth #4: Most Consumers Want More Protection from Payday Lenders. Survey data suggests that a significant majority of payday lending customers are satisfied with the service they receive. Meanwhile, state regulators report very few complaints about payday lenders.

Moreover, the evidence shows that payday lending offers many benefits to consumers:

• Greater Consumer Welfare. Payday loans allow consumers to better weather short-term financial difficulties, avoid bankruptcies and bounce fewer checks.
• Increased Access to Credit. Payday loans offer access to credit to those who might not be able to obtain it from other sources such as banks, credit unions or credit cards.
• Transparency. Payday loan terms are displayed prominently in stores for all to see, so customers do not have to parse hundreds of pages of legalese in bank/checking account terms to determine how much the fees will be and when and how they will be assessed.
• Cost. Payday loans frequently offer cheaper rates and better terms than alternate options, such as bank overdraft/bounced check fees, credit card late fees, utility late/reconnect fees, pawn shops, auto title lenders and rent-to-own businesses.
• Better Than Alternatives. Payday loans may be preferable for other reasons, such as allowing borrowers to avoid skipping medical visits, having utilities shut off, resorting to dangerous loan sharks, or enduring embarrassment and potential conflict from borrowing from friends or relatives.

Ultimately, consumers have already rendered their verdict: they believe they benefit from the option of payday loans. So instead of restricting or eliminating payday lending markets through regulation, policymakers should seek to open them up to competition by repealing payday lending bans and regulations. The goal should be to maximize consumer choice and minimize the cost of short-term loan transactions. This will benefit economic growth generally and short-term borrowers in particular.

The post Payday Lending: Protecting or Harming Consumers? appeared first on Reason Foundation.

The brief shows that Sallie Mae has used its political influence to build and maintain its profitability in spite of the financial crisis and throughout numerous attempts to reform the industry. It has used this influence recently to secure massive servicing contracts from the expanded Direct Loan Program, acquire a multi-billion dollar bailout of the student loan industry, and to procure the removal of significant debtor protections from privately issued student loans, of which the company is the largest originator.

The resulting situation is unfair to students and taxpayers alike: students end up paying higher college tuition fees and are saddled with more debt; taxpayers are left sitting on a ticking time bomb of accumulated government-backed debt. When the student loan bubble bursts and Uncle Sam is called upon to bail out Sallie Mae, the cost could run into the billions.

What is the solution? Ideally, the federal government should exit higher education finance altogether. This would not only stop the cronyism in the system, it would also lay the ground work for a more robust private sector student loan industry.

The post Crony Capitalism and Sallie Mae appeared first on Reason Foundation.

Policy proposals from both Republicans and Democrats, a white paper from the Treasury Department and the Department of Housing and Urban Development, and a host of research groups and academics have almost all focused on reform ideas that view the private sector as the foundation for the housing market. Despite this uniform focus, a number of roadblocks severely limit the pace and scope of mortgage finance risk to the private sector:

• A profound lack of confidence in the models used by credit rating agencies to assess residential mortgage-backed securities (RMBS) and in the rating agencies themselves;
• High conforming loan limits which perpetuate market share dominance of Fannie Mae and Freddie Mac, and the growing market share of Ginnie Mae and FHA;
• Risk retention requirements in the Dodd-Frank Act; and
• The complex legal framework governing RMBS.

The proposed rating-agency changes in Dodd-Frank are not enough to overcome this distrust. What we propose instead to overcome private sector skepticism is a series of legislative policy reforms, industry led reforms, and regulatory reforms:

• First, Congress should authorize underwriters to include property-level address data in RMBS disclosures so that investors or independent analytic firms can perform more detailed and accurate risk assessments at lower cost.
• Second, the mortgage-finance industry should create an organization-a Mortgage Underwriting Standards Board-to provide self-regulation against misrepresentation and to enhance liquidity by replacing QRMs with industry established categories of mortgages that are transparently defined by risk appetite to compete with the status quo binary standard (i.e., AAA, BB-, CCC+) that improperly shields investors from the true nature of the mortgages they are investing in.
• Third, the mortgage-finance industry should encourage common formatting of RMBS collateral data and the inclusion of cashflow-waterfall models with prospectuses to make investor due diligence easier, more competitive, and less costly.
• Fourth, the NRSRO system should be completely abolished. While it remains, regulators should encourage greater access to RMBS offering materials prior to origination (so that they are not only available to the issuer-hired rating agency), and allow third parties to challenge overly optimistic ratings used in the determination of bank regulatory capital requirements.

