Since becoming US President, Donald Trump has enjoyed a period of economic certainty. John Williams, the President of the Federal Reserve Bank of New York, remarked that the economy ‘is in a good place.’ Bloomberg reported that Atlanta-based money merger Invesco Ltd has re-positioned a $1 billion exchange-traded fund after its propriety signals indicated that the economy was returning to an expansionary environment. The Labor Department added a net 224,000 jobs last month, and wage growth has exceeded three per cent. This is all positive news, but could America be sleepwalking into another housing crisis similar to 2008 without realising?
Even Williams highlighted a number of signs that economic momentum may be slowing due to declining manufacturing growth, domestic job gains shrinking, and inflation below the Fed’s central target, all of which may be negatively affecting people’s decisions when they spend and set prices. However, since 2015, US banks have been selling products named as a ‘Bespoke Tranche Opportunity’ (BTO).
For those who have seen Adam McKay’s blockbuster, The Big Short, you will probably remember this product’s name cropped up at the end of the film. The Big Short explores the role that subprime mortgages played in the 2008 Recession. A BTO is a repackaged synthetic CDO. The latter was introduced in 1997 as part of the Broad Index Secured Trust Offering. It is a complex derivative financial security sometimes described as a bet on the performance of mortgage products, rather than a real mortgage security. Any credit default swap is covered by insurance on the possibility that securities based on cash assets will default. Prior to 2008, synthetic CDOs enabled large wagers to be made on the value of mortgage-related securities, which critics argued may have led to lower standards and fraud.
A BTO may serve as the reference portfolio for a synthetic CDO arranged by an investment bank. These complex derivative financial securities were criticised for causing the last recession, and now they are still being sold as BTOs. If the Trump administration fails to clamp down on these products soon, another housing crisis will happen on his watch. We will see families lose their homes the way they did in 2007-09. It seems like Congress failed to learn anything from that period.
The best way Trump can prevent the spread of BTOs is by reforming the Community Reinvestment Act (CRA). This legislation was implemented in 1977, and rolled out subprime mortgages onto the housing market to provide poorer households with the chance of owning their own home. They were later linked to CDOs after Clinton relaxed the CRA in 1995 to prevent vigorous credit checks on poorer households that will never be able to repay their subprime loans. The American Enterprise Institute discovered in 2013 that 2.2 million risky loans were held by CRA programmes. The 2010 Dodd-Frank Act designed to prevent a crisis like 2008 was too harsh on small banks, which is why the President repealed sections of it in 2018 to allow banks with less than $250 billion in assets to compete on the market. Yet nine years after Dodd-Frank, they are still selling CDOs. This proves the spread of risky financial securities cannot truly end until the CRA has been reformed, because banks are still under pressure to lend to poorer households.
The President would do well to listen to the Office of the Comptroller of the Currency. Last year, they advised him to improve the CRA by clarifying the types of activities eligible for CRA consideration: establishing metric-based thresholds for CRA ratings, making bank CRA performance more transparent, and improving regulatory decisions related to the CRA.
The hurdle he faces is the Democrats. Nancy Pelosi controls the House of Representatives, which will make it difficult for the President to pass any CRA reform. When Bush tried to clamp down on Fannie Mae and Freddie Mac, Democratic opposition in the Senate killed his bill. By the time CRA reform was approved in 2005, it was too late. Trump could face the same challenge if he pursues the same path.
CNN reported Clinton urged Trump to run for president when they were playing golf because he could ‘see the genius’ behind the Republican’s ‘economic populism.’ The President is economically literate and if he did embark on CRA reform, this would only reinforce that sentiment. But unless he can persuade the Democrats to join him, bad banking practices will continue, and this could only lead to an economic disaster happening yet again to another Republican president.