At long last, the ten-member Financial Crisis Inquiry Commission (FCIC) has issued its gargantuan report on the credit meltdown that pulverized Wall Street and triggered the worst U.S. economic slump since World War II. Its official conclusions reflect the opinions of the six Democratic commission members: Phil Angelides (the chairman), Brooksley Born, Byron Georgiou, Bob Graham, Heather Murren, and John Thompson. The four Republican members released two dissenting statements: one by Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas (the vice chairman), the other by Peter Wallison.
In ascribing blame for the crisis, the majority report points to “the captains of finance and the public stewards of our financial system,” in particular the Federal Reserve. Specifically, it rebukes the Fed for failing to establish “prudent mortgage-lending standards” that could have curbed the proliferation of risky loans, noting that the Fed “was the one entity empowered to do so.” The report argues that deregulation “had stripped away key safeguards, which could have helped avoid catastrophe,” but it affirms that regulatory authorities still had “ample power” at their disposal — power that went unexercised.
Wall Street comes in for a lashing (“dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis”), as do the credit raters (“This crisis could not have happened without the rating agencies”). The six Democrats also take swipes at “predatory lending” and inadequate oversight of the derivative market, singling out the 2000 Commodity Futures Modernization Act — which limited federal regulation of most over-the-counter derivatives — as “a key turning point in the march toward the financial crisis.”
All told, they depict the meltdown as a wholly preventable consequence of regulatory mistakes and corporate irresponsibility. While there is obviously some truth to that — every boom-bust cycle is marked by government blunders and reckless behavior — the FCIC majority narrative either neglects or minimizes critical parts of the story, making it woefully incomplete and more than a bit misleading.
Hennessey, Holtz-Eakin, and Thomas put the U.S. housing crash in its proper international perspective. During the late 1990s, developing countries such as China began accumulating massive current-account surpluses. This “global saving glut” (as Fed chairman Ben Bernanke famously described it) unleashed a flood of cheap capital into the high-consuming West that — combined with increased risk tolerance — helped generate credit bubbles, which in turn spawned housing bubbles.
America was hardly the only rich country to experience a major property boom. Real-estate prices also skyrocketed — and collapsed — in Britain, Ireland, Spain, Iceland, and elsewhere. Major financial companies with diverse investment portfolios failed all across Europe. Today, Britain is implementing a tough fiscal-austerity program; Ireland has been forced to accept a gigantic multilateral bailout; the Spanish unemployment rate is a mind-boggling 20 percent; and Iceland has become a byword for economic cataclysm.
Whereas many conservatives — most prominently, Stanford economist John Taylor — have fingered excessively loose monetary policy as the chief source of the U.S. bubble, Hennessey et al. contend that the underlying roots were actually “global capital flows and risk repricing.” In their estimation, monetary laxity “may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis.”
What about the much-maligned government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac? The mortgage twins operated under a perverse business model — public backing for private profits — while seeking to fulfill affordable-housing mandates imposed on them by Washington. As foreign capital flooded into the U.S., GSE bonds seemed like a wise investment. After all, Fannie and Freddie enjoyed an implicit federal bailout guarantee, which assuaged concerns over the size and configuration of their holdings. Indeed, the perceived safety of GSE debt functioned as a magnet for the Chinese government and other global investors.
While Fannie and Freddie unquestionably contributed to the growth of nontraditional mortgages (NTMs), the exact volume of their contribution remains disputed. In a thoughtful 2010 paper, George Mason University economist Russell Roberts separated GSE activities into two periods. During the first, which lasted from 1998 to 2003, Fannie and Freddie “played an important role in pushing up the demand for housing at the low end of the market. That in turn made subprime loans increasingly attractive to other financial institutions as the prices of houses rose steadily.” From 2004 to 2006, “commercial banks and investment banks were bigger direct players than the GSEs in the subprime market,” but the GSEs continued to buy enormous quantities of NTMs and subprime mortgage-backed securities (MBS). As MarketWatch reported in September 2006, citing data from Inside Mortgage Finance Publications, Fannie and Freddie purchased nearly 44 percent of the subprime MBS sold in 2004. A year later, the corresponding figure was above 35 percent. During the first half of 2006, it was over 25 percent.
