Bad History, Worse Policy: How a False Narrative about the Financial Crisis led to the Dodd-Frank Act

By Peter J. Wallison

This timely study focuses on how the government-constructed narratives surrounding the collapse of Fannie Mae and Freddie Mac and the 2008 financial crisis shaped the policymaking that led to the Dodd-Frank Act. The book shows that every major provision of the act can be traced directly to that narrative, which ignored the government’s own role and focused entirely on the errors of the private sector. In the next Congress, whether or not the Republicans are in control of the House and Senate, there will be a concerted effort to make changes in—or even repeal—the Dodd-Frank Act. The essays in this book, originally published by AEI as Financial Services Outlooks, and the accompanying commentary provide a thorough backgrounder for anyone interested in financial policy.

• Language: English
• Publisher: AEI Press
• Release date: Oct 25, 2013
• ISBN: 9780844772400

Peter J. Wallison

Peter J. Wallison is a member of the Financial Crisis Inquiry Commission (FCIC) and a codirector of financial policy studies at the American Enterprise Institute.

Book preview

Preface

The winners write the history, so a contemporary and contrary view is essential. With their victory in the elections of 2012, Barack Obama and the Democrats put themselves in a position to cement the Dodd-Frank Act into law. As this is written, more than two years after the act was passed, fewer than half of all the regulations required by the act had been finalized, but the election provided the Obama administration with four more years in which to get the job done. Sadly, the result will be much slower growth for the U.S. economy and a decline in the significance of the U.S. financial industry—formerly the world leader—in the global economy.

At some point in the future, scholars will wonder why the United States tied its own hands and limited its economic growth in the early 2000s. They will look back at the period after the second World War and note that until the second decade of the 21st century the United States led the world in innovation and economic growth, with startling advances particularly evident in the living standards of the middle class. Then, in 2008, there was a financial crisis, and in 2010 the Dodd-Frank Act, a financial reform law; after that, the wheels of the U.S. economy just turned more slowly.

I hope this book, made possible by a generous grant from the Templeton Foundation, will help future scholars sort it all out—that it will be seen as a chronicle of why and how the U.S. crushed the life out of one of its most successful industries, impeded the growth of its economy and hobbled improvement in the lives of its own citizens. It is made up principally of 30 essays, beginning in 2004 and extending through 2012, in which I chronicled the underlying causes of the crisis and how the left developed a false narrative both to deny the government’s role in the crisis and to provide a foundation for legislation that would place the U.S. financial system under the government’s control. These essays, called Financial Services Outlooks, are included in substantially the form in which they were originally published by the American Enterprise Institute.

I have tried to provide some context for these essays with accompanying commentary that places them in the political and economic background that existed at the time they were written. If, in retrospect, there are errors in the essays, I thought it best to leave them uncorrected, as evidence of what was known, or what I thought, at a particular time. Similarly, as I was writing the commentary, regulations were being proposed, modified and in some cases issued in final form; these changes could not be incorporated into the book before its publication in early 2013.

Introduction: Obamacare for the Financial System

The Great Depression persuaded the public that private enterprise was a fundamentally unstable system, that the Depression represented a failure of free market capitalism, that the government had to step in. . . . The widespread acceptance of these views sparked the enormous growth in the power of government . . . that is still going on. We now know, as many economists knew then, that . . . the truth about the Depression was very different. The Depression was produced, or at the very least, made far worse by perverse monetary policies followed by the U.S. authorities. . . . Far from being a failure of free market capitalism, the Depression was a failure of government. Unfortunately, that failure did not end with the Great Depression. . . . In practice, just as during the Depression, far from promoting stability, the government has itself been the major single source of instability.

—Milton Friedman, A Monetary History of the United States

The 2008 financial crisis was the most serious shock to the U.S. economy since the Great Depression. It triggered a lengthy recession, deepened a painful housing market collapse, and set the stage for massive taxpayer bailouts. Perhaps most serious, the 2008 crisis triggered a view—never far below the surface on the left—that capitalism itself was at fault. Wall Street greed, private sector irresponsibility, and regulatory failure quickly became the heart of the narrative pushed by the left and embraced by the Obama administration and the mainstream media. This narrative helped to shackle public opinion behind the Dodd-Frank Act (DFA),¹a modern analog of New Deal legislation like the National Industrial Recovery Act and the Agricultural Adjustment Act, both of which were eventually declared unconstitutional.

Instead of a thorough study of the causes of the financial crisis, we got the left’s perennial prescription for the economy’s ills—more government controls. Like its health care twin, popularly known as Obamacare, the DFA leaves the financial system nominally in private hands but subjects it to so many controls that it will no longer be able to function independently of the government. In this book, I will attempt to show how this was brought about through the development, propagation, and acceptance of false narratives—first about the government sponsored enterprises (GSEs) the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and then about the financial crisis itself.

The DFA is yet another example of the aphorism that the speed and scale of a government prescription is directly proportional to the vapidity of its diagnosis. In effect, the most serious U.S. financial crisis in at least eighty years has never been thoroughly investigated, nor its causes fully debated. From the moment in the 2008 presidential debates that President Obama called it the result of Republican deregulation, no serious consideration was given by his administration or the Democratic Congress to the real causes of the financial crisis. Together, in the DFA, they enacted far-reaching legislation that will likely hobble one of the most successful industries this country has ever produced, and they will have done it on the basis of nothing more substantive than a half-baked political slogan.

A challenge to this dominant narrative is now emerging. During the 2011 and 2012 Republican presidential debates, almost all the candidates—including the eventual victor, Mitt Romney—argued that the 2008 financial crisis was caused by U.S. government housing policy. Republicans in Congress have also introduced legislation to repeal the act in its entirety. These efforts are not necessarily driven solely by ideological considerations. There is strong evidence that the DFA has impeded recovery from the recession that followed the financial crisis. Enacted in July 2010, the act started the gross domestic product (GDP)—including both the housing and manufacturing sectors—on a downward track from which it never fully recovered. Before the DFA, average GDP growth had been 2.5 percent. After, through the third quarter of 2012, it was 2 percent.

