Housing bubbles in the United States Does American federal macroprudential regulation foster an environment that effectively deals with housing bubbles?

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Housing bubbles in the United States

Does American federal macroprudential regulation foster an

environment that effectively deals with housing bubbles?

Master’s Program in Law and Finance LL.M. Name: Isabelle Felipa Pörschke

Email: isabelle.poerschke@gmx.net Student Number: 12584460

Supervisor: Fatjon Kaja

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Abstract

The purpose of this thesis is to analyse the effectiveness of macroprudential policies to regulate housing bubbles, at the example of the U.S. Dodd Frank Wall Street Reform and Consumer Protection Act (hereafter Dodd Frank). Following the global financial crisis, it has become evident that the sensitivity of households, creditors and the whole financial system to housing bubbles creates systemic risk, as the burst of the bubble was a core driver of the past crisis. In the U.S., the direct response to this was the Dodd Frank Act, with a greater focus on financial stability and in this context particularly relevant, the implementation of new

mortgage requirements. However, the regulation’s impact of aligning mortgages to the ‘ability to repay’, in contrast to arbitrary lending practices that led to the crisis in the first place, is limited. While the Dodd Frank Act in theory provides a macroprudential framework that could address the risk posed by housing bubbles, through stricter mortgage lending, this contribution analyses how this regulation’s scope, tools and particularly exemptions for government-sponsored enterprises (GSE) limit its effectiveness. Based on a wide analysis of existing literature, this thesis aims to change the perspective when assessing the effectiveness of macroprudential regulation, by shifting the focus from purely the design, to a more holistic approach accommodating for additional factors influencing its effective implementation. The research concludes that despite attempting to limit systemic shocks by regulating bubbles, this does not mean that bubbles can be prevented completely. Thus, it is important to strengthen the resilience of the economy through overall market discipline, to mitigate the costs created by bubbles in the future.

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List of abbreviations

SIFI Systemically Important Financial Institution FSOC Financial Stability Oversight Council SEC Securities Exchange Commission CPFB Consumer Financial Protection Bureau QM Qualified Mortgage

G-SIB Global Systemically Important Bank GSE Government Sponsored Enterprise

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Introduction

The purpose of this thesis is to assess how effectively macroprudential policy regulates housing bubbles in the U.S., specifically at the example of the Dodd Frank Act. The

significant role of housing bubbles in creating systemic risk became evident in the financial crisis of 2008, revealing the failure of financial regulation during bubble periods1_and

creating severe consequences for the financial system. Following the crisis, the regulatory response has experienced a shift towards largely macroprudential regulation thanks to its benefits in addressing the procyclicality issue of financial systems,2_{as well the targeted}

nature of its tools, namely sector specific, which can control the severity of housing bubbles.

The response to the financial crisis in the past is Basel III, attempting to increase market discipline and counteract bank’s risky behaviour. This entails global standards for banks, which however are purely a guidance, and not targeted at regulating housing bubbles specifically. The regulatory response in the U.S. is the previously mentioned Dodd Frank Act.3 Regrettably, it does not effectively address the ‘too big to fail’ perception of

institutions, as in respect of mortgage requirements, there is still a government safety net. Thus, it continues to tolerate exceptions that create inefficiencies, fuelling rather than limiting housing bubbles.4 Furthermore, the Dodd Frank Act’s deficiencies in regulating housing bubbles stem from its ineffective provisions regarding mortgages, where the implementation of macroprudential tools fails to limit systemic risk in the housing sector.5

The conclusion of this thesis is firstly, that housing bubbles cannot be prevented,6 but their magnitude and costs can be mitigated through effective macroprudential regulation, limiting their systemic risk for the financial system. Secondly, this thesis emphasises that a key driver of the effectiveness of macroprudential regulation is the consideration of additional factors of implementation. For these purposes, the Dodd Frank Act could ultimately be a useful

framework to regulate housing bubbles, if it would be amended not only with a focus on

1_{Gerding, (2013), 14.}

2_{Borio, Furfine and Lowe (2001), 35.}

3_{Dodd–Frank Wall Street Reform and Consumer Protection Act, enacted on 21}st_{July 2010} 4_{Amadeo (2019)}

5_{Bubb and Krishnamurthy (2015), 1601.} 6_{Gerding (2013), 339.}

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design, but rather prioritising effective implementation, to make it resilient to the distortion of financial regulation during bubbles.7

The thesis is structured as follows. Chapter 1 sets out the difficulty of identifying housing bubbles, as well as the importance of regulating these, based on their implication for systemic risk. The types of regulatory responses, particularly the benefit of macroprudential regulation is shown in chapter 2, depicting the macroprudential tools along the cross-systemic and time-varying dimensions. The introduction of the Basel standards, but more importantly, the elements of the Dodd Frank Act are analysed in chapter 3. The deficiencies of the Dodd Frank Act, particularly in relation to mortgages, indicate its failure to effectively regulate housing bubbles, forming a main part of the chapter. After setting out the essential elements of mortgage regulation, chapter 4 evaluates the limits of macroprudential regulation and suggests a greater emphasis on the implementation, to ensure it effectively regulates housing bubbles. This is followed by the conclusion.

7_{Gerding (2013), 475.}

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1 Housing bubbles

Housing bubbles are a key driver in the creation of systemic risk, contributing significantly towards the development of financial crises.8 It is thus important to investigate their

identification, measurement, causes and consequences, as well as policy implications in this chapter. This provides the necessary context to assess the regulatory responses thereafter.

1.1 Defining, identifying and measuring housing bubbles

The term ‘bubble’ is used to describe an asset price that has experienced a sustained run-up that cannot be justified by the fundamental value of the asset,9 a situation in which ‘excessive public expectations of future price increases cause prices to be temporarily elevated’.10

Determining the existence of housing bubbles is based on the particular cause for a price rise. If this is only due to investors’ expectations of inflated prices in the future, then a bubble exists.11 Housing bubbles describe the behaviour of homebuyers who believe the future price increase of their house can compensate for the fact that they bought a house that is too expensive for them in the first place. Furthermore, buyers overestimate their ability to afford mortgage payments, accepting higher payments than they should, considering their financial capabilities such as income levels and job security.

While there is a general agreement on the definition of housing bubbles, its identification is uncertain: the issue is here to distinguish a permanent boom, in form of a productivity increase, from a bubble,12 as bubbles are most obvious only once they burst. However, it is possible to simplify the bubble identification, by not assessing the existence of a housing bubble purely based on investor’s expectations and sustained mispricing,13 but also comparing current prices to a reliable index of housing prices.14 One approach to identify bubbles could be on the basis of the price development of rent, when house prices rise much more than rental rates. This however poses the problem of how to determine which deviation from rental rates is ‘abnormal’, enhanced by the variability involved in assessing the assets’

8_{Baker (2008), 73.}

9_{Flood, R. and Garber M.(1980), 745.} 10_{Case K. and Shiller R. (2004), 299.} 11_{Stiglitz J. (1990), 13.}

12_{Takatoshi I. (2003), 547.}

13_{Brunnermeier and Oehmke (2012), 12.} 14_{Wallison P. (2014)}

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‘fundamental value’ and the impact of loose interest rates driving the bubble-like price rise. Thus, the identification of housing bubbles creates uncertainty regarding what elements would enable a uniform identification, as well as the issue of the time of identification, where

ex post identification does not help to prevent bubbles in the first place. Ultimately, the

identification is still too unclear to be used as an effective tool to support the prevention, or more realistically, to minimise the magnitude and mitigate the effect of bubbles through regulation. An understanding of housing bubbles’ causes is however useful, in order to identify alarming events potentially leading up to a housing bubble.

