The American Spectator

Yesterday the Financial Crisis Inquiry Commission released its report on the causes of the financial crisis, accompanied by two separate dissents from Republican members of the commission. The FCIC concluded that the financial collapse was avoidable, and placed blame for the meltdown primarily on risky practices on Wall Street and ineffective regulation. One dissenting report instead argued that a number (10 actually) of causes, including global financial developments, led to the creation and collapse of the housing bubble. The authors, Bill Thomas, Keith Hennessey, and Douglas Holtz-Eakin, summed up their view in the Wall Street Journal. The other dissent was written by American Enterprise Institute financial scholar Peter Wallison, who accentuated the role that the government played in inflating the bubble, especially through Fannie Mae and Freddie Mac. 

At this stage the argument is an academic one, because with last year’s Dodd-Frank financial regulation bill, Congress has already considered and finalized its response to the financial crisis. The FCIC report won’t shape any further legislation or regulation: Dodd-Frank is the new regime and probably will be until the next financial crisis. 

What the FCIC report will do, though, is shape the narrative and history of the financial crisis. That narrative is undoubtedly still a relevant argument. Considering that academics still debate the causes of the Great Depression today, 80 years later, there is a lot at stake in interpreting the causes of the 2007-2009 crisis. 

And where the FCIC and the dissents differ is in the interpretation of the same facts. On the question of the role that the GSEs (primarily Fannie and Freddie) played in the housing bubble and collapse, the commissioners and Wallison see a different story when looking at the numbers. 

Here is the commissioners’ summary of their view of the GSEs:

We conclude that these two entities contributed to the crisis, but were not a primary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. 

The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold. They purchased the highest rated non-GSE mortgage-backed securities and their participation in this market added helium to the housing balloon, but their purchases never represented a majority of the market. Those purchases represented 10.5% of non-GSE subprime mortgage-backed securities in 2001, with the share rising to 40% in 2004, and falling back to 28% by 2008. They relaxed their underwriting standards to purchase or guarantee riskier loans and related securities in order to meetstock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees-justifying their activities on the broad and sustained public policy support for homeownership. [Emphasis mine.]

And here’s Wallison: 

…on June 30, 2008, immediately prior to the onset of the financial crisis, the GSEs held or had guaranteed 12 million subprime and Alt-A loans. This was 37 percent of their total mortgage exposure of 32 million loans, which in turn was approximately 58 percent of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie, accordingly, were by far the dominant players in the U.S. mortgage market before the financial crisis and their underwriting standards largely set the standards for the rest of the mortgage financing industry. [Emphasis mine.]

Where the FCIC and Wallison disagree, then, is whether Fannie and Freddie “followed” Wall Street or “set the standards” for others involved in mortgage finance. The fact that they were heavily involved in the mortgage industry during the run-up is not in dispute. 

Wallison uses a metaphor submitted by former National Economic Council chair Larry Summers to frame the debate and explain why he thinks that government policies and agencies — including Fannie and Freddie, the Federal Housing Administration, and the Community Reinvestment Act — were among the root causes of the financial crisis:

In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time-the absence of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises.

The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk NTMs with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages-half of all mortgages outstanding in the U.S. in 2008-and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.