These results illustrate the underlying rationale for an exchange between Jamie Dimon, the chairman of JPMorgan Chase, the largest U.S. bank, and Fed chief Ben Bernanke on June 8, 2011: Dimon said, I have a great fear that someone’s going to write a book in 10 or 20 years and the book is going to talk about the things we did in the middle of the crisis that actually slowed down the recovery. . . . Has anyone bothered to study the cumulative effect of all these [regulations]? . . . Is this holding us back [from creating jobs] at this point?² Bernanke’s reply was candid: Has anybody done a comprehensive analysis of the impact [of new regulations] on credit? I can’t pretend that anybody really has. You know, it’s just too complicated. We don’t really have the quantitative tools to do that.³

Narratives and Policy

If government housing policy—and not lack of regulation—caused the financial crisis, more and tighter regulation as embodied in the DFA would be the wrong policy response. It will unnecessarily increase costs for the private sector and reduce economic growth and jobs. Instead, one would repeal Dodd-Frank, change government housing policy, and then evaluate whether any additional regulation is necessary.

These were ideas I had been pressing for many years through the Financial Services Outlook essays that form the heart of this book. Between 2004 and 2012, I had written more than seventy essays on the regulation of financial services. From these, with a generous grant to AEI from the John Templeton Foundation, I selected twenty-nine Outlook that covered important aspects of three related topics Fannie Mae and Freddie Mac, the financial crisis of 2008, and the Dodd-Frank Act.

In reviewing these essays, I found that they reflect a common theme: the power of ideas—shaped into a narrative or description of an event—to affect public policy. Until 2004, when both GSEs were found to have manipulated their accounting, they were thought to be politically powerful but well managed and essentially harmless toilers in the housing finance vineyard. This image—the product of a well-tended narrative about their benign and helpful role in housing finance—protected them from serious challenge. After the financial crisis, despite a strong case that the government’s housing finance policies were the principal cause of the breakdown, the left succeeded in constructing a counternarrative in which unbridled free markets were the principal culprits. This narrative was accepted uncritically by the media and became the conventional explanation for the crisis. With no other ideas admitted into the public square, the DFA was the inevitable result.

Accordingly, this book emphasizes the importance of narratives in shaping public policy. Before policies and laws can be changed, the narrative that gave rise to the existing policies must be challenged or shown to be wrongly founded or outdated. Obviously, this is not a new insight; it’s always been clear that ideas have consequences. But in the case of the Dodd-Frank Act, it is possible to discern a clear line from the narrative about the GSEs, through the initial ideologically tinged narrative about the causes of the financial crisis, to the principal terms of the act. In order to repeal the act, then, it is necessary to show that its policy rationale—the underlying narrative—is false. That is the purpose of this book.

When I joined AEI in 1999, I had already decided that my first project would be to explore the role of Fannie Mae and Freddie Mac in the U.S. housing finance system. I’d had this idea in mind since my years as general counsel of the Treasury, when I’d first encountered these obscure but immensely powerful Washington institutions. In 1999 I knew relatively little about the two GSEs, but enough to recognize that they represented a peculiar and troubling business model—shareholder-owned private firms that were listed on the New York Stock Exchange, thinly capitalized, highly profitable, and the beneficiaries of what was then described by outside observers as implicit government backing. The companies denied that they had any such government support, implicit or otherwise, and of course the government—often through the Treasury Department—issued the same denial. But the markets refused to believe it and continued to provide Fannie and Freddie with rates on their debt securities that were better than AAA and only slightly higher than what Treasury itself was required to pay.

This structure worried me. It was not clear how their risk-taking could be controlled if creditors—the only group that doesn’t benefit from risk-taking—have no incentive to care whether the two firms are taking risks. In other words, how could there be any form of market discipline if the credit markets were assured that they would be reimbursed by Uncle Sam if one or both of the GSEs were to fail? Here, undoubtedly, was the clearest and most troubling case of moral hazard in the U.S. financial system. Even government deposit insurance covers only a specified amount of bank deposits; Fannie and Freddie had accumulated liabilities of more than $5 trillion, and all of these obligations were implicitly on the government’s books. If the markets were correct about the nature of this government backing, the taxpayers were eventually going to face substantial costs.

Fannie and Freddie were regulated, to be sure, but I am skeptical in general about the efficacy of regulation. Government employees, as diligent as they may be, simply do not have the incentives to be tough and thorough in supervising complex financial institutions. And if these incentives are absent, regulation itself creates moral hazard by providing an illusory sense that an objective third party is controlling a regulated firm’s risk-taking. Indeed, the fact that they were regulated at all was a strong signal to the markets that the government was aware of its implicit obligations and would stand by them. Under these circumstances, weak regulation was the worst of all possible worlds, and the regulatory structure for the GSEs in 1999 was notoriously weak. For example, their regulator, the Office of Federal Housing Enterprises Oversight (OFHEO), did not even have the ability to increase their capital as their risks increased; their capital level had been set by statute at an appallingly low level—2.5 percent on their mortgage assets and forty-five basis points on their guarantees of mortgage-backed securities (MBS). Accordingly, my objective—as outlined in chapter 1—was to raise public awareness of the risks associated with these two firms in the hope that this would spur congressional action for tighter and more comprehensive regulation.

There is some irony associated with my view of the GSEs’ potential risks for taxpayers; during the time I was studying the GSEs, I was largely unaware of the nature and scope of the risks they were actually taking. This was not because of my own limitations as an analyst—limitations I readily admit—but because the same lack of disclosure that characterized the GSEs’ financial statements also extended to their activities in buying and securitizing mortgages. Although their fraudulent accounting awakened Congress, the White House, and Fed chairman Alan Greenspan to the dangers they might potentially pose to the financial system and the taxpayers, by late 2004 few people had yet realized that the GSEs were also buying hundreds of billions of dollars of subprime and other low-quality mortgages in order to meet the affordable housing goals that had been imposed on them by Congress in 1992. It wasn’t until shortly before they became insolvent and were taken over by their regulator—acting as a conservator—that the data began to come out in understandable form. These data made clear for the first time the poor quality of the mortgages the GSEs had been acquiring. It showed not only why they had become insolvent but why their activity was a primary element in the government housing policies that ultimately caused the 2008 financial crisis.