1.2 Causes and consequences of housing bubbles & policy implications 1.2.1 Causes

The causes of housing bubbles are diverse, however generally, loose monetary policy

facilitating house purchases due to low costs of borrowing and global imbalances that lead to excessive credit availability,15 are conditions that facilitate the development of bubbles. This has severe implications for the stability and systemic risk of a financial system.

The dominant theories of causes of housing bubbles can be split up into demand side and supply side theories.16 Demand side theories are based on the view that housing prices rise due to rising consumer demand for housing. This includes consumer’s irrational beliefs of continuous price increases, as well as the inelasticity of housing supply due to regulatory, as well as spatial restrictions. Supply side policies are based on the increased supply of housing finance leading to higher housing prices due to increased demand by consumers who make leveraged bids. A significant element of this is the consideration of loose monetary policy producing artificially cheap mortgage credit, creating a house price development towards a bubble.17 Furthermore, the lending boom, as well as capital inflows from abroad have

contributed to the bubble. This was accompanied by general changes in the mortgage market, where increased securitization resulted in lower overall credit quality, with the availability of cheap credit and lower standards having fuelled the run up in housing prices.18 This built the foundation for a crisis, characterised by wrong incentives, where the discovery of the low quality of the credits was only a question of time.

15_{Allen F. and Gu X. (2018), 234.} 16_{Levitin A. and Wachter S. (2010), 1.} 17_ibid

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1.2.2 Consequences of housing bubbles – systemic risk

The bursting of housing bubbles is associated with damaging effects on the real economy,19 in the form of financial instability, ultimately leading to a financial crisis.

Evidence has been provided that collapses in real estate prices are one of the major causes of financial crises.20 A period of booming asset prices, initially triggered by fundamental or financial innovation, accompanied by high leverage and credit growth is followed by a collapse, including debt overhang and deleveraging spirals, leading to macroeconomic

instability.21 A real estate bubble burst is a shock to the financial system, with investors being exposed to the to rapidly falling prices and lenders being exposed to non-performing loans resulting in large losses, creating great uncertainty and financial instability. Amplification mechanisms reduce the economic activity in a significant and persistent manner.22 Moreover, housing bubbles contribute to the creation of systemic risk due to increased household

leverage, excessive risk taking and lower lending standards.23_{Ultimately, the default of}

mortgage payments was a key driver of banks’ liquidity crisis, deepening the crisis. On the supply side, declining housing prices and foreclosures contributing to increased supply, as well as on the demand side, suddenly tightened credit requirements reducing the number of potential buyers, lowered housing prices further. This created significant wealth losses for the U.S. population, to an extent that financial stress was inevitable. This systemic risk creation directly contributed to the financial crisis, as due to the collapsing housing market, banks had to incur large losses and financial institutions’ exposure to this aggravated problems in the financial sector.24 Looking back, this systemic risk creation resulting from the housing bubble burst could have been mitigated by regulation. Mortgage regulation should therefore be designed to withstand a bubble and to mitigate its macroeconomic effects.25

1.2.3 Policy implications of housing bubbles: Gerding’s regulatory instability hypothesis One approach to address these implications of housing bubbles is based on the regulatory instability hypothesis, which is the view that bubbles trigger the deterioration of financial

19_{Allen F. et al.(2011), 1.}

20_{Crowe, Dell’Aricia, Igan, Rabanal (2011), 4.} 21_ibid

22_{Brunnermeier and Oehmke (2012), 7.} 23_{Hessel and Peeters (2011), 5.}

24_{Baker (2008), 73.}

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laws.26 This helps to establish what factors financial regulation must be able to withstand in order to not fail during bubble periods.

The hypothesis is based on the claim that the deterioration occurs when regulation is most needed, as ‘when markets boom, investors and financial institutions exercise less care and take on more risk and leverage, and a financial crisis looms.’27 The following five factors during bubbles lead to regulatory failure: First, the regulatory stimulus cycle, through which bubbles exert pressure on governments to adjust regulation to stimulate financial markets through deregulation and loosened enforcement of existing rules.28_{Secondly, compliance rot}

entails the nature of bubbles creating incentives of market participants to disobey financial laws, due to general disobedience, further lowering overall compliance.29 Thirdly, bubbles lead to regulatory arbitrage, as market participants want to participate in surging financial markets, evading the regulations through finding economic substitutes that are less regulated.30 Fourthly, regulations are procyclical, interacting with cycles in a way that exacerbates booms and busts. Lastly, regulations do not counteract the herd behaviour that initially caused asset price bubbles, but rather encourage enhanced demand for certain asset classes due to their preferred status.31 These dynamics weaken financial regulation, leading to an increased risk of financial failure when regulations are most needed. This endangers the functioning of regulation in mitigating the magnitude of bubbles and promoting resilience to bubbles that are bursting.32 The regulatory instability hypothesis argues policymakers should fear the situation when any of the elements are present, resulting in undermined systemic risk regulation, where bubbles easily lead to ‘economic chaos’.33

These factors exemplify how law can fail during bubbles. While this does not directly solve the problem of how to minimize the costs and magnitude of housing bubbles in general, it gives a set of early warning indicators, undermining regulation. When aiming to design regulation that is resistant to bubble dynamics, the five factors help to assess the

appropriateness of current regulation in addressing housing bubbles, shifting the focus on the regulation’s design rather than purely its substance.

26_{Gerding (2013), 2.} 27_ibid 28_ibid 29_ibid 30_{Gerding (2013), 3.} 31_ibid 32_ibid 33_{Gerding (2013), 14.}

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2 Regulatory response

The regulatory response to the financial crisis has revealed a development towards macroprudential regulation.34 This chapter will provide the reasons for this development, starting from setting out the unsuitability of monetary policy, as well as depicting the dimensions and tools of macroprudential policies.

2.1 Monetary policy

Despite the diverse views of the role of monetary policy in the past, its role has now been widely limited regarding its ability to contain asset bubbles. This is based on the fact that its use would require extreme tightening, having disproportionately large consequences in the form of lower GDP, unemployment, and lower inflation,35 relative to the potential gain of limiting the bubble. However, it might still have the role of complementing macroprudential policies to regulate housing bubbles effectively. Nevertheless, with the evidence of housing bubbles’ implications for systemic risk, future policy is required to address housing bubbles in a more targeted, preventative manner.

