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Bank Regulation and Mortgage Market Reform

Two sets of major financial sector regulatory reform initiatives are currently unfolding in the United States (U.S.). One set concerns bank regulatory reform as embedded in the 2010 Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and the 2010 Basel III bank regulatory proposals. While the Dodd-Frank Act and Basel III both include regulatory changes that affect mortgage market activity, neither addresses the regulatory adjustments that would be necessary for a fundamental U.S. mortgage market reform. The second financial sector regulatory reform concerns precisely a fundamental U.S. mortgage market reform as proposed in the recent U.S. Treasury/HUD (2011) White Paper.

The White Paper recommends winding down Fannie Mae and Freddie Mac (the two large government sponsored enterprises (GSEs)) and proposes a set of options for redesigning the U.S. mortgage market to operate without them. The White Paper, however, provides no details concerning complementary bank regulatory reforms.

The result is that the bank regulation and mortgage market reforms are developing independently of one another. This is particularly striking since the subprime crisis, which is the major impetus for both reforms, was particularly damaging to the banking sector ad financial markets precisely because the banking and mortgage market regulatory failures interacted. One quantitative measure of this interaction is that the cumulative losses on subprime mortgages are estimated at no more than $1 trillion, whereas the total U.S. household sector net worth was over $78 trillion at year-end 2007.

Thus the direct, one-time, estimated subprime loss of $ 1 trillion equaled less than 1.3% of the U.S. net worth. While 1.3% is not a minor amount, fluctuations in the stock market frequently create far greater losses without threatening to bring down the U.S. banking or financial systems. A further factor is thus necessary to explain why the subprime mortgage losses had a systemic impact on the U.S. banking and financial systems. Most commentaries identify the high concentration of subprime mortgage risks within the U.S. banks and related financial firms as a primary culprit.

Bank Regulation and Mortgage Market Reform