There is a sequel to all of this. In July 2009, I was appointed by John Boehner, then the House minority leader, as a member of the Financial Crisis Inquiry Commission (FCIC), a congressionally appointed ten-member group (six Democrats and four Republicans) that was to investigate the causes of the financial crisis and report to Congress, the president and the American people. Ultimately, for the reasons outlined below, I dissented from the commission’s majority report.⁴ In my dissent, I pointed out that by 2008, because of government housing policies, almost half of all mortgages in the United States were subprime or otherwise weak and that the vast majority of these mortgages were on the books of government agencies like Fannie and Freddie. The FCIC majority ignored these numbers. Nevertheless, in December 2011, the SEC sued some of the top officers of Fannie and Freddie during the period prior to their insolvency, alleging that they had failed to disclose the full scope of their purchases of sub-prime and other low-quality mortgages. The SEC had been able to conduct a thorough investigation of the books and records of the GSEs and had obtained nonprosecution agreements in which both firms admitted that they had acquired and not disclosed the mortgages that ultimately caused their insolvency. These agreements showed that there were actually more subprime and low-quality mortgages on their books in 2008 than I had reported in my dissent.

Because Fannie and Freddie were hiding their subprime credit risks, I and others—including Alan Greenspan and economists at the Fed—were focused on the interest rate risk associated with their portfolios of mortgages and mortgage-backed securities. Together, the GSEs held mortgages and MBS with a value of more than $1.5 trillion. Their statutory capital was extremely thin, only 2.5 percent of their assets, and they were carrying these instruments with borrowed funds. If interest rates should rise above the rate on the funds they had borrowed, they would begin to suffer cash and accounting losses on the value of the instruments themselves. For example, if the GSEs were earning 5 percent on the mortgages in their portfolios but were required to pay 6 percent for the funds necessary to carry these portfolios, they would sustain significant losses. Because they were so thinly capitalized, it would not take long for them to become insolvent. In addition, their assets would have to be written down, causing a further decline in capital. These losses, in turn, could trigger much higher funding costs, eventually requiring the government either to come to their rescue or close them down. Ultimately, of course, it was their credit risk-taking and not their interest rate risk-taking that did them in. Their shares fell sharply in value in the summer of 2008, when investors realized that the unprecedented number of mortgage delinquencies and defaults would affect their profitability, even if the government protected their creditors.

This raises the legitimate question of whether it was the GSE form itself or government housing policy that caused the failure of these two firms and ultimately the financial crisis. The answer is: both. If it had not been for the GSE form, which allowed Fannie and Freddie to operate with the implicit backing of the U.S. government, they could never have grown as large as they did and could never have had such outsized influence on the U.S. housing market. In addition, it was the moral hazard associated with this implicit government backing—the belief in the credit markets that the government would never allow Fannie or Freddie to fail—that allowed them to operate without anyone’s scrutiny. The fact is that no investor that was buying their securities—either their debt securities or the MBS they had guaranteed—cared what risks they were taking. In the end, everyone was confident that Uncle Sam would stand behind them, a confidence that was fully borne out. This enabled the U.S. Department of Housing and Urban Development (HUD) to raise the affordable housing goals over time—substantially increasing their risk-taking—without engendering any significant concern in the credit markets. To the extent that financial analysts were looking at Fannie and Freddie, they were equity analysts, who probably believed the narrative that Fannie and Freddie only bought prime mortgages. Even if housing prices stopped rising, they reasoned, the high quality of the GSEs’ portfolios would keep them from suffering debilitating losses.

The Narrative on Fannie Mae and Freddie Mac

There was little support for tighter and more comprehensive regulation of Fannie and Freddie when I joined AEI in 1999. To the extent that they were known at all, the GSEs were seen as largely benign facilitators of an efficient housing market, and their soft-focus advertising emphasized their contributions to the American dream of homeownership. Americans generally thought of the U.S. housing finance system as efficient and effective, and the politicians who supported it called it the envy of the world. Few Americans—or lawmakers for that matter—knew that the U.S. mortgage interest rates and homeownership rates were somewhere in the middle of the pack for developed countries, even though only the United States directly subsidized housing finance, allowed refinancing without penalty, and in many states allowed nonrecourse mortgages in which homeowners had no liability on the mortgage note beyond whatever value the lender received on foreclosure. With all this misplaced satisfaction, it was difficult for Congressman Richard Baker—then the head of the House subcommittee with jurisdiction over the GSEs—to find cosponsors for tougher regulation of the GSEs, even among Republicans.

Between 1999 and 2005, I sponsored seventeen AEI public conferences about the GSEs and the risks they posed to the taxpayers. But apart from raising interest in the GSEs in the Washington policy community, my efforts seemed to produce no significant additional support for regulatory legislation. During much of this period, when Alan Greenspan was asked in congressional testimony about Fannie and Freddie, he usually said that he thought they were well-managed institutions and didn’t see any particular reason for the Fed to be concerned about them. This was essentially the conventional wisdom—the narrative—about the GSEs. They were seen as a necessary part of the plumbing of the housing finance system, and exploring what problems they might cause in the future was more trouble than it was worth. It seemed as though things would go on this way indefinitely, with the two firms skating by their critics on the strength of their unparalleled Washington networks, the narrative about their quietly helpful role in fostering homeownership, and (not coincidentally) the fact that they had made the realtors, homebuilders, and securities industry—three highly influential lobbying groups—into their cheerleaders, surrogates, and ardent backers in lobbying Congress.

But then, in 2003 and 2004, as recounted more fully in chapter 1, things went wildly off the rails for the GSEs. In the wake of the Enron scandal, their own manipulation of accounting standards challenged the conventional narrative that they were good corporate citizens and unlikely to be the source of financial problems. They were no longer the untouchables. A new narrative developed—that they were more concerned about their own profitability than advancing homeownership and were potentially problematic for the health of the economy. No one truly understood the scope of the dangers they posed. That did not become clear until the financial crisis. But under the new narrative, it was not safe for most lawmakers to be seen in public with them. Alan Greenspan, now awakened to the dangers they posed, was a powerful voice, calling for reform in almost every appearance before Congress. And Washington institutions such as the Fed’s economic staff and the Congressional Budget Office began examining whether their shareholders—rather than homeowners—were really getting the benefit of the government subsidy they enjoyed.

Still, the GSEs were powerful enough to stymie moves by the Bush administration—even with a Republican Congress—to improve and tighten their regulation. Fannie and Freddie had lost their aura of invincibility and their reputation as good and honest corporate citizens, but their support by various important interest groups, and the formidable networks they had established in Washington, gave them sufficient raw power in Congress to prevent serious tightening of their regulation.

