Peter Wallison of the American Enterprise Institute has written a comprehensive new book on the 2008–09 financial crisis. It is your duty to read it — and it feels like a duty, too.
That is not intended as a slight to Wallison, one of the best minds on the right when it comes to issues of this sort. Rather, the book is an illuminating instance of why friends of the free market so often win the argument but lose the fight. On the one hand, we have the likes of Barack Obama, Elizabeth Warren, Barney Frank, the Occupy clown show, etc., doing a sort of John Adams chorus: “Greed! Greed! Billionaires! Greed! Greed! Wall Street Greed!” And the response from the responsible Right is: “Because most PMBS held by financial institutions were rated AAA, they were used by many banks and other financial firms for short-term collateralized borrowing through repurchase agreements,” a sentence that appears in the introduction (!) to Wallison’s book.
The opening sentence of the next chapter is: “This chapter will explain the crucial relationship between mortgage underwriting standards and mortgage defaults.”
“Greed! Greed! Billionaires! Greed! Greed! Wall Street Greed!”
Thinking is hard.
Wallison is a codirector of AEI’s financial-policy-studies program, and his purpose here is threefold: first, to show that the subprime-mortgage meltdown and subsequent financial crisis were in the main a result of government housing policy rather than of profit-seeking in financial institutions; second, to show that the Dodd-Frank financial-reform law is therefore a very expensive and cumbrous non-solution to the problems behind the crisis; and, third, to show that the actual problems behind the crisis remain unsolved, leaving the United States and the world open to a second round of chaos.
The Left’s version of this story is black hats and white hats, evil Wall Street bankers and predatory lenders who descended upon the village to rape and pillage and would do so again if not for the heroic regulators deputized to stop them. Wallison’s version has its share of villains, too, prominent among them politicians who leaned on federal agencies and the government-sponsored enterprises (Fannie Mae and Freddie Mac) to reduce their lending standards, along with Fannie and Freddie executives who intentionally misled the government and investors about their exposure to subprime mortgages and to securities based on them.
It’s strange, really: The people convicted of “greed” in this mess lost a ton of money — and would have and should have lost more but for the bailouts — while the people who actually benefited from the housing policies in question (from Democratic-affiliated “community activists” to slimy senators and the profiteers at Freddie and Fannie) mostly came through the storm without too much trouble. That’s not to say no trouble: Among the important sources for Wallison’s insights into what was actually happening at Fannie and Freddie were the non-prosecution agreements their executives signed with the SEC after lying about the riskiness of their mortgage portfolios.
One could not wish for a more thoroughly documented or closely argued account of the real causes of the financial crisis. Wallison’s case is this: In 1992, Congress gave the Department of Housing and Urban Development the power to set “goals” — read “quotas” — for Fannie and Freddie, under which a certain percentage of those agencies’ mortgage portfolios would have to be loans to low- and moderate-income borrowers. At first, that quota was 30 percent, but HUD, goaded by politicians and community activists, kept raising it, all the way to 56 percent. In addition, it established sub-quotas for certain very-low-income communities. But there were not enough high-quality borrowers — meaning those with good credit, substantial down payments, and low overall debt — to meet those goals. So Fannie and Freddie, which completely dominate the mortgage market and thereby act as effective benchmarkers, lowered the standards for the mortgages they would buy or guarantee.
At the same time, the agencies were engaged in a campaign to mislead the public, regulators, investors, and Congress about the quality of their holdings. Some loans have “subprime characteristics” — for instance, when the borrower has a FICO credit rating of 660 or below or makes a down payment of less than 10 percent — but Fannie and Freddie did not treat them as subprime loans for the purposes of their own bookkeeping. Rather, Fannie and Freddie considered a loan subprime only if it came from a lender specializing in subprime mortgages or if the lender explicitly labeled the loan “subprime.”
That enabled Fannie and Freddie to continue insisting that subprime loans made up less than 1 percent of their portfolios. The truth, as Wallison demonstrates, was something else: With Fannie and Freddie driving down lending standards, by 2008 58 percent of all mortgages in the United States were either subprime or otherwise nonconforming (“Alt-A”) risky loans, such as those lacking the usual documentation of income and the like. Which is to say, the great majority of mortgages were in fact subprime or Alt-A — and Fannie and Freddie held 70 percent of them. Other federal agencies held an additional 6 percent.
Wallison demolishes the myth that “deregulation” was a meaningful contributor to the financial crisis. To begin with, there was very little deregulation to speak of, and such regulatory reforms as there were — e.g., the repeal of the Glass-Steagall provisions that kept investment banks and traditional banks out of each others’ business — had little to no effect. Rather, regulation contributed mightily to the crisis: The Basel rules, which govern how much of a capital cushion financial institutions must maintain against certain kinds of risk, made holding mortgages and mortgage-backed securities much more attractive than holding high-quality business loans. The decision of regulators to allow financial firms to park certain holdings off balance sheet was another crucial failure. Regulators behaving badly is not the same thing as “deregulation” — the regulators were in the mix, and they made things measurably worse.
And while there are many useful correctives for the Left in these pages, there are some for conservatives, too. Many conservatives, particularly those sympathetic to the Austrian school of economics, have assumed that the main driver of capital into the residential real-estate market was the Fed’s loosey-goosey monetary policy, but Wallison shows definitively that this was not the case — and indeed could not have been the case, inasmuch as the creation of the housing bubble was well under way long before the Fed easing in question began to take place.
The real problem was the collapse in lending standards, with each of the big three — borrower credit rating, size of down payment, and borrower debt-to-income ratio — eroding practically overnight. Here, Wallison’s insights are particularly interesting, and the arithmetic is straightforward: If the down-payment requirement is 10 percent, then a borrower with $20,000 on hand can buy a $200,000 house. But reduce that down payment to 5 percent and the same borrower can buy a $400,000 house. Once down payments went to zero — or into negative territory, with cash-out mortgages — it was nearly inevitable that housing prices would soar, and that the size of mortgages taken on by households of any given level of income and wealth would skyrocket. Given a choice between a 20 percent down payment and a 10 percent, 5 percent, or 0 percent down payment — and given the misplaced belief that housing is a magical product the price of which only goes up — many families chose to buy insanely expensive homes.
This lesson was entirely lost on the architects of Dodd-Frank. As Wallison documents, an early version of that bill would have imposed strict down-payment requirements on mortgage borrowers. The usual community activists howled that this would have a disproportionate effect on the poor, and those requirements were watered down and then watered down some more until there was so much water they drowned in it.
The federalists among us must appreciate that Texas, which forbids loan-to-value ratios in excess of 80 percent — thereby effectively requiring 20 percent down payments and forbidding cash-out financing and home-equity loans in excess of 80 percent of a house’s value — largely escaped the subprime meltdown. For federal policymakers, that’s the obvious takeaway: If you want to avoid another subprime-mortgage meltdown, then discourage subprime mortgages by forbidding the federal government and its allied enterprises to acquire, guarantee, subsidize, or otherwise support any mortgages that (1) don’t include a 20 percent down payment; (2) are made to borrowers with FICO scores under 660; or (3) are made to high-debt borrowers or those without proper documentation.
That won’t prevent the next financial crisis; it will only ensure that it is not a subprime-mortgage crisis. If you are interested in broader financial reform, Wallison has some ideas about that, too. You’re going to have to eat your veggies if you want to know what they are. My advice: Dig in.