2.2 Macroprudential policy

The goal of macroprudential policy is to preserve financial stability of the system as a whole, rather than of individual institutions36 and to prevent the build-up of systemic risk that has negative implications for the functioning of the financial system and the real economy.37 A targeted approach can be more effective in regulating the housing sector and reduce the costs associated with policy intervention.38 Effective macroprudential policies can contain risks ex

ante and help build buffers to absorb shocks ex post,39 providing a cushion for the adverse effects of financial and credit cycles and preventing systemic crises. The new objective of

34_{Baker A. (2012), 113.}

35_{Assenmacher-Wesche and Gerlach, (2008), 1.}

36_{Working Group on Macroprudential Policy G30 (2010), 13.} 37_{Buch, Vogel, Weigert (2018), 3.}

38_{Dell'Ariccia et al. (2012), 4.} 39_{Claessens et al. (2013), 3.}

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financial stability, for overall macroeconomic stability, requires new tools that can target specific sources of financial imbalances.40

Especially in the U.S., macroprudential regulation at a federal level is essential to prevent a ‘race to the bottom’ among individual states’ microprudential rules, such as in the case of the ‘winner’ Delaware in context of corporate law.41 To effectively limit systemic risk, e.g. through mortgage regulation, and avoid a constant power exchange between state and federal level, macroprudential regulation is necessary. This can minimize regulatory gaps, with financial stability unquestionably being a federal issue.

2.2.1 Dimensions of macroprudential regulation

Macroprudential regulation entails two distinct perspectives: 1) the cross-sectional systemic risk perspective, with the tools addressing the globalisation and interconnectedness within banking systems to make banks more resilient, and 2) the time-series systemic risks, in which tools are addressing the procyclicality of financial cycles.

2.2.1.1 The cross-sectional dimension

The cross-sectional systemic risks stem from the global interconnectedness of institutions. Macroprudential policy addresses this by focussing on the stability of institutions as a whole rather than individually. Banks are connected in terms of their balance sheet, their investment strategies and the risk created by financial instruments. The distress or failure of one affects the others. Financial innovation and financial globalisation increased the importance of financial factors and the interconnectedness across countries.42 Regulation did not respond to this innovation, as markets were seen as efficient and self-correcting.43 This facilitated excessive credit growth and the build-up of financial imbalances.44 Acknowledging the global connectedness of financial institutions helps to limit regulatory arbitrage.

Consequently, if regulators aim to protect the stability of the system as a whole, they should

40_{Claessens et al. (2013), 3.} 41_{Bainbridge et al. (2017), 75.} 42_{Hessel and Peeters (2011), 5.} 43_ibid

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actively monitor changes in activity and modify the measures according to emergent risks to stability.45

2.2.1.2 The time-series dimension

The time-series systemic risk takes the importance of the financial cycles of credit and leverage for economic stability into account.46 The financial system is inherently

procyclical;47_{perceptions of value and risk, as well as the willingness to take risks move}

procyclically.48 The process of credit expansion and asset price bubbles is mutually reinforcing the procyclicality of the financial system, which tends to interact with the real economy in ways that can amplify economic fluctuations.49 During booms, rising asset prices loosen external financing constraints, with further capital deepening, rising productivity and rising profits. For housing prices, price increases stimulate demand, as buyers attempt to buy before prices escalate further. Banks’ assessment of the risk of loss in residential mortgage lending becomes more relaxed due to high price levels, as even on default, mortgage loans are secured by houses that are appreciating in value. The more house prices rise, the more the banks’ willingness to lend rises. This upward spiral of credit expansion further fuels demand and thus prices. Borrowers attempt to benefit from higher home values by securing debt with their house, however eventually the overvaluation is discovered. Banks realise that borrowers struggle to repay mortgages and declining real estate prices are further reinforced due to tighter credit policies, resulting in a lack of funds for loan repayments. With higher default rates and declining asset values, the sale of collateral further lowers asset prices. The upward spiral during booms thus operates in reverse in economic downturns: This creates capital shortage for banks, which results in less financing available for homeowners, lowering demand for housing and thus lowering house prices.

This procyclicality of financial cycles provides evidence of the severity of banks’ exposure to real estate crashes, invoking a banking crisis. The procyclicality is an issue especially in the development of housing bubbles, as this leads to excessive optimism regarding house prices,

45_{Armour et al (2016), 409.} 46_{Armour et al (2016), 413.} 47_{Borio and White (2004), 1.} 48_{Borio (2005), 1.}

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exacerbating all market participants’ willingness to lend and borrow, leading to irrational prices and leverage, creating a risky bubble. Together with the interconnectedness of banks, this means that this exposure of banks quickly spreads globally, directly creating systemic risk.

Thus, countercyclical regulation is essential, limiting borrowers’ ability to borrow and lenders’ ability to lend, based on realistic ‘ability to repay’, which limits the occurrence of inflated prices that create distorted mechanisms of risk taking. This calls for countercyclical tools, that build up buffers in good times that can be relied on in bad times.

2.2.2 Types of Macroprudential tools

Macroprudential tools aim at reducing the magnitude of a real estate boom through restricting leverage and strengthening the financial system’s resilience to the effects of a real estate bust, e.g. by requiring banks to build up capital buffers. The macroprudential tools can be

separated along the already mentioned perspectives, tools that focus on the cross-sectional dimension, the sources of distress within the financial system at a time,50 and tools addressing the time-series dimension of financial stability, i.e. the procyclicality in the financial

system.51

Cross-sectional measures involve the identification of ‘systemically important’ financial institutions (SIFIs) beyond banks. This addresses the concern that nonbank institutions equally create systemic risk and the Basel Committee on Banking Supervision has agreed on systemic capital surcharges for both global and domestic systemically important banks.52

Time-varying measures respond to concerns of sectoral as well as procyclical risk creation. As credit fuelled asset booms trigger financial crises, it is important to limit the boom in specific sectors, without harming economic growth disproportionally. The procyclicality of financial cycles could specifically be addressed through capital and liquidity requirements, controlling the cost and composition of the liabilities of financial institutions through increased capital and liquidity buffers.53 The supply side would be addressed by limiting bank lending to particular asset types such as housing, preventing excessive risk

50_{Crockett (2000)}

51_{Galati and Moessner (2011), 1.} 52_{Claessens (2015), 398.} 53_{Dell’Ariccia et al. (2016), 301.}

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concentration in lending to that sector. Furthermore, countercyclical capital buffers54 and capital conservation buffers55 can promote the financial market’s resilience to shocks. Additionally, risk weights, as well as leverage caps increase the cost of bank capital and thus lending in good times,56 overall limiting the build-up of systemic risk.