By 2005 the administration felt strongly enough about the need for tougher GSE regulation that it opposed House legislation—adopted by the Republican-led House Financial Services Committee (HFSC)—because it did not go far enough in controlling the two firms. When the Democrats took control of Congress in 2006, the chances for reform looked bleak, especially because Barney Frank—the GSEs’ biggest booster in Congress—became the HFSC’s chair. However, Frank was willing to work with Hank Paulson, Bush’s new Treasury secretary, to develop fairly strong regulatory legislation, and Frank was able to move the legislation through the House. Frank’s new openness to tighter regulation of the GSEs showed that conditions in Washington had indeed changed significantly, but it had taken a major and somewhat serendipitous event—the sudden dismissal of the top three officials of Freddie described in chapter 1—to make that change happen. Without the destruction of the GSEs’ image as honest and well-managed firms—in other words, the destruction of the prevailing narrative about them in Washington—it is doubtful that Congress would have taken the steps to increase the power of their regulator before the financial crisis hit in September 2008.

The Narrative for the Financial Crisis

Unfortunately, as it turned out, this stitch was not in time. As outlined more fully in chapter 2, the first indications of a coming financial crisis appeared in 2007. Government officials who would be expected to have the best information about what was happening in the financial markets—particularly the new chairman of the Federal Reserve, Ben Bernanke, who replaced Greenspan in 2006—were unable to foresee what was coming. In March 2007, Bernanke told Congress that at this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained.⁵ One year later, the problem that was likely to be contained had grown so serious that it induced the Fed to rescue Bear Stearns, one of the largest investment banks on Wall Street. By September 2008, in the midst of the presidential campaign, the subprime problem was out of control; virtually all of the world’s largest financial institutions appeared to be in trouble, and Lehman Brothers—another large investment bank—was allowed to fail, shocking the market, causing banks and others to hoard cash, and bringing on a full-scale panic now known as the financial crisis.

From the beginning, the government blamed the private sector, and particularly Wall Street, for the financial crisis. Like the narrative for the Great Depression described in the Milton Friedman quote that keynoted this introduction, the financial crisis narrative was simple and wrong. In this telling, the crisis was caused by irresponsible private-sector risk-taking, greed on Wall Street, and predatory lending by unscrupulous and unregulated mortgage originators. To this, during the 2008 presidential debates, then-candidate Obama added Republican deregulation, supplying both a partisan element and insufficient regulation as another cause. Blaming the private sector and the largest banks for the financial crisis absolved the government’s housing policies—which had been initiated during the Clinton administration and actively pursued under George W. Bush—and created a foundation for the enactment of the DFA. Because it was accepted and propagated without serious examination by the media, this explanation for the crisis still has a tight hold on what Americans believe about the crisis that befell them in 2008.

In point of fact, the government itself was principally responsible for the crisis. Ill-considered housing policies, imposed on and implemented by Fannie Mae and Freddie Mac, fostered the creation of twenty-eight million subprime and other weak and risky mortgages⁶—half of all mortgages in the United States. Of these, by 2008, 74 percent were on the books of Fannie and Freddie or other government-controlled or regulated agencies—with about three-quarters of these on the books of the GSEs—showing irrefutably where the demand for these subprime mortgages originated. Beginning in 2007, these loans failed in massive numbers, driving down housing prices, weakening the financial institutions that held them, and causing the panic and the financial crisis

There was still a lot about the GSEs that was unknown, and a lot that was assumed to be true and was not. One of the most persistent myths, even today, is that Fannie and Freddie only bought prime loans.⁷ This had been true before the 1990s, but because of a 1992 change in their governing law, it had not been true for the sixteen years leading up to the financial crisis. Unknown to me and to others who were following the GSE issue, since 1992 the GSEs had been acquiring increasing numbers of subprime and other weak and risky loans. The law that made this necessary was the Housing and Community Development Act of 1992,⁸ which required that 30 percent of all loans the GSEs acquired had to be made to low- and moderate-income (LMI) borrowers, defined as borrowers with incomes at or below the median in the communities where they lived. The Department of Housing and Urban Development (HUD) had been given authority to administer the act, and through both the Clinton and Bush administrations it had expanded and tightened this quota so that, by 2007, 55 percent of all loans they acquired had to be LMI loans.⁹

Although it was possible to find prime loans among LMI borrowers, it was not easy; to meet a quota of 50 percent or more, the GSEs were required to substantially reduce their underwriting standards. However, they did not accurately report what they had done. For example, although they were acquiring large numbers of loans that would ordinarily be considered subprime because they were made to borrowers with FICO credit scores lower than 660, Fannie and Freddie did not use this common definition for determining whether a loan was subprime. Instead, they defined mortgages as subprime only if they had bought these loans from subprime originators. In their reports to firms that aggregated and published mortgage market data, the GSEs did not reveal this definitional sleight of hand, and thus almost all the GSEs’ loans were recorded as prime when in fact substantial numbers—perhaps as much as 40 percent—were subprime or otherwise of low quality.

This was an extremely important fact and the reason why I and so many others—including Bernanke, other regulators, and most private sector observers—did not understand the true scope of the risks the GSEs were creating until their insolvency and the onset of the financial crisis. If they had fully disclosed their purchases of subprime loans and mortgage-backed securities based on subprime and other weak loans, investors, risk managers, analysts, and even regulators would have had a better understanding as the financial crisis approached of the riskiness of both the mortgage market and the assets of the largest financial institutions. In December 2011, the Securities and Exchange Commission (SEC) sued the former top officers of Fannie and Freddie for failing to disclose the full extent of the subprime and other risky loans they were acquiring.

The funds the government poured into the housing market helped to build a ten-year housing price bubble, extending from 1997 to 2007. Housing bubbles suppress delinquencies and defaults, because rising prices allow borrowers to refinance or sell the home before a default occurs. By 2002, investors around the world and on Wall Street began to believe that privately issued mortgage-backed securities—based on subprime loans—were good risk-adjusted investments; they were producing high yields but were not showing the losses that were normally associated with subprime loans. The boom in Wall Street activity extended from about 2004 to 2006, and by 2007—when the private MBS market collapsed in tandem with the housing bubble—there were about 7.8 million subprime loans outstanding in the form of privately issued mortgage-backed securities (PMBS)—less than 26 percent of the twenty-eight million outstanding.

