What Is to Be Done? (About the Subprime Meltdown, That Is)

Doug Elmendorf's view:

Notes on Policy Responses to the Subprime Mortgage Unraveling: In recent months, rising delinquencies and foreclosures of subprime mortgages have caused turmoil in broader financial markets, raised fears that many subprime borrowers could lose their homes, and led economic forecasters to boost the estimated odds of a recession next year. These economic and financial developments raise... broad policy questions.... These notes offer my answers.... My goal is not to be original, but rather to present a compilation and critical appraisal of many ideas that have been discussed by analysts.... I conclude:

• The Federal Reserve should reduce, but not slash, the federal funds rate, unless stronger evidence emerges of a freezing-up in credit markets or a significant slowing in overall economic activity.
• Monetary policy should have been slightly less expansionary in 2004 and 2005, but this would not have materially altered recent events.
• The government should help struggling households to refinance their mortgages, but this help should be reasonably narrowly targeted and should avoid harming the mortgage market and other financial markets in the long run.
• The government should place greater restrictions on the mortgages offered to riskier borrowers, but it should try not to dampen financial innovation generally.
• Federal banking supervision does not need to be extended to all mortgage lenders.
• However, the government should strengthen its oversight of credit rating agencies.

I disagree with Elmendorf's (6): I do not really see what the government can do in the credit-rating field that is likely to be useful. I also disagree with (5): anything that is a bank--that leverages its capital by borrowing short and lending long and in the process tells those from whom it borrows that their assets are more liquid than its assets--needs to be under the regulatory umbrella to some degree; and mortgage lenders are definitely banks in this sense.

Comments

[Doug]

Hi Brad,
Thanks for linking to my notes. I think you misunderstand my point #5, where the key word is "federal." Ned Gramlich pointed out that half of subprime mortgages in 2005 were issued by mortgage companies chartered and supervised by the states (compared with essentially no prime mortgages), and that the problem mortgages are heavily concentrated in that sector. He concluded in his book that all mortgage lenders should be covered by a *federal* supervisor. Others have argued that *federal* supervision is important for the Fed's ability to restore liquidity to these institutions. However, in Ned's Jackson Hole remarks, he said that the same regulatory end might be achieved by collaboration among federal and state supervisors, which was already underway. My notes cited this point and added some other reasons why I thought replacing state supervision with *federal* supervision was not needed (at least for these reasons--whether our overall supervisory structure makes sense is a harder issue). I was not arguing for no supervision of these institutions at all. I wonder, though, about your argument that any institution "borrowing short and lending long" is like a bank and needs to be regulated. I see your logic, but doesn't it apply to essentially all issuers of commercial paper?
On my point #6 about credit ratings agencies, I wish I had better ideas than I do. But regulators can, at the least, illuminate the potential conflict of interest between rating securities and soliciting business from securities issuers, and generate more separation between these functions within those organizations. However, I would not (and hope I do not in my notes) overstate the likely effectiveness of these steps.
Doug

[mgrund]

In regard to the oversight of the ratings agency-- They are already defacto regulators as they hold the key to the Investment grade criteria. If the regulators are to refer to these ratings when evaluating the health of an institution then there must be regulation.

How about establishing a random audit process to evalute the ratings on an on going baisis. Say 1% of the ratings would be redone by a federal watch dog-- if they concur no action is taken. If they do not then addtional sudits are conducted. If the watch dog finds a systemic problem then the agency can be placed on propation, publicly if necessary and then as a last resort they can lose the status as a National reconginsed rating agency.

I think you will find that they will be much more carefull in the future if this threat exists.

And I think we all agree that we need to have more compition in this field.