These proposals would encourage investor due diligence and facilitate the availability of third-party analysis. By increasing access to information and insight, they should encourage investors to buy private-label RMBS, enabling the government to scale back its involvement in residential mortgage finance without precipitating a collapse in home prices. Attracting private capital to residential mortgage finance is challenging. But perpetuating government control of housing finance in today’s era of high deficits is unaffordable.

The post Restoring Trust in Mortgage-Backed Securities appeared first on Reason Foundation.

The debate is focused largely on whether or not to raise taxes on the rich in order to chip away at the deficit. But there is a lot of confusion as to how exactly increased taxes on the top 2 percent of wage earners would impact small businesses and economic growth.

President Barack Obama is chief among those confused. He appears to be concerned with the health of small businesses in America, but at the same time is proposing policies that will hurt businesses large and small.

In a Labor Day speech in Milwaukee, the president suggested that helping small businesses is vital to economic recovery and proposed a permanent extension of the research and development credit established by the Bush administration. He also argued for letting businesses write down 100 percent of their capital investments over a one-year time frame, instead of the current three to 20-year process.

However, at the same time Obama also proposed allowing income tax rates on those making more than $250,000 to go up, which will hit small business profits, since those profits are often filed as individual income. Obama also defended letting rates go up for wealthy taxpayers on investment profits, including capital gains and dividends.

This policy stems from the administration’s attempt to manipulate capital towards what it sees as productive ends. On the one hand, the administration would like more federal revenue spent on the stimulus without adding to the deficit. On the other hand, White House economists want more investments in the economy to boost productivity and with it employment and exports.

These contradictory policy goals will only blend if stimulus spending actually helps the private sector grow. However, they both face an uphill battle.

Politically speaking, increasing taxes for the wealthier segments of society is popular, even though the wealthiest 10 percent already pay 70 percent of federal taxes. But what is often misunderstood is that small business owners will take a substantial hit from these taxes. Many small businesses make more than $250,000 a year-though they don’t earn enough for it to make financial sense to file their taxes in the corporate bracket.

Your local dry cleaner or grocer likely brings in more than $250,000, but then has to pay their few employees from those earnings, leaving the owners with take home pay far below the rich man’s threshold. It is these employers and entrepreneurs that would be hit hard by a rate increase on the top two tax brackets.

The Tax Foundation has recently estimated that-assuming business income is the last dollar of income a taxpayer earns-39 percent of the proposed $629 billion tax increase on high-income taxpayers would be extracted from business income. This policy path is completely at odds with the administration’s attempts to boost small business spending. Of course, that policy path has additional flaws of its own.

It is understandable that the administration wants to see a boost in business investment for new plant equipment, vehicles, computers, and other capital purchases. Unemployment has remained high and the uncertainty holding the economy hostage has sidelined some $2 trillion in retained earnings, according to The Wall Street Journal.
Maintaining the research and development (R&D) tax credit will avoid having current investments pulled out of the economy and creating losses in the near-term (though the private sector would pick up the slack in the long-term). And the ability to write down capital quickly could prove a substantial incentive for investment. Increased business spending would also be good for jobs and productivity.

However, even if the tax cuts work as planned, they won’t be enough to lead the economy out of recovery. While the R&D credit would be permanent, the investment credit would only be for one year. This means the short-term investment in 2011 will be partially stolen from 2012 and 2013 just as we’ve seen with the aftermath of 2009’s Cash for Clunkers program. In fact, if the credit was too effective, it might cause a significant decline in GDP for 2012 and beyond, a prologue of which we are watching now in the housing market in the wake of the First-Time Homebuyer Credit’s negative impact on sales and home prices.