When the great ten-year housing bubble deflated, it caused the collapse of the PMBS market as buyers were frightened off by an unprecedented number of delinquencies and defaults. This mortgage meltdown, as it was called in the media, weakened the financial condition of all the institutions that had substantial investments in these instruments. An event of this kind, a weakening of an entire industry because of a sudden decline in the value of a widely held asset, is known to scholars as a common shock.¹⁰

The rescue of Bear Stearns in March 2008 temporarily calmed the markets; investors and creditors thought the U.S. government had signaled that it would rescue all large financial firms. But when Lehman was allowed to file for bankruptcy in September 2008, market participants were shocked, and a full-scale panic ensued. Banks and others, fearful of withdrawals by depositors and counterparties, hoarded cash, and the sudden evaporation of credit was what defined the financial crisis. Fannie and Freddie became insolvent and were taken over by the government only a week before Lehman Brothers’ failure brought on the financial crisis. These two events were not unrelated. The GSEs had dominated the housing finance market ever since the savings and loan industry collapsed almost twenty years earlier. Moreover, a sharp decline in mortgage and housing values—the mortgage meltdown—is what precipitated the crisis. These related events should have been a powerful indicator that the GSEs’ housing finance activities had some role in the financial crisis.

But it was not to be. The whole question of the government’s responsibility for the crisis became enmeshed in the partisan and ideological struggles that were roiling the waters in Washington on the eve of the 2008 election. By characterizing the financial crisis as a result of Republican deregulation, President Obama made the crisis not only a partisan matter—a failure of the Bush administration—but also an ideological challenge to the Republicans’ governing philosophy. Obama’s statement was wrong, but neither John McCain nor his advisers were able to respond effectively. Indeed, McCain made things worse by saying on numerous occasions that the financial crisis was caused by Wall Street greed. This became the accepted narrative—the conventional wisdom—asserted in news articles and dozens of books as though it were the uncontroverted truth. Any effort to show the GSEs’ role, and the role of government housing policy, was denounced as a loony idea¹¹ or irredeemably partisan, if not ignored altogether. Accordingly, the most serious financial disaster since the Great Depression did not receive—and has never received—the careful study it deserved.

The effort to suppress a competing narrative—an alternative explanation of the financial crisis—reached the level of farce with the report of the Financial Crisis Inquiry Commission (FCIC), a group set up by Congress in 2009 to investigate and report on the causes of the 2008 crisis. With a government charter and government funding, one would expect that the commission would be duty-bound to consider every reasonable possibility. It didn’t come close. Composed of ten members—six Democratic and four Republican appointees (I was one of the Republican appointees)—the commission was completely controlled by its chair, Philip Angelides, a Democrat who had run for governor of California and was a confidant of House Speaker Nancy Pelosi. Angelides appointed almost every member of the staff, decided what the commission would investigate, established a schedule of public hearings on what he thought were key topics before there had been any investigation, and reviewed and revised drafts of the report before the other commissioners saw them. The Republican vice chair, Bill Thomas, a former congressman with a populist streak who knew little about the financial markets, was ineffective in getting Angelides to look into anything other than the subjects the Democrats wanted to pursue.

As a result, the report’s discussion of the GSEs’ role in the financial crisis was almost completely perfunctory, and the whole report was a sad whitewash—nothing but a confirmation of the left’s position that the crisis was the result of ineffective regulation of an irresponsible private sector. I wrote a one-hundred-page dissent that—in typical fashion for Angelides—was cut to nine pages in the version of the report that was commercially distributed through bookstores.

The irony is that this did not have to be a partisan dispute. The Bush administration was at least as culpable as the Clinton administration in pushing Fannie and Freddie to acquire the subprime and other low-quality mortgages that eventually drove them to insolvency, helped to build a gigantic ten-year housing bubble, and—as outlined in my dissent and discussed below—caused the financial crisis. It is, however, an ideological dispute. Even today, there is a frenzied effort on the left to counter any suggestion that the government had a role in the financial crisis, through the GSEs or otherwise.¹² Although there are no data that challenge the overwhelming evidence of the government’s central role, the left apparently believes that implicating the government in the financial crisis is an impermissible heresy.

Nevertheless, scholars and others are gradually making an effort to ferret out and publish the facts about the financial crisis. In December 2011, for example, Gretchen Morgenson and Josh Rosner published Reckless Endangerment, in which they argued that Fannie Mae’s efforts to solidify its political position by making subprime mortgages available to low-income borrowers had contributed to the financial crisis.¹³ And in June 2012, Oonagh McDonald, a respected United Kingdom scholar and former Labour member of Parliament, published Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare.¹⁴ This book indicts the U.S. government for causing the financial crisis by pursuing an ideologically based effort to foster loans to low-income borrowers, regardless of their ability to pay. Other books are also on the way, as scholars and others begin to question the underlying factual basis for the left’s narrative.

The Narrative and the Dodd-Frank Act

The rescue of Bear Stearns in March 2008, based on a Fed loan to JPMorgan Chase, was a seminal event in the development of a narrative that would support the Dodd-Frank Act. There had been many rescues of banks over the years, and these could be explained by the fact that banks held government-insured deposits, were essential to the payment system, were government supervised, and were the institutions where many middle-class families kept their savings. In addition, the business of banking involves smaller banks holding deposits in larger institutions, permitting efficient transfers of funds through netting debits and credits. For this reason, the failure of a large bank could deprive many smaller institutions of necessary funds, with adverse effects throughout the financial system and the economy.

Bear Stearns involved none of these special factors, so the government’s extraordinary use of its own resources to rescue Bear had to be justified in a different way. The justification used by the Bush administration and the Federal Reserve was that Bear was interconnected with other financial firms—especially through its activities in the credit default swap (CDS) market—and because of these interconnections Bear’s failure would have brought down the entire financial system. Immediately after Lehman’s bankruptcy, this interconnectedness theory was folded into the existing narrative about the causes of the crisis so that the narrative now explained why there had been a financial crisis (insufficient regulation) and why the government had to take extraordinary action (interconnections).

