Mortgages: Has Dodd-Frank failed?

Industry needed its 250 new standards

Four years have now passed since Dodd-Frank was enacted and it's fair to ask if Wall Street Reform has been a success or failure.

The general complaints regarding Dodd-Frank can be broken down this way: The legislation is too complex and too inflexible so the result is fewer mortgages and a weaker housing market than might otherwise be the case.

“Dodd-Frank has already overwhelmed the regulatory system, stifled the financial industry and impaired economic growth,” argues Peter J. Wallison, a senior fellow at the American Enterprise Institute.

If the goal of Dodd-Frank was to decrease regulation and stimulate economic growth, then probably it has failed. But that was not the goal of the legislation; the goal was in fact more regulation to protect the economy from risk — not surprising given the financial crisis in which the law was conceived.

Dodd-Frank Versus Hands-Off Regulation

The need for Wall Street Reform arose precisely because the financial industry was under-regulated. No less an authority than Alan Greenspan, the former head of the Federal Reserve and chief architect of the less-regulation approach, told Congress in 2008 that “those of us who have looked to the self-interest of lending institutions to protect shareholders equity, myself included, are in a state of shocked disbelief.”

Meanwhile, it wasn't just stock prices and shareholder equity which fell. An estimated seven million homes were lost to foreclosure while real estate equity plummeted by $7 trillion, according to the Russell Sage Foundation. Even in 2014, U.S. home values remain 6.5 percent lower than the 2007 peak, according to the Federal Housing Finance Agency.

Dodd-Frank and Risk

In an ideal world we want mortgages with several characteristics: They must be cheap, long-term, universally available, not in foreclosure and devoid entirely of gotcha clauses, hidden costs and surprise expenses.

Dodd-Frank contains roughly 250 new standards. While so many new regulations might seem overwhelming to anyone who has struggled with government forms, the reality is that in Washington nothing related to mortgages passes muster without input from the financial industry. According to the Center for Public Integrity “more than 850 banks, hedge funds, companies, associations, and other organizations hired 3,000-plus lobbyists to work on the reform bills.” That works out to 12 well-paid lobbyists per regulation.

Meanwhile, on the other side of the lending system, who represents homeowners? There's no “Association for the Protection of Mortgage Borrowers,” no APMB PAC which can hand out money to congressional candidates, and certainly there are no APMB lobbyists who can comment on proposed legislation.

Dodd-Frank and Lower Mortgage Rates

The purpose of so many rules under Wall Street Reform is to cut off dangerous financial practices. The reward is less risk and that raises a question: Why is less risk so important?

When you get a mortgage you borrow money. The only way to borrow money is to have a lender on the other side of the transaction with funds. In the U.S. many mortgages are funded and held by lenders who keep the loans for their entire term. Such loans are called “portfolio” mortgages.

However, most loans today are not portfolio mortgages. Instead, the system works this way: You borrow money to buy or refinance a house. The loan must meet certain standards. After closing the loan is sold in the “secondary market,” an electronic mortgage marketplace. Once in the secondary market a loan may be bought and sold by investors worldwide.

To make the secondary market work you need investors with capital such as pension funds, college endowments and insurance companies. These investors might buy mortgages but then they might also purchase Treasury securities, corporate bonds, corporate equities or any number of other options. If mortgages are believed to represent the best mix of risk and reward then that's where many investors will place their dollars.

Borrowers benefit from investor funds in a very tangible way. If mortgages are popular with investors then a lot of cash goes toward real estate financing and mortgage rates fall. Lower rates make homes more affordable and that increases the pool of possible buyers. More buyers help push home values higher.

Investors, of course, want to know a lot of things about mortgages. What’s the borrower’s credit score? How much was put down? Is the loan insured by the Federal Housing Administration, Veterans Administration or a private mortgage insurance company?  What was the fair market value of the property at the time of financing?

Investors also want to know about foreclosures. Low foreclosure rates mean there’s little investor risk, indeed the lower the foreclosure rate the better.

The essential purpose of Dodd-Frank is to limit risk. Less risk means fewer foreclosures, safer mortgage-backed securities, fewer bank failures and lots of investors who will want to keep their dollars in the safe-and-secure U.S. mortgage system, thus pushing down mortgage rates.

So where is the proof of success? How has Dodd-Frank bettered the marketplace?

The acid test for mortgage lending is very simple: How many loans fail? We know that some homes will be foreclosed every year because people lose jobs, medical emergencies arise, couples get divorced and car accidents result in huge bills.

Data from RealtyTrac shows what’s happened in the mortgage marketplace.

For loans originated in 2000 — before the widespread marketing of "affordability" loan products and "non-traditional" mortgages such as option ARMs, interest-only loans and no-doc mortgage applications — the rate of loans actively in foreclosure now in 2014 is 0.39 percent. For every 1,000,000 mortgages originated in 2000, lenders could expect 3,900 foreclosures.

For loans originated in 2006 the foreclosure rate is much higher, 2.44 percent, six times greater than for loans originated in 2000. For every 1,000,000 loans made in 2006 there are 24,400 loans in the foreclosure process as of this year.

Dodd-Frank passed in the summer of 2010. Loans made in 2013 — the last full year for which we have records, show a foreclosure rate of 0.20 percent. For every 1,000,000 mortgages originated in 2013 just 2,000 are in foreclosure — about half the rate seen before the era of hands-off regulation. One result is that the financial system now holds an estimated $2 trillion in excess capital, money which helps explain today’s low mortgage levels, according to the National Association of Home Builders.

But what about foreclosure activity? There still seem to be a lot of auctions.

To a very large extent the foreclosure activity we now see is a lagging measure, the last dregs of the Greenspan era. As the Mortgage Bankers Association points out, more than 90 percent of today’s seriously delinquent loans were originated in 2009 and before.

So Dodd-Frank has succeeded in its overarching goal to protect the housing market, financial industry and overall economy from the type of catastrophic fallout that might occur — and in fact did occur in 2008 — if risk is not carefully accounted for in mortgage origination.

Some might argue, and make a very persuasive argument, that this success comes at too high of a cost — hobbling the housing market recovery and holding back more robust economic growth. Still, given a choice, we’re probably in a better place when the financial industry is asking for permission rather than begging for forgiveness.

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