Furthermore, asset concentration and credit growth limits affect the composition of the assets of financial institutions, by imposing limits on the speed of credit growth or on sectoral asset concentration of loan portfolios.57 These measures reduce banks’ exposure to sectoral and aggregate shocks through diversification.58_{Especially in context of sectoral loan}

concentration, macroprudential tools are essential to limit lending in the real estate sector. In addition to limiting risk exposure through diversification, macroprudential tools can limit lending by banks. While the following also affects borrowers through criteria imposed on them, these are tools to limit credit growth by reducing bank’s ability to supply credits. This can occur through loan eligibility criteria, limiting the pool of borrowers that have access to finance to improve the average quality of loans, examples being loan-to-value (LTV) and debt-to-income (DTI) limits.59_{Eligibility criteria can be tailored to a loan portfolio’s risk}

profile, e.g. linking LTV limits to local house price dynamics.60 LTV and DTI can be used to limit risk through higher risk-weighted capital charges for lending, to support particular types of more marginal lending, restrictions on the proportion of bank assets that may consist of marginal real estate loans, and outright prohibitions on bank lending for marginal real estate loans.61 These macroprudential tools can be particularly efficient in limiting systemic risk, as well as addressing specific sector risk, contrary to monetary policy that is less targeted.62 Evidently, macroprudential regulation is suitable in addressing the interconnectedness of banks through its cross-sectional tools, identifying risk creating institutions to impose risk specific rules, and the procyclicality of financial cycles and regulation through its

time-varying tools, building up buffers and adjusting loans to their sectoral risk. Thus, this targeted approach is suitable in context of regulating housing bubbles.

54_{can be 0, the buffer that will apply to each bank will reflect the geographic composition of its portfolio of}

credit exposures.

55_{mandatory for all banks to build up an additional loss-absorbing capital cushion to improve their resilience to}

stresses

56_{Dell’Ariccia et al. (2016), 301.} 57_{Dell’Ariccia et al. (2016), 301.}

58_{Claessens, Kose, Laeven, Valencia (2014), 434.} 59_{Crowe, Dell’Aricia, Igan, Rabanal (2013), 3.} 60_{Dell’Ariccia et al. (2016), 301.}

61_{Armour et al (2016), 421.} 62_{Armour et al (2016), 424.}

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2.3 The relationship of macroprudential policy with monetary policy

While some view macroprudential regulation as a substitute for monetary policy,63 it is more useful to consider them as complementary.64 Ideally, with macroprudential policies targeting the sources of threats to financial stability, monetary policy should primarily focus on price and output stability.65 The complementary nature of macroprudential and monetary policies is based on two reasons: First, the interest rate alone may be too blunt to address sector specific financial stability risks.66 Macroprudential policies can be targeted at specific sectors,

regions, institutions, products or practices in contrast to interest rates that apply uniformly to the economy and the financial system. Second, financial booms may be too powerful to only be targeted by one type of policy. Thus, it is reasonable to complement macroprudential policies with monetary tools, that pursue price stability, output stability and financial stability. A strong macroprudential framework at a federal level can ensure this interaction works effectively.67 Moreover, the effects of monetary policy and macroprudential policy are likely to reinforce each other:68_{When implementing one policy, any changes in the other}

need to be considered, with any intervention affecting economic and financial conditions. Macroprudential settings will influence credit supply conditions, and hence monetary policy transmission.69 Measures that strengthen the resilience of the financial system may also support monetary policy by influencing credit conditions more effectively, reducing the impact of financial frictions on credit supply.70 Nevertheless, due to the targeted nature of macroprudential tools, its dominance is desirable in order to effectively regulate the real estate sector. Consequently, monetary policy, while overall contributing towards financial stability, is less relevant when assessing the regulation of housing bubbles.

With the background provided on macroprudential regulation, its aims, tools and effects will be analysed along its implementation in practice in the following chapter, ultimately

evaluating its success in respect of targeting housing bubbles.

63_{Cecchetti and Kohler (2012), 1.} 64_{Gadanecz and Jaryam (2015), 2.} 65_{Claessens et al. (2013), 3.} 66_{Gadanecz and Jaryam (2015), 2.} 67_{Kohn (2014)}

68_{Hoogduin (2010), 1.} 69_ibid

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3 Examples of regulatory response: Basel III and the Dodd Frank Act

This chapter consists of an introduction of Basel III, its implementation in the U.S. and an assessment of its effectiveness. An overview of the impact of the Dodd Frank Act, its current status and an analysis of its deficiencies, particularly in respect to mortgages, follows. Both the international Basel III standards and the U.S. Dodd Frank Act are examples of regulatory frameworks implementing macroprudential rules.

3.1 Basel III

Basel III builds on the guidelines detailed in Basel I and in Basel II; it responds to the financial crisis and targets banks by restricting the availability of bank debt, strengthening requirements on bank's minimum capital ratios. Basel III became enforced in 2019, and has emerged as an international standard, even though it formally functions only as a voluntary framework. It introduces requirements on capital and funding stability, in order to mitigate the risk of bank runs. Basel III imposes higher capital requirements to account for higher risk, based on risk weighted assets, complemented by a leverage ratio.71 Furthermore, the

implemented capital buffers address the procyclicality of the capital requirements, to protect the banking sector from excessive credit growth and also requiring banks to conduct stress tests to assess credits spreads in recession periods.72 These time-varying macroprudential tools deal with the procyclicality of financial cycles. Additional buffers address the cross-sectional perspective of macroprudential tools: the systemic risk buffer requires big banks to hold more capital, which is at national discretion, targeting the build-up of correlated risk. This can be required at a level of institution, but also based on a sector, e.g. specific

requirements for mortgages. Furthermore, there is a higher loss absorbency requirement for Systemically Important Banks (SIBs), as well as Globally Systemically Important Institutions (G-SIB), based on interconnectedness, cross-jurisdictional activities, complexity, size and substitutability.73_{These macroprudential measures aim at limiting risk, addressing}

71_{BIS (2012), 5.}

72_{A mandatory capital conservation buffer is added to the CET1 capital ratio, for banks to hold from 2019}

onwards. A discretionary counter-cyclical buffer functions as loss reserve, allowing national regulators to require additional capital during periods of high credit growth, being triggered when credit to GDP deviates from long term trends, BIS (2014), 5.

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procyclicality, limiting leverage and reducing the externality of systemic risk created by systemically important institutions. This is complemented by liquidity requirements.

3.1.1 U.S. implementation of Basel III

In 2013, the Basel III Final Rule, substantially implemented all of Basel III standards in the U.S., replacing Basel I from 1989 (Basel II was never introduced), with remaining elements of Basel III and the Volcker rule having been fully phased in by 2019.74_{This applies to all}

institutions with more than $50 billion in assets,75 imposing the following requirements: Risk-based capital and leverage requirements, stress tests and capital adequacy requirements, and an optional risk-based capital surcharge. The Basel standards provide a floor for the capital requirements of the Dodd Frank Act in the U.S.76

3.1.2 Effectiveness of Basel III

Basel III is less suitable to regulate housing bubbles, as it creates excessive risk concentration in the housing sector and its capital requirements have insufficient reach due the existence of shadow banking, creating inefficiencies.77

The countercyclical regulation seeks to reduce the spill-over effects from troubled financial institutions on the financial system and the economy.78 However, static risk weights on asset classes can have negative effects, as they alter incentives within the financial sector: By providing a relative advantage to the asset class of mortgage backed securities through advantageous risk weights, this results in encouraging greater lending in the residential mortgage sector. As banks lent with lower quality standards before the crisis, they made worse mortgages in terms of borrowers meeting the requirements imposed on them, such as loan-to-value standards. Despite residential mortgages generally having been a stable asset class, a static risk-weight favouring this asset class made it endogenously riskier,79 due to the concentrated exposure in a single asset class.