There is seldom an opportunity in social science to disprove ideas like this, since history seldom repeats itself without ambiguity, but in this case the failure of Lehman six months after Bear provides strong evidence that the interconnectedness theory is wrong.¹⁵ Lehman was substantially larger than Bear, but it operated the same way. It financed itself in large part through repurchase agreements (known as repos)—essentially very short-term collateralized loans—carried on a substantial business in derivatives, including CDSs, and was very active in trading and investing in MBS backed by subprime mortgages.

In other words, Lehman was just a larger version of Bear. Yet, with one exception (the Reserve Primary Fund, a money market mutual fund discussed below), when Lehman failed there were no knock-on effects—no instances where another firm was dragged into insolvency by the losses on its exposure to Lehman. For example, all CDSs written on Lehman—that is, insuring against Lehman’s default—were settled with the exchange of $5.2 billion among hundreds of counterparties about five weeks after the bankruptcy petition was filed, and the overwhelming majority of CDSs to which Lehman itself was a party were canceled as provided in the CDS contracts. Those CDSs where Lehman counterparties were in the money (i.e., were owed something by Lehman) became creditors of the Lehman estate. There were losses, to be sure, but there is no record of any firm having failed as a result of Lehman’s failure. This is extremely important in evaluating the judgment of Paulson and Bernanke in rescuing Bear Stearns. If Lehman did not have any knock-on effects in the panicky market at the time, it is highly unlikely that Bear Stearns—a much smaller firm—would have had a more dramatic impact on the market when it had failed six months earlier.

Some analysts argue that the actions of the government after Lehman’s bankruptcy prevented or mitigated Lehman’s knock-on effects, but this seems implausible. The two principal government actions were the Troubled Assets Relief Program (TARP), which made available more than $800 billion for the acquisition of what the media had labeled toxic assets—principally the PMBS—that had weakened U.S. financial institutions, and an FDIC program that guaranteed loans by insured banks. TARP ultimately became a program for recapitalizing banks, but the first investments were not made until six weeks after Lehman’s bankruptcy and were almost entirely repaid eight months later. Clearly, these capital injections were not necessary to fill holes in balance sheets caused by Lehman’s inability to meet its obligations. The FDIC guarantee program also did not repair balance sheets. It simply gave institutions the confidence to continue lending. Indeed, both TARP and the FDIC’s program had only one objective—restoring confidence, not repairing balance sheets weakened by the knock-on effects of Lehman’s failure.

In other words, the interconnectedness theory is wrong; Lehman’s failure might have had ill effects, but not because it dragged down other firms. None of the large firms that were either rescued or failed after Lehman—AIG, Wachovia, Washington Mutual, Merrill Lynch—was materially weakened because of its exposure to Lehman.

Why, then, were so many firms in financial trouble after Lehman? The short answer is that they were in trouble before Lehman, but the longer answer is our old friend, government housing policies. When the huge housing bubble created by these policies began to deflate in 2007, many banks and other financial institutions were holding PMBS backed by sub-prime loans. Although these were only 26 percent of the twenty-eight million low-quality mortgages outstanding, they represented almost $2 trillion.

When an unprecedented number of mortgages became delinquent or defaulted as the bubble deflated, investors fled the market for PMBS. Mark-to-market accounting, applicable for financial institutions virtually worldwide, then required these firms to write down the value of their PMBS assets to market values, which in a market without buyers were close to zero. The write-downs substantially reduced capital positions, making many of these institutions look unstable and perhaps insolvent. In addition, those that were using PMBS for liquidity purposes—something that was true of Bear and Lehman—found their liquidity drying up as creditors refused to take these instruments in repo transactions.

A broad weakening in the capital or liquidity of financial institutions because of a sharp decline in the value of a widely held asset, as noted earlier, is known as a common shock. Exactly this hit large numbers of financial institutions in the United States and around the world when what became known as the mortgage meltdown began in late 2006 and continued through 2007 and 2008. Even before the rescue of Bear and the bankruptcy of Lehman, the deteriorating financial condition of large numbers of financial institutions was setting the market up for a panic. All that was needed was a triggering event.

Lehman’s bankruptcy was the trigger. It was part of an immense government blunder—one of the worst in all of financial history—in which the U.S. government first rescued Bear Stearns and then allowed Lehman, an even larger firm, to fail. The Bear rescue was the original sin; it suggested that the government had established a policy of rescuing all large financial institutions. But six months later, in what the market can only have considered an irrational act, the government reversed its policy and allowed Lehman to fail.

This was a classic case of moral hazard, where the government’s actions distorted the normal response of the market. If Bear had been allowed to fail, market participants would have begun raising capital in order to persuade investors and others that they were strong enough to avoid a similar fate. Some capital was raised, but not enough; managements of the largest firms thought that the government’s willingness to rescue large financial firms would keep their creditors and counterparties from running. After all, if they were going to be fully bailed out as Bear’s creditors were, there would be no need to run. This prospect calmed the market for the six months between Bear’s rescue and the Lehman collapse. Spreads on Lehman in the CDS market, which would be an expression of the market’s fear of default, remained relatively steady from the time of Bear’s rescue in March until just before the weekend of September 12–14, 2008. At that point, the spreads blew out when it became clear that the government had no potential buyers for Lehman and no apparent rescue plan.

The moral hazard created by the rescue of Bear had many other damaging effects. Although it kept the credit markets temporarily calm—despite a lot of bad news—the rescue probably also misled the managements of large firms such as Lehman into believing that they could avoid diluting their shares, and drive a harder bargain with potential acquirers, than the firm’s financial condition would warrant. This discouraged purchasers, who saw these firms as potentially insolvent, and probably prevented an acquisition. In addition, although the government offered $30 billion in support for JPMorgan to acquire Bear, it was offering nothing to potential acquirers of Lehman. This alone would have prevented a deal; few acquirers want to look like suckers.

Finally, it is likely that the one firm that suffered a major loss because of Lehman’s failure—the Reserve Primary Fund—was also a casualty of moral hazard. The fund had held a substantial amount of Lehman’s commercial paper, which it could have sold in the weeks and months before the Lehman bankruptcy. It is possible that the fund’s management declined to do so in the belief that eventually the creditors of Lehman, like the creditors of Bear, would be made whole. When Lehman failed, the commercial paper lost most of its value, and the fund was unable to redeem all its shares for $1 each. This is known as breaking the buck, and in the panicky condition of market participants at the time it induced a run on other money market funds, requiring the Treasury to step in with a temporary guarantee. The Reserve Fund was the only firm seriously affected by Lehman’s failure, and although the shareholder run on other funds was a serious matter, in the absence of a market panic it is highly unlikely that a single mutual fund breaking the buck—something that had happened only once before, with no adverse consequences—would induce a financial crisis.

