Policymakers forget duty to protect taxpayers from financial failures

Amid the wreckage of the 2008 financial crisis and the ensuing “Great Recession,” there was one conclusion that everybody could seemingly agree upon: Taxpayers should never again be forced to cover the failed bets of the nation’s biggest banks. 

Nine years later, the steady campaign of lobbying and influence-peddling by those same “too-big-to-fail” institutions has had a powerful effect. In fact, it appears to have given policymakers who once spoke loudly about protecting taxpayers from future bailouts a serious case of amnesia. 

{mosads}Consider several of the mortgage market “reform” proposals that legislators and some former government bureaucrats have offered in recent years. Surprisingly, almost all of them would require that taxpayers shoulder the costs of any future mortgage market crisis by providing an explicit government guarantee to trillions of dollars in qualified residential mortgage-backed securities. 

One such proposal was co-authored by two former Obama administration officials who now represent large financial institutions, Jim Parrott and Gene Sperling, along with Mark Zandi of Moody Analytics, who serves on the board of directors of a private mortgage insurer that suffered massive losses in the crisis.

Michael Bright, a former Countrywide, Wachovia, BlackRock and PennyMac employee and former staffer to Senator Bob Corker (R-Tenn.), who was also a director of the Mortgage Bankers Association, put forward another proposal. Bright co-authored his plan with Ed DeMarco, the former acting director of the Federal Housing Finance Agency who currently works at the Financial Service Roundtable.

Similar proposals from BlackRock, the Mortgage Bankers Association and two senators — Corker and Mark Warner (D-Va.) — also primarily represent the interests of large financial institutions.

While all of these proposals purport to “protect the taxpayer,” in reality, they create a full and explicit government guarantee behind all qualifying mortgage-backed securities and employ gimmicks that falsely claim to hold investors responsible for a portion of losses — ahead of the taxpayer. As we witnessed during the 2008 crisis, during periods of economic distress, private investors withdraw liquidity and walk away from markets.

There is no question that the flawed proposals will lead to the same outcome: the government is forced absorb economic risks. In essence, these proposals envision a new housing finance system whereby the federal government would expand its balance sheet by roughly $5 trillion in good times with the “promise” of insulation from losses, but when the going gets tough, the government would ultimately be forced to bear the losses. 

Rather than requiring Fannie Mae and Freddie Mac — or successor firms — to transfer real risk to the capital markets, acquire catastrophic reinsurance and hold appropriate levels of capital to survive a hundred-year flood, these proposals would provide an explicit government guarantee behind private mortgage securities.

Imagine for a moment that we faced another crisis like 2008 and that a major bank is on the verge of collapse. Because Dodd-Frank effectively prevents the government from providing open-market assistance to failing firms, the Federal Deposit Insurance Corporation would likely place the bank in receivership.

While this troubled bank is in receivership, government officials could come to realize (as the government-sponsored enterprises did during the crisis) that as many as 25 percent of the mortgages guaranteed by the troubled bank did not meet the appropriate underwriting standards. As a result, the guarantor would be forced to either recognize massive losses on behalf of taxpayers or try to “put back” the mortgages to the bank’s estate.

The result would be devastating, as it would pit the mortgage-backed securities claims against the claims of bank depositors. In such a circumstance, the government would likely elect to recognize losses directly rather than force the losses onto bank depositors, as that would risk creating a run on a larger number of banks.

The most egregious and explicit example of Washington’s favoritism for the big banks would become transparent upon creation of any explicit government guarantee behind mortgage-backed securities. Banks would effectively receive a gift of over $200 billion in the form of substantially-lower capital requirements, and the taxpayer would once again be exposed to banks with less capital than they need to prudently weather a financial storm. Here’s how: 

When a bank holds a single-family mortgage that is not guaranteed by the government or a federal agency, it must set aside between 50-100 percent of the value of the loan in the form of capital. In the case of securities guaranteed by Fannie and Freddie, that capital requirement drops to 20 percent. But when banks hold securities explicitly guaranteed by the government, they do not need to set aside a dime in capital. 

Moreover, under the Basel Accord’s liquidity coverage ratio (LCR), banks are required to segregate their assets into three buckets. The buckets determine the amount of liquid assets that must be maintained to avoid future calamities, and each bucket applies a specific formula to the assets based on their perceived liquidity.

For instance, banks holding securities issued by Fannie Mae and Freddie Mac are required to apply a 15-percent liquidity ratio and are only allowed to hold up to 40 percent of their total assets in these securities. If, however, the big banks are successful in getting legislators to enact an explicit government guarantee behind all mortgage-backed securities, the required haircut would fall to zero, and they could hold an unlimited amount of these securities.    

Memories are short, of course. But it is distressing that such bank-centric and taxpayer-harmful proposals are being widely circulated less than a decade after the worst financial crisis in a generation. These proposals would directly benefit Wells Fargo and other firms that have a record of abusing their customers and the broader public.

As legislators continue to fund their campaigns with the sale of the public trust, we should remind them that those who cannot learn from history are condemned to repeat it.

Josh Rosner is managing director at independent research consultancy Graham Fisher & Co. He is the co-author of the New York Times Best Seller, “Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon.” Rosner advises regulators, policymakers and institutional investors on banking and mortgage finance and previously held roles at Medley Global Advisors, CIBC World Markets and Oppenheimer & Company.

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