An even worse scenario for the administration would be if the small business tax cut did not inspire any new investment to come off the bench. Many small businesses already write off up to $250,000 on equipment and other capital investments. So small businesses would have to significantly increase what they spend to see a tax benefit. Yet tax advisor Maureen McGetrick says that businesses like small retail stores and consulting firms don’t need to spend more than $250,000 in any given year. “You don’t see a lot of small businesses making that type of investment,” she told the Journal.

Further still, businesses are only likely to invest once their debt has been brought down significantly, and when they see a near-term benefit for the investment. Just because a fisherman could invest in upgrades to his boat doesn’t mean he has the demand for the additional lobsters or cod he might pull in.

On the stimulus side, all the evidence of the past two years-and historical evidence from examples like Japan-shows that dumping cash into runways and railroads is unlikely to create sustainable economic growth. And even if the spending does create a positive spark, the current proposed $50 billion in infrastructure spending will have a diluted effect in the near-term since the American Recovery and Reinvestment Act’s stimulus spending isn’t even complete yet.

The true danger is that the increased taxes required to pay for this stimulus (and the previous additions to the deficit) won’t be a net benefit to the economy. The top 3 percent of the economy consumes one fourth of purchased goods in America. Those top three are also big savers, which is necessary for investment to flourish in a post-cheap money world.

One of the presuppositions of the Obama plan is that since savings don’t help the economy, it would be better to tax the rich (who are savers), and give that money to spenders to stimulate the economy. But on the contrary, without savings-cash put in the bank-far less capital would be available to borrow for productive private sector investments. “If you don’t put money in the local bank,” says William C. Dunkelberg, chief economist at the National Federation of Independent Business, “we can’t finance any of these investment expenditures. It’s that simple.” The U.S. has a dismal savings rate as it is.

Increasing the top marginal tax rates to generate $650 billion to $900 billion in federal revenues over the next 10 years means that the same amount of money won’t be invested in the economy as consumption or savings. If the government can find a way to get a better return with that cash than the private sector, however, then the White House may be able to make a strong argument for the tax cut in retrospect. Historical data suggests this won’t be the case.

The near-term goal for the administration should be fighting uncertainty. Nervousness about future tax increases-either in 2011 or beyond-has frozen many businesses in their tracks. Regulatory concerns are keeping the banking industry holding tightly to its cash. And the administration’s failed attempts to deal with housing and unemployment have consumers less than enthused about dialing up their credit lines again. A confusing tax proposal that has contradictory ends isn’t the best way to bring certainty to this market.

Anthony Randazzo is director of economic research at Reason Foundation. This column first appeared at Reason.com.

The post The Tax Man Cometh appeared first on Reason Foundation.

Lawmakers are wrestling through legislative options in an effort to remake the regulatory system that is being blamed by many for the current recession. While absolutely true that financial sector regulations are out of date and problematic in many ways, the restructuring process could cause even more damage if it’s not done properly.

Some regulation is not necessarily a bad thing, but getting it right takes a lot of work. Broadly speaking, regulation is intended to provide a common set of standards-rules of the game-for market activity and to prevent information asymmetry where a few people have significantly better information than the average investor. Regulations must govern against harmful business practices, but shouldn’t overburden the wealth creation process.

The free market critique of many regulations is that they usually result in a host of unintended consequences, creating perverse incentives that distort decision-making, and unnecessarily restrict business activity. The mark-to-market regulations that rigidly priced assets below their long-term values during the meltdown last fall are a perfect example of a well-intended but harmful regulation practice.

Mark-to-market laws were intended to prevent fraud by creating a standard accounting method for determining the value of financial assets. However, these regulations forced assets that temporarily lost value in September to be priced below what their long-term worth really was. This in turn destroyed bank balance sheets and was the direct cause of firms such as Lehman Brothers and Washington Mutual failing.