If the Treasury and the Fed actually believed that there would be a systemic financial crisis if Bear was not rescued, the case for rescuing Lehman was even stronger. In reality, the failure to rescue Lehman—after rescuing Bear—was a world historical blunder by Treasury secretary Hank Paulson and Fed chair Ben Bernanke. The moral hazard created by the Bear rescue made it inevitable that there would be chaos if any other large financial institution was allowed to fail. However, when a financial crisis occurred after Lehman’s bankruptcy, Secretary Paulson and Chairman Bernanke claimed that they had faced a Hobson’s choice between bankruptcy and a government bailout, which they claimed was beyond the Fed’s legal authority. The underlying implication of this argument was that if they hadn’t been required to accept bankruptcy—if there had been another choice—a financial crisis could have been averted. In other words, it was the bankruptcy of Lehman that caused the chaos and panic that followed.

This notion eventually formed the conceptual underpinning for Title II of the Dodd-Frank Act, which established a government resolution system for financial institutions, separate from bankruptcy. Known as the Orderly Liquidation Authority (OLA), this title gives extraordinary power to the secretary of the Treasury, who can seize any financial firm he believes may cause instability in the U.S. financial system if it fails and turn it over to the FDIC for liquidation. If the firm challenges the secretary’s judgment, the secretary can then take the issue to court, which is given only one day to decide the matter. If it doesn’t make a decision in this time, the firm is consigned by operation of law to the FDIC, which must dismiss the management and liquidate the firm.

But as discussed in chapter 3, the underlying assumption of the OLA—that if the FDIC takes over a financial firm the outcome will be different from the chaos and panic that followed Lehman’s bankruptcy—does not survive analysis. Three interrelated factors caused the panic after Lehman: (1) the moral hazard created by the earlier rescue of Bear; (2) the desire of investors to get their money out of a failing firm as quickly as possible, and (3) the weakening of virtually all large financial institutions at the same time as a result of the common shock associated with the mortgage meltdown.

There is nothing about the OLA that would have prevented any of these things from happening or would have resulted in a different outcome if—instead of filing for bankruptcy—Lehman had been seized by the FDIC under OLA authority. The shock to the market, and the resulting panic, would have been the same. In other words, the OLA would not be any improvement over bankruptcy.

The invalid interconnectedness theory and the mistaken view that the OLA would be better than bankruptcy are only two of the distorted facts that underlay the narrative for the Dodd-Frank Act. Others, also discussed in chapter 3, are the notion that the financial crisis was caused by predatory lending (the foundation for the Consumer Financial Protection Bureau in Title X and the Qualified Mortgage requirements in Title XIV), unregulated derivatives (the basis for new regulatory authority for the Commodity Futures Trading Commission and the Securities and Exchange Commission in Titles VII and IX), private mortgage securitization (the source of the Qualified Residential Mortgage and the 5 percent risk retention requirement of Title IX), or the proprietary trading by banks and other financial institutions (the conceptual underpinning of the Volcker Rule in Title VI).

The FCIC’s investigation of predatory lending was never able to demonstrate with data that it was a significant factor in the financial crisis. There were plenty of anecdotes and much testimony, but never any numbers to suggest that predatory lending was so widespread as to require a whole new regulatory scheme at the federal level or the new rules for mortgage lending that imposed heavy penalties for making a loan that a borrower ultimately could not afford. It was clear that large numbers of mortgages went to people who ultimately could not meet their obligations, but it is far more likely that borrowers were taking advantage of the reduced underwriting standards produced by government policies than that originators were taking advantage of ignorant borrowers.

Although AIG got into serious trouble with its activities in the credit default swaps market, it was an outlier. There are no other examples of firms suffering the same debilitating losses. AIG’s problems did not come from a lack of regulation in the market for credit default swaps or other derivatives. Instead, it is an example of bad management by a firm with a weak understanding of the risks it was assuming. This is no more a basis for regulating an entire market than imprudent lending by a single firm would justify regulating all lenders.

Mortgage securitization was mischaracterized in the left’s narrative as an originate to distribute process, as though the supply produced the demand. This is exactly backward. As outlined above, initially government housing policies, and later private investor demand, created a market for subprime and other low-quality loans. Securitization was one way that this market was served, but securitization in itself was not the cause of the decline in underwriting standards. The notion that originators could create the demand for low-quality loans reflects a mistaken and naïve understanding of how markets work.

Finally, the Volcker Rule is based on the false idea that proprietary trading of securities by banks and their affiliates was somehow a cause of the financial crisis. There is simply no evidence of this and no evidence that this trading is riskier than lending. Prior to the crisis, trading activity by banks was a profitable business and added needed liquidity to the debt markets. The prohibition on proprietary trading will have serious adverse effects on the profitability of banks as well as issuers and buyers of debt instruments, who ultimately rely on market making by banks to keep their securities liquid.

Accordingly, almost nothing about the left’s narrative for the financial crisis is correct. The crisis was not caused by lack of regulation, greed on Wall Street, or predatory lending by an irresponsible private sector; it was caused by the government’s irresponsible and poorly conceived housing policy. The chaos and panic that occurred after Lehman’s bankruptcy was not caused by the interconnectedness of large financial institutions or the knock-on effects of the Lehman failure; it was the result of a common shock that had weakened the financial condition of all large financial institutions that were holding PMBS assets when the mortgage meltdown occurred, together with the moral hazard created by the earlier rescue of Bear Stearns. Finally, there was no Hobson’s choice between bankruptcy and a bailout for Lehman. Given the weakened financial condition of all large financial institutions at the time Lehman failed, together with government’s irrational reversal of policy on financial rescues, a panic was inevitable when Lehman filed for bankruptcy and would have occurred even if Lehman had been taken over by the FDIC under the OLA established by the Dodd-Frank Act.