74_{BIS (2014), 5.}

75_{The threshold has now however been increased to $100B due to Donald Trump signing the Economic}

Growth, Regulatory Relief and Consumer Protection Act into law in 2018

76_{Wyatt E. (2011)} 77_{Acharya (2012), 3.} 78_{McCoy (2016), 1182.} 79_{Acharya (2012), 3.}

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Another deficiency exists based on a significant amount of lending occurring outside the regulated banking system,80 resulting in bank capital levels being less effective at mitigating financial risk. Prior to the financial crisis, many loans were originated by nonbank institutions and nonbank subsidiaries of bank holding companies, which held mortgage loans but were not subject to capital requirements.81 Furthermore, large financial institutions supported financial structures allowing mortgages to be financed off the balance sheets of supervised banks.82 Evidently, in the U.S., the side effect of increased capital requirements for banks was an increase in the size of the shadow banking system. Therefore, while higher capital

requirements for banks may enhance the stability of the banking system, large amounts of lending activity actually occur in unregulated systems, such that raising capital requirements makes the overall financial system riskier.

Thus, Basel is ineffective in equally regulating banks and nonbanking institutions. Currently, the only solution would be to reduce nonbank lending activities to increase the influence of higher bank capital requirements on overall lending activity, based on the economy’s credit availability becoming more sensitive to changes in bank capitalization levels.83

The Basel standards function in the U.S. as a general guidance, which is useful to limit the availability of bank debt and targeting banks specifically. While this is partly effective in promoting financial stability, there are apparent deficiencies, preventing it from limiting overall systemic risk. Nevertheless, with regard to regulating housing bubbles, the main focus is the Dodd Frank Act, with Basel III only providing the foundation for conceptualising capital standards.

3.2 The Dodd Frank Act

The primary macroprudential regulation in the U.S. is the Dodd Frank Act, that was enacted in 2010 and imposed changes to financial regulation in response to the financial crisis. Being called the ‘most substantial regulatory response to the economy since the Great

Depression’,84_{the Act set high expectations to regulate lenders, in order to protect consumers}

and limit the severity of future crises. It was enacted as a measure to promote financial stability, accountability and transparency in the U.S. financial system, to end the perception

80_{Getter (2014), 1.} 81_ibid

82_ibid

83_{Getter (2014), 1.}

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of some financial institutions being ‘too big to fail’ and for the enhanced protection of consumers, through increased regulation of the consumer finance industry.85

At its core, the Volcker rule forbids banks to make speculative investments with their own account in the form of proprietary trading with risky investment firms, such as private equity funds or hedge funds.86 However, these investments in risky assets are allowed if they are on behalf of clients. A more active monitoring of systemic risk was enforced through the

increased oversight of the financial industry, through the creation of the Financial Stability Oversight Council (FSOC), to identify risky practices of banks and nonbank financial companies.87 Furthermore, Dodd Frank extended the SEC’s authority to regulate high-risk financial products. The new Consumer Financial Protection Bureau (CFPB) regulates consumer financial products and services, educates consumers and ensures fair treatment by financial institutions.88 A new Federal Insurance Office was created to monitor the insurance industry, making recommendations to the FSOC regarding an individual insurer’s additional oversight.89_{The enhanced oversight of credit rating agencies was carried out through the}

creation of an Office of Credit Rating, within the Security and Exchange Commission (SEC), to ensure the accuracy and neutrality of ratings, by monitoring credit agencies’ practices.90 Finally, new regulations for the protection of whistle-blowers promote insiders’ willingness and ability to report wrongdoing within the financial services industry.

Essentially, Dodd Frank aimed at promoting market discipline, limiting and controlling the behaviour of financial institutions, insurers and credit rating agencies that caused the financial crisis — while also increasing consumer protection.91

Moreover, the Dodd Frank Act requires banks of a certain size to hold specific capital levels and reserves. Dodd Frank empowers the FSOC to identify certain banks as being

systemically important financial institutions (SIFIs), that could pose a threat to financial stability, requiring them to adhere to specific rules to protect their assets. This is aimed at preventing banks, that take deposits, from making risky bets on the financial markets, by controlling the size of banks’ capital reserves and requiring banks to run stress tests that

85_{Bieber (2019)} 86_ibid 87_{Bieber (2019)} 88_{Bieber (2019)} 89_ibid 90_ibid 91_ibid

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simulate a crisis to check the effect on their solvency. The capital requirements in the Dodd Frank Act use the Basel III requirements as a floor; however, Dodd Frank capital

requirements would take precedence over Basel in any case. The Collins Amendment creates a statutory floor; this enables regulators to impose more stringent Basel III capital rules than those historically to banks, but not to apply less stringent rules, except when complying with countercyclical requirements. The Dodd Frank Act requires banking regulators to revise and establish the minimum leverage and risk-based capital requirements for banks and to also apply these to systemically important institutions. At present, banks which engage in more complex activities such as securities trading are categorized as having to meet the

requirement92 of being ‘well capitalized’, to reflect the additional risk undertaken.93 Banks which conduct simple banking activities only need to meet the standards of being ‘adequately capitalized’.

3.2.1 The rollback of the Dodd Frank Act

While the original Dodd Frank Act imposed numerous and significant changes in response to the financial crisis, provisions such as higher capital requirements have been loosened again for some banks in 2018, when president Donald Trump signed the Economic Growth,

Regulatory Relief and Consumer Protection Act into law.94 The original Act applied its most stringent standards of higher capital reserves and yearly stress tests to any bank that had $50 billion in assets or more, whereas the 2018 law lifted that standard to being applicable to banks with at least $100 billion in assets. This creates two tiers – under $100 billion and from $100 billion to $250 billion – in which the regulator has the option to apply the enhanced prudential standards to banks exceeding the $100 billion threshold, to assess the resiliency of their operations from a liquidity, risk management and capital adequacy standpoint.95 For the smaller banks specifically, prudential standards are loosened, as these are not considered to be systemically important institutions. This is evident in the form of lower capital

requirements, reduced financial reporting, particularly racial and income data on mortgage holders and the conditions of stress tests being less strict. Banks with assets below $10 billion

92_{‘well capitalized’, with a tier 1 capital ratio of 6%, total ratio of 10% and minimum leverage ratio of 5% and}

‘adequately capitalized’ with a tier 1 capital ratio of 4%, total ratio of 8% and minimum leverage ratio of 4%, Moody’s (2011)

93_{Moody’s (2011)} 94_{KPMG (2018)} 95_{Protiviti (2018)}

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are now exempt from the Volcker rule (prohibiting banks from speculative trading). Notably, the amendment also eases the provision of mortgages for smaller banks, making the access to mortgages easier for individuals: Dodd Frank included rules about the types of mortgages that banks could offer, limiting them to relatively safe qualified mortgages.96 The 2018 law created a new compliance option for mortgages originated and held by banks and credit unions with less than $10 billion in assets to be considered ‘qualified mortgages’, creating the presumption of automatically complying with the ‘ability to repay’ rule.97

Ultimately, the Dodd Frank Act implemented multiple significant changes in response to the financial crisis, raising overall prudential standards. Nevertheless, it also has several

deficiencies, particularly relating to its scope and nature of implementation, which will be discussed in the following section.