In order to avoid similar unintended consequences, there are three things the White House, Federal Reserve, Congress and others should bear in mind as they lay the groundwork for updating the financial regulatory system.

First, regulators should make sure they are identifying and addressing the root problems. Consider the complaints about short selling. This practice, essentially betting that a company is going to do poorly instead of betting that they will do well, has been cited as a cause for many major stock collapses. The theory is that if several people start betting against a particular stock, this can cause a panic, leading to a massive selloff of that stock. In such a case, the short sellers make money, and the firm loses capital.

The question is, should regulators ban or limit short selling in the regulatory overhaul? The reality is that short selling serves a good purpose. Massive short selling of a stock may accurately signal a problem with the firm. It would be foolish to regulate this knowledge sharing process out of the system.

Some believe that traders who short sell stocks spread false rumors that a firm is doing poorly in order to get people to sell the stock. But when this happens it is an exception, not a systemic problem.

“The ban on short-selling may prolong the crisis in the sense that it will now take the markets longer to adjust to the true values of financial companies,” Adam Reed, a finance professor at the University of North Carolina at Chapel Hill, told The New York Times.

Second, when redesigning regulations to avoid future cascading meltdowns, lawmakers should design laws that require firms to be responsible for their market activity. In simple terms: require companies to have some skin in the game. One problem that developed over the past several years is that companies on Wall Street began to act as if they had some implicit safety net. Capital reserve ratios swung heavily towards debt-banks were leveraged as much as 30 to 1-leaving many scrambling when asset values rapidly dropped.

This might mean revisiting capital reserve requirements, but it absolutely means the government should clarify its position relative to these firms. The Fed, FDIC, Treasury, and rest of the government should explicitly state that they will not be responsible for future failures, and that companies should keep this in mind when making investments.

The costly failures of Fannie Mae and Freddie Mac are examples of what happens when government-sponsored enterprises, or any large firms, believe they can draw on taxpayer funds as an investment safety net.

If a company does not have the capacity to orderly enter bankruptcy proceedings at any given moment, then they must be depending on something else, like taxpayers, to save them-or they are defrauding their investors.

Third, the government should ensure that its newly adjusted regulatory system does not restrict entrepreneurial activity.

The Group of Thirty, an influential group of financial leaders and academics, released a financial overhaul plan with 18 recommendations in January. Chaired by former Federal Reserve chairman Paul Volker, the plan recommends restricting banks from engaging in investment activity, thereby dividing up deposit bearing institutions and private-equity firms. Such a move would virtually reinstate the Glass-Steagall Act regulations that kept commercial and investment banks separate for nearly 70 years.

The repeal of Glass-Steagall in 1999 created an era of unprecedented growth in the financial sector. It allowed for the emergence of firms like Bank of America and Citigroup. But those banks overleveraged themselves and have now fallen. The problem was not that successful banks were too mixed up with investing; they simply failed to adequately manage their risk. And instead of being punished by the market, they are being bailed out by taxpayers.

Under current law, banks can leverage deposits into investments, providing capital to business ventures. Restricting commercial banks from engaging in this investment activity would dramatically reduce the flow of capital to private equity and limit entrepreneurial activity.

Better regulation would concentrate on setting reserve requirements for big firms so that they are not allowed to become “too big to fail.”

The reality is that economic analysts and financial experts are fallible, whether they work on Capitol Hill or in the Financial District. Imagine if after the Dot-Com bubble burst there had been a national movement to overhaul the financial sector’s regulations. The very same people we now demonize for their actions over the past few years would have been the people we asked to fix everything.

Simply put, lawmakers won’t be perfect in redesigning the regulatory system. While this doesn’t mean we shouldn’t try to fix regulatory problems, it does mean that we should recognize the limits of our ability to solve every problem and not excessively regulate, restrict, and handcuff the market.

Anthony Randazzo is a policy analyst at Reason Foundation.

The post Government Officials Say Sweeping Financial Overhaul Is Coming appeared first on Reason Foundation.