The mortgage frenzy was encouraged by insufficient leverage and liquidity requirements, not to mention a credit-rating oligopoly that performed miserably in delivering accurate risk projections. It was also fueled by America’s corporate-tax regime, which treats debt capital much more favorably than equity capital. (According to a 2005 Congressional Budget Office study, the effective tax rate on equity-financed corporate capital income is 42.5 percentage points higher than that on debt-financed corporate capital income.)
The “Great Moderation” of macroeconomic volatility had led to a reduction in risk aversion. Moreover, decades of government bailouts had led to widespread expectations that federal officials would come to the rescue of large financial institutions. Those expectations were bolstered in March 2008, when Washington orchestrated the sale of Bear Stearns. Six months later, it seized control of Fannie and Freddie, placing them into federal conservatorship.
Hennessey et al. conclude that the GSEs “did not by themselves cause the crisis, but they contributed significantly in a number of ways.” Wallison takes a different view, insisting that “the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans — half of all mortgages in the United States — which were ready to default as soon as the massive 1997-2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path — fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high risk residential mortgages — the great financial crisis of 2008 would never have occurred.”
Wallison notes that the deflation of prior American housing bubbles (such as those in the 1970s and 1980s) did not spark calamitous financial busts. However, the latest bubble “was in a class by itself.” Its size, he argues, was less important than its structure. The explosion of NTMs was the crucial variable that created the conditions for disaster: “It doesn’t matter where the funds that built the bubble actually originated; the important question is why they were transformed into the NTMs that were prone to failure as soon as the great bubble deflated.” Wallison directs us to research by former Fannie Mae chief credit officer Edward Pinto, who has estimated that, by mid-2008, nearly half of all “outstanding single-family first mortgage loans” in the United States were NTMs. There were about 26.7 million NTMs in total, most of which could be traced back to “government policies and requirements.”
What all this means is that more than two years after the implosion of Lehman Brothers, we still do not have an authoritative bipartisan consensus on what exactly precipitated such a catastrophe in the financial markets. Yet the seeds of the crisis seem fairly clear. The credit bubbles that formed in America and Europe stemmed — at least partly — from global economic imbalances and reduced risk aversion. Both the level and the composition of saving in emerging-market countries were profoundly significant, as Goldman Sachs economists Kevin Daly and Ben Broadbent explained in a 2009 study. (“In particular,” wrote Daly and Broadbent, “the evidence points to a preference for fixed-income over equity assets,” which had far-reaching effects.) A Niagara of cheap capital flowed out of Asia and into the West.
But that doesn’t mean we should let Alan Greenspan or other central bankers off the hook. Taylor has made a persuasive case that the former Fed boss kept interest rates “too low for too long.” Why? Partly because of deflation fears, and partly because, as University of Chicago economist Raghuram Rajan observed in his 2010 book, Fault Lines, “it took 38 months after the trough of the 2001 recession for all the lost jobs to be restored. Indeed, job losses continued well into the recovery.” Faced with a “jobless” economic rebound, the Fed was under tremendous pressure to maintain an environment of easy money. Interest rates stayed too low for too long in many European countries as well, especially Ireland and Spain (both of which, not coincidentally, had mammoth housing bubbles).
A variety of factors — abundant credit and greater risk tolerance being just two of them — helped stimulate a colossal boom in the U.S. property sector. These factors included demographic shifts, ineffective regulation, inaccurate credit ratings, excessive leveraging, a debt-friendly tax code, perverse incentives, deeply ingrained bailout expectations, byzantine financial innovation, and — last but certainly not least — government housing policy. According to Columbia Business School economist Charles Calomiris, “Logic and historical experience suggest that even in the presence of loose monetary policy and global imbalances, if the U.S. government had not been playing the role of risky-mortgage pusher in the years leading up to the crisis, mortgage-related losses would have been cut by more than half.” As Pinto told Congress in December 2008, the GSEs “went from being the watchdogs of credit standards and thoughtful innovators to the leaders in default prone loans and poorly designed products.”
The precise distribution of blame for the meltdown remains highly controversial. Myriad actors, policies, and economic forces contributed to it, but some were far more critical than others. Untangling the principal causes of the bubble and crisis is not simply a matter of writing good history. It is also about learning the correct lessons from what transpired — the lessons that should guide U.S. economic management in the turbulent years ahead.
— Duncan Currie is deputy managing editor of National Review Online.