3.2.2 Deficiencies of the Dodd Frank Act

The Dodd Frank Act has been criticized since it was first announced. Supporters98_{claim it}

imposes adequate restrictions on Wall Street, but critics declare the rules as excessive, burdening investors and slowing economic growth.99 With the recent modifications of the Dodd Frank Act, Trumps’ signing of the narrowing in 2018 and a limit to the Volcker rule in 2019, the Dodd Frank Act’s force, sufficiency and acceptance appears questionable.

While the Dodd Frank Act did succeed in generally increasing prudential standards, creating additional agencies that enforce these, it did not succeed in reducing overall risk, especially with its recent changes representing a shift back to a more lenient approach towards smaller banks. Consequently, it has clear deficiencies in reaching the aim of financial stability, particularly in relation to housing, with the rules not being effective when implemented. Firstly, the Dodd Frank Act has recently been rolled back,100 lifting stress tests and capital standards to a standard of $100 billion in assets.101 This opens the door for banks demanding leniency, based on how they present their assets, leaving regulators to revise the rule for

96_{Kaul and Goodman (2018)} 97_{Perkins et al. (2018), 1.}

98_{However, even the main supporters have become critical: Barney Frank himself, one of Dodd-Frank’s chief}

architects, recently acknowledged he ‘sees areas where the law could be eased,’ and former FED chair Bernanke remarked ‘[lenders] may have gone a little bit too far on mortgage credit conditions,‘ during a 2014 conference on housing. Holmes (2018)

99_{Onion, Sullivan and Mullen (2020)} 100_{Alexander et al. (2018)}

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years, rebounding risky Wall Street behaviour. Along with this, it appears that the ‘too big to fail’ issue is not effectively addressed, with the narrowed Volcker rule further supporting the public safety net, resulting in banks’ willingness to make risky decisions having increased rather than decreased.102 The narrowing of the Dodd Frank Act is a step into the wrong direction, contrary to the post-crisis view of having to limit large banks’ risky behaviour that creates systemic risk. Especially the ineffective capital requirements create deficiencies, however the focus here is the Dodd Frank’s effectiveness in relation to housing bubbles. Secondly, the Dodd Frank Act creates wrong incentives by charging ex post rather than ex

ante.103 If firms default during a crisis, the surviving systemically important financial institutions must balance out the unpaid debts ex post.104 This actually increases moral hazard, because prudent firms need to smooth out the mistakes of others, and those less cautious firms know there is a backup.

Thirdly, with the aim of reducing systemic risk created by housing bubbles, the implementation of the Dodd Frank Act is ineffective, as the ‘too big to fail’ exception continues to exist in context of government exemptions. The federal safety net for

government sponsored enterprises (hereafter GSE) continuously creates inefficiencies. The distortive role played by government guarantees to the financial sector of mortgages is particularly evident in the case of the U.S. federal mortgage providers, Fannie Mae and Freddie Mac. On the outset, these increased homeownership rates in the U.S., providing liquidity to the thousands of banks and mortgage companies that make loans to finance housing, by buying mortgages from lenders and either holding these in their portfolios or packaging the loans into sellable mortgage-backed securities (MBS). However, their function as implied government-backed monopolies had negative consequences.105 At the peak of the housing bubble in the U.S., just before the crisis, Fannie and Freddie increased their leverage and began investing in subprime securities that credit agencies incorrectly identified as low risk. They also lowered the underwriting standards in their securitization business, requiring almost no income documentation, purchasing and securitizing subprime mortgages. Due to their large losses during the financial crisis, the two firms were allowed to take on another $200 billion in debt, aiming to stabilize the economy in 2008,106 followed by the FHFA putting the companies into conservatorship, with U.S. taxpayers having to cover future

102_{Hu (2019)}

103_{Acharya and Richardson (2011)} 104_{Beck (2011), 68.}

105_{Kyl (2003)} 106_{Amadeo (2019)}

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losses. With this backup, Fannie Mae and Freddie Mac continue to take excessive risks,107 endangering the stability of the financial system.

3.2.2.1 The inefficiency of the GSE exemption

The Dodd Frank Act tolerates a GSE exemption, as the FSOC has not officially designated Fannie Mae and Freddie Mac as systemically important financial institution (SIFI). The FSOC has the authority to bring a nonbank financial company under increased supervision and regulation by the Federal Reserve Board (FRB),108 if it determines that ‘material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.’ (U.S.C. § 5323 (a)(1))109

Thus, the FSOC has expansive powers to determine the criteria of a SIFI designation, enabling them in this case to allow Fannie Mae and Freddie Mac to continue to be a ‘too big to fail institution’, by not designating them as SIFI. Objectively, this can be seen as

unreasonable, as the enterprise operates the systemically risky business of guaranteeing real estate loan performance. With larger total assets than the biggest U.S. banks,110 Fannie Mae and Freddie Mac can and should legitimately be exposed to higher capital requirements and capital buffers.111 Their official designation as SIFI would lead to increased supervision, having to meet higher requirements, which from a risk, as well as size perspective would make sense. This situation exemplifies the trade-off of macroprudential regulation and economic growth, as enforcing the supervision on Freddie Mae and Fannie Mac would likely harm access to housing. This could explain why the FSOC is using their discretion to not make the official SIFI designation. However, with legislative reform calling for a

privatisation of GSEs and thus removing the taxpayer funded subsidies,112 there is hope for a reduction of the inefficiencies created by a government financial safety net in the mortgage sector in the near future. The goal of ending conservatorship for Fannie Mae and Freddie Mac is significant, because it is the only situation in which the question of their SIFI status

107_{Kyl (2003)}

108_{Dodd Frank Act 2010 s113} 109_{Holtz-Eakin (2019)} 110_{Michel (2020)} 111_ibid

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arises.113 Based on the large GSE losses and the general consensus among policymakers and stakeholders that the government must diminish the GSEs’ presence in housing finance, legislators should push forward, only being slowed down by the economy’s ability to handle the reform.114

Nonetheless, an excessive focus on privatising Fannie and Freddie requires caution, as the administration has shifted the majority of federal high-risk mortgage initiatives to the Federal Housing Association (FHA), the government’s original subprime lender.115 The Dodd Frank Act currently exempts the FHA from appropriate standards on mortgage quality, again facilitating the existence of low-quality mortgages in the market.116 This does not solve the problem of the inefficiencies created by GSEs in the mortgage market, as it essentially puts a GSE back in the same position, with a guarantee by the government. While the FHA has increased the borrowing standards in 2020,117 to ensure that it is not exposed to too risky mortgages, this still requires more attention. The Dodd Frank Act needs to be amended to create equally applying quality standards to the FHA and other government agencies, while still allowing loans to low income borrowers. This would assure that the agency does not replace Fannie and Freddie, accompanied by its inefficiencies.118

Ultimately, the Dodd Frank Act is deficient in terms of its decreasing scope rebounding the build-up of systemic risk, the creation of wrong incentives due to its ex ante effects and for this thesis most significantly, the failure to address the government housing policies that caused the financial crisis. While these issues could only partly be resolved by amending the Act, it becomes evident that macroprudential regulation could address the systemic risk created by housing more effectively in theory, however in reality fails to do so, causing harm.