All of this makes clear that the Dodd-Frank Act is based on a false narrative of what caused the financial crisis and was not a legitimate response to the crisis. As former White House chief of staff Rahm Emanuel famously said, You never want a serious crisis to go to waste. What I mean by that is an opportunity to do things you think you could not do before.¹⁶ Instead, as Emanuel suggested, it represents a use of the financial crisis for ideological purposes—to enable the government to gain greater political control over the U.S. financial system. Under these circumstances, the act should be repealed.

In succeeding chapters of this book, I detail my efforts to combat the left’s narrative through Financial Services Outlook issued between 2004 and 2012. By 2012, I had made some progress; the Republican presidential candidate was arguing that the financial crisis was caused by the government’s housing policies and that the Dodd-Frank Act should be repealed. But there still had been relatively few instances in which an alternative description of what had happened in the financial crisis appeared in the mainstream media. Until that occurs and the false narrative that underpins the Dodd-Frank Act is identified for the American people, any effort to repeal the act will be an uphill struggle.

Footnotes

1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (July 21, 2010).

2. Quoted in Canfield and Associates, GSE Report, July 1, 2011, 1.

3. Ibid.

4. Peter J. Wallison, Dissent from the Majority Report of the Financial Crisis Inquiry Commission, 23–28, http://www.aei.org/files/2011/01/26/Wallisondissent.pdf.

5. Newsmax, March 27, 2007, http://archive.newsmax.com/archives/ic/2007/3/28/110709.shtml.

6. In my dissent and elsewhere, until December 2011, I used the number twenty-seven million to describe the number of subprime and other risky mortgages in the financial system in 2008. In December 2011, the SEC sued certain top officers of Fannie Mae and Freddie Mac, alleging that they failed to inform investors of the number of subprime loans they had acquired. Accompanying the SEC press release on the subject were nonprosecution agreements between the SEC and the two GSEs in which the GSEs agreed to the SEC’s finding that the actual number of subprime and other low-quality loans that the GSEs held or had guaranteed in 2008 was closer to thirteen million, raising the total number of outstanding subprime and other nonprime loans to twenty-eight million.

7. In an article in the New York Times on July 14, 2008, columnist Paul Krugman stated, incorrectly, that Fannie and Freddie were not allowed to acquire subprime loans and that this showed the value of regulation. Because of careless or ideologically driven columnists such as Krugman, who is widely read, the false narrative about Fannie and Freddie and ultimately the financial crisis was perpetuated.

8. Title XIII of the Housing and Community Development Act of 1992, Public Law 102-550, 106 Stat. 3672, H.R. 5334 (enacted October 28, 1992).

9. See http://www.aei.org/files/2011/01/26/Wallisondissent.pdf, 71, table 10.

10. George Kaufman and Kenneth Scott, What Is Systemic Risk and Do Bank Regulators Retard or Contribute to It? Independent Review 7, no. 3 (Winter 2003): 3.

11. Joe Nocera, Inquiry Is Missing a Bottom Line, New York Times, January 28, 2011.

12. See, for example, Joe Nocera, The Big Lie, New York Times, December 24, 2011, http://www.nytimes.com/2011/12/24/opinion/nocera-the-big-lie.html?_r=2.

13. Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time (New York: St. Martin’s Griffin, 2011).

14. Oonagh McDonald, Fannie Mae and Freddie Mac: Turning the American Dream into a Nightmare (New York: Bloomsbury, 2012).

15. This conclusion, citing the relevant FSOs, is supported in an extensive analysis of the financial crisis by Hal Scott of Harvard Law School, Interconnections and Contagion, November 20, 2012, http://www.capmktsreg.org/pdfs/2012.11.20_Interconnectedness_and_Contagion.pdf.

16. See http://www.youtube.com/watch?v=1yeA_kHHLow.

1

Fannie Mae and Freddie Mac

Under the direction of James A. Johnson, Fannie Mae’s calculating and politically connected chief executive, the company capitalized on its government ties, building itself in to the largest and most powerful financial institution in the world. . . . Fannie Mae led the way in relaxing loan underwriting standards, for example, a shift that was quickly followed by private lenders. . . . Eliminating the traditional due diligence conducted by lenders soon became the playbook for financial executives across the country.

— Gretchen Morgenson and Joshua Rosner,

Reckless Endangerment: How Outsized Ambition, Greed,

and Corruption Led to Economic Armageddon

In 1999, when I started focusing my attention on the GSEs, the narrative about Fannie and Freddie was daunting. They were considered to be well-run and profitable institutions with a strong political base and were doing good work in promoting homeownership without any cost to the taxpayers. They could raise funds in the capital markets without increasing the national debt and spend money to increase homeownership without increasing the deficit. Although their actual function in the housing market—operating a secondary market in mortgages purchased from originators—was not widely understood by the public, their soft-focus advertising associated them with expanding the American dream of homeownership. It was a win-win all around. This narrative made the GSEs virtually impregnable in Washington.

There was, to be sure, a little-known seamier side. Fannie Mae controlled a foundation that it used to distribute grants to organizations and individuals who were in a position to provide it with political support or endorse its programs, and it maintained a network of local offices—often staffed with relatives of influential lawmakers—that encouraged political support for them among their constituents. Fannie, in particular, also had a reputation for thuggish behavior in which it threatened the livelihoods of its critics,¹ and both firms made substantial political contributions to their congressional supporters and occasionally hired away the best staffers of opponents who were not susceptible to other kinds of intimidation.

The GSEs’ Narrative and the Sources of Their Power

Fannie’s and Freddie’s association with housing enabled them to attack any effort to restrain their activities as an attack on housing and the American dream. In this they were supported by three powerful interest groups, the National Association of Realtors, the National Association of Homebuilders, and the securities industry, which made substantial profits from underwriting and distributing their securities. Their own political contributions were supplemented by the considerable contributions of the realtors, homebuilders, and securities firms, which they were able to command and direct to favored lawmakers by sponsoring fundraisers. Most academics and other observers of the housing industry would agree that Fannie and Freddie were a long-term problem of some kind, but given all the other issues that were confronting Washington in 1999, taking on Fannie and Freddie was way down the list.

From the beginning, my opposition was based on the view that any government-sponsored enterprise would eventually self-destruct—with enormous costs to the taxpayers—because its government backing allowed it to avoid the creditor oversight known as market discipline. Profit-making firms such as Fannie and Freddie that were exempt from this kind of oversight would inevitably take excessive risks in order to boost their profits and the compensation of management. Fannie and Freddie were regulated by an