3.2.2.2 The Dodd Frank Act and mortgages

The Dodd Frank Act is particularly deficient in respect of mortgages, with the GSE exemption exemplifying the limited scope of Dodd Frank’s mortgage provisions. Furthermore, the ineffective implementation of macroprudential tools is created by the mortgage requirements, which Fannie Mae and Freddie Mac are exempted from. One of the

113_{Holtz-Eakin (2019)}

114_{Hertzog (2013), 1.} 115_{Wallison and Pinto (2010)}

116_{Safe harbour under Dodd Frank 2010 Act s 1412} 117_{Lane (2019)}

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most significant accomplishments of the Consumer Financial Protection Bureau (CFPB) was finalizing the qualified mortgage (QM) rule: Section 1411 of the Dodd Frank Act creates a duty for creditors making a residential mortgage loan to make ‘a reasonable and good faith determination of the borrower’s ‘ability to repay’ based on verified and documented

information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan, according to its terms.’119 Information considered is borrower income, assets, debt, and employment. One way to meet this requirement is by originating a ‘qualified mortgage,’ as defined by the QM rule. The QM rule aims to prevent borrowers from

obtaining loans they could not afford and to protect lenders from borrower litigation,

claiming the lender failed to verify a borrower’s ‘ability to repay’.120 There is a presumption that a borrower who obtains a QM has the ‘ability to repay’. All qualified mortgages need to meet multiple mandatory requirements.121 Specifically, qualified mortgages must satisfy at least one of the following three criteria:

1. The borrower’s total monthly debt-to-income (DTI) ratio must be 43 percent or less. 2. The loan must be eligible for purchase by Fannie Mae or Freddie Mac (the

government- sponsored enterprises, or GSEs) or insured by the Federal Housing Administration (FHA), the US Department of Veterans Affairs (VA), or the US Department of Agriculture Rural Development (USDA), regardless of DTI ratio. 3. The loan must be originated by insured depositories with total assets less than 10

billion, but only if the mortgage is held in portfolio.122

However, the exceptions to the rules create inefficiencies: Evidently, there is an issue of scope, due to the exemption for GSEs as well as the special rules for the FHA. Loans backed by GSEs, such as Fannie Mae and Freddie Mac, are exempt from debt-to-income

requirements, which is called the GSE patch or the qualified mortgage patch.123 The FHA, VA, or USDA apply separate QM rules for their loans,124 which do not have a maximum DTI requirement. The GSE patch is a temporary measure that is set to expire on January 10, 2021, or on the day the GSEs exit Federal Housing Finance Agency conservatorship, whichever

119_{Dodd–Frank Act 2010, s 1411(a)(2), § 129C(a)(1), 124 Stat. 1376, 2142} 120_{Goodman (2019)}

121_{The loan cannot have negative amortization, interest-only payments, or balloon payments. Total points and}

fees cannot exceed 3 percent of the loan amount. The mortgage term must be 30 years or less. Kaul and Goodman (2018)

122_{Kaul and Goodman (2018)} 123_ibid

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occurs first. The FHA, VA, and USDA QM rules are permanent, with their special position being supported through the lack of a maximum DTI requirement.125 This means that the issue could be resolved in respect of Fannie Mae and Freddie Mac, once it is removed from conservatorship, however it remains for the FHA. This exemplifies the need for the Dodd Frank Act to equally apply to government agencies, limiting mortgage availability based on the risk of default, to ensure it effectively addresses the systemic risk created by housing bubbles. Nonetheless, this again shows the trade-off with housing affordability: The

challenge of implementing the ‘ability to repay’/QM rule being to maintain the balance with the goal of protecting mortgage borrowers from predatory lending, ensuring broad access to mortgage credit.126 However, this balance should be achieved by ensuring equal enforcement of the provisions and ensuring home ownership through specific subsidies for low income families.

Furthermore, the inefficient implementation in terms of scope is evident in the changes of Dodd Frank mortgage requirements through the Economic Growth, Regulatory Relief and Consumer Protection Act.127_{This enables smaller banks to offer mortgages outside the QM}

rule, based on that they don’t sell it. By holding that mortgage on the books, it would be deemed a QM. The carve-out applies to institutions with less than $10 billion in assets.128 This lets smaller banks and credit unions still qualify for the legal protections without meeting all of the requirements that are typical for underwriting qualified mortgages. Nevertheless, despite keeping the mortgage in its own portfolio, instead of selling it to investors, thus keeping the risk with the bank, this still leads to excessive risk concentration for the asset type of mortgages within banks. The issue here is that again wrong incentives are created, giving ‘lenders a major safe harbour for non-traditional underwriting practices reminiscent of those that caused the crisis,’129 creating risk in the housing market.

3.2.2.3 Inefficient implementation of Dodd Frank’s tools

Another deficiency of the Dodd Frank Act is the indirect implementation of its tools, limiting its effectiveness. During housing bubbles, the typical excessive optimism makes the Dodd Frank Act’s indirect, incentive-based approach ineffective or even counterproductive.130 An

125_{Kaul and Goodman (2018)} 126_{Hizmo and Sherlund (2018)}

127_{Economic Growth, Regulatory Relief and Consumer Protection Act (2018)} 128_{Witkowski (2018)}

129_{Gelzinis and Valenti (2018)}

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indirect approach, purely increasing costs of borrowing will likely increase, rather than reduce systemic risk by concentrating mortgage risk in SIFIS. To effectively address the risk created by housing bubbles, mortgage leverage should be directly regulated.

The use of indirect lender based regulation is the focus on ensuring ‘skin in the game’ through risk retention requirements:131 Through this, lenders cannot just sell the loans to securitizers that pass them off to investors, as the Dodd Frank Act requires securitizers to retain credit risk, creating incentives to assess the quality of the mortgages, which protects investors.132 This is aimed at addressing the pre-crisis issue of increased lending to riskier borrowers. This is ineffective where lenders are so overoptimistic regarding the price development (bubble situation), that even additional costs imposed on them do not cause them to appropriately account for the probability of default. Its ineffectiveness lies in the assumption that investors make rational decisions regarding the chances of default, which is however impaired during bubbles, where the expectation about continuous house price rises are irrational.133_{Furthermore, any form of risk retention on the side of the lender, does not}

reduce risk per se, but instead just over-concentrates it on the securitizer. The risk retention tool of the Dodd Frank Act134 fails to limit systemic risk when implemented, due to

incentives in bubbles creating irrational behaviour and risk retention regulation not reducing risk, but actually just concentrating it in one place.

Moreover, on the borrower side, even if the ‘ability to repay’ rule would extend to GSEs, this is not necessarily effective in the situation of a housing bubble. This is due to the ‘ability to repay’ criteria itself: the statute and implementing regulations, imposing a duty to make a ’reasonable’ determination in ‘good faith’, do not mandate any specific standards for how lenders use the required information135 of the previously discussed section 1411 to determine a borrower’s ‘ability to repay’. The formal bright line requirement of documenting the borrower’s credit history, employment status, income, debt-to-income ratio, and assets does not involve an effective assessment, as it is only enforced ex post, after a borrower actually does not repay. The CFPB notes the ‘litigation [under the ability-to-repay rule] likely would arise only when a consumer in fact was unable to repay the loan (i.e. […] was seriously

131_{Dodd Frank Act 2010, s 941(b)} 132_{Bubb and Krishnamurthy (2015), 1546.} 133_{Bubb and Krishnamurthy (2015), 1546.} 134_{Norris (2013)}

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delinquent or had defaulted).’136 This operates as a standard and not a rule, since what counts as ‘reasonable’ is only apparent ex post, upon default.137 This gives the lender a wide

discretion through the subjective assessment of reasonableness and good faith.

Furthermore, lenders enjoy a presumption of compliance with the ‘ability to repay’ rule as long as the loan is a qualified mortgage.138 The presumption is irrebuttable for all qualified mortgages except higher-priced qualified mortgages.139 To rebut the presumption of a ‘reasonable’ determination of ‘ability to repay’ in a higher-priced transaction, a borrower must show that the lender did not make a reasonable and good faith determination of their repayment ability at the time, by showing that the borrower’s income, debt obligations, and mortgage payments140 would leave the borrower with insufficient residual income or assets other than the value of the house that secured the loan, with which to meet living expenses.141 Nevertheless, the general presumption of compliance represents the inefficient

implementation of the requirements, as the rules focus on intentional, opportunistic

behaviour, rather than errors of judgement. Thus, the procyclicality involved in assessing the ‘ability to repay’ is not addressed, as in a bubble, lenders can record the borrower’s income and assets as required to comply with the ‘ability to repay’ rule and still make the loan. This requirement only leads to increased underwriting costs; however, it does not prevent lenders from making the loan, due to their excessively positive expectations regarding house prices in bubble periods.142 Here, the formal documenting, without an actual ex ante assessment does not prevent risky mortgages, by not accounting for creditors’ and borrowers’ errors in assessing ‘ability to repay’, due to the subjective assessment allowing this.

Ultimately, the Dodd Frank Act’s deficiencies regarding the regulation of mortgages stem from the indirect implementation of its tools creating inefficiencies, and the lack of objectivity when applying provisions, failing to address the procyclicality in bubbles, distorting lenders’ assessment of credit risk.

136_{Ability-to-Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z), 78 Fed.}

Reg. at 6512.

137_{Bubb and Krishnamurthy (2015), 1596.} 138_{Dodd Frank Act 2010, s1411,1412} 139_{Andreano and Bacon (2019)}

140_{12 Consumer Finance Regulation. § 1026.43(e)(1) (2015)} 141_{McCoy (2016), 1182.}

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3.3 Essential elements of mortgage regulation

It has become evident that the implementation of Dodd Frank provisions aimed at limiting opportunistic behaviour is ineffective due to the distorted decision-making during bubbles.143 Instead, the focus should be on achieving overall market discipline, where the Dodd Frank provisions apply equally to government agencies, and specific rules, such as the ‘ability to repay’ rule don’t become ineffective due to excessive discretion given to the involved parties in assessing whether the standards are met.

In order to regulate housing bubbles, mortgage-driven housing demand and supply needs to be controlled and thus the ability to issue, as well as, to take out mortgages, restricted. Additionally, overall resilience of the economy is also essential to limit systemic risk. The deficiency of the Dodd Frank Act of only focussing on lender and borrower behaviour ignores the actual presence and impact of a housing bubble on economic stability. The market-wide overoptimism regarding house prices in a bubble has important implications for the design of regulation.144 It should not only limit lenders’ and securitizers’ ability to benefit from wrong decisions of borrowers and investors, but instead also protect the overall

economy from the distorted decision-making during housing bubbles, with mortgage regulation being resistant to the irrationality of the market. Overoptimism regarding house prices in a bubble will defeat indirect regulation, excessively focussing on incentives. Consequently, direct regulatory approaches will be more effective in protecting banks and borrowers.145

Ex ante regulatory tools would be more useful to limit the build-up of risk and to mitigate

housing bubbles, with macroprudential tools reducing the boom part of the financial cycle. A suitable tool would be an ex ante limit on mortgage leverage, limiting how much a debtor can borrow against the value of real estate.146 Requiring significant down payments would limit the frequency and magnitude of housing bubbles, by limiting the proportion of debt.

143_{Bubb and Krishnamurthy (2015), 1608.} 144_ibid

145_{Bubb and Krishnamurthy (2015), 1544.} 146_{Bubb and Krishnamurthy (2015), 1548.}

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3.3.1 LTV

Firstly, a leverage limit would reduce the dependency of mortgage loans on house price development.147 Borrower’s equity provides a buffer for mortgages when house prices fall. Simultaneously, this reduces the exposure of households to undiversified, highly leveraged investments in housing, by addressing the procyclicality of loosened credit conditions during a boom.148 Thus, a leverage limit would reduce the likelihood of a bubble to develop, by allowing savings growth to constrain house price growth.149_{Secondly, a leverage limit would}

indicate the likelihood of individuals to default. Low loan-to-value (hereafter LTV) loans default less easily, because borrowers who are able to make larger down payments are less risky, with the LTV limit creating incentives to save money for down payments.150 Thirdly, a leverage limit would lower defaults by reducing households’ debt burden.151 A leverage limit would prevent households from becoming overleveraged during bubbles, and a reaction to the limit would be buying a less expensive home or deciding to rent. At the same time, households with sufficient liquid resources for making large down payments are also less likely to borrow as much to purchase their homes. Overall, the threat to the financial and economic stability could be reduced, due to a leverage limit reducing the mortgage debt asset class.

By reducing households’ debt levels stemming from housing, this would limit their exposure to housing bubbles and their burst, lowering the macroeconomic spill-overs of housing bubbles. The LTV limit is thus particularly beneficial as a countercyclical tool, as lower LTV ratios can slow down housing prices and credit growth.152 The negative effect of a leverage limit restricting access to mortgage credit and possibly distorting homeownership could be balanced out by public grants and guarantees. Furthermore, a leverage limit has the effect of reducing the overall defaults of mortgages, resulting in lower interest rates on mortgages and therefore making mortgage credit more affordable.153 Ultimately, the benefit of a leverage limit reducing debt levels, limiting the sensitivity of households to house price developments and overall reducing the likelihood and magnitude of housing bubbles, can outweigh the cost of restricted access to homeownership.

147_ibid

148_ibid

149_{Bubb and Krishnamurthy (2015), 1612.} 150_{Bubb and Krishnamurthy (2015), 1614.} 151_ibid

152_{McCoy (2016), 1182.}

Housing bubbles in the United States Does American federal macroprudential regulation foster an environment that effectively deals with housing bubbles?