Bad History: How a False Narrative About the Financial Crisis Led to Dodd-Frank
By Peter J. Wallison
(AEI Press, 581 pages, $90)
HAD PETER J. WALLISON practiced his trade in the old Soviet Union, he would soon have been dispatched to the Gulag for the crime of telling unflattering truths about government bungling. In the U.S, his penalty has been less harsh but equally frustrating for a serious scholar. Washington power brokers simply ignored the warnings he began issuing in 2004 that government housing policies would ultimately lead to grief. He was of course right.
When the housing bubble burst, the global financial services industry found itself awash with toxic mortgage securities, and the 2008 financial meltdown ensued. Then Mr. Wallison got another shock: Barack Obama and the Democratic 111th Congress responded to the crisis by further ignoring wise counsel and creating a legislative absurdity called the Dodd-Frank Wall Street Reform and Consumer Protection Act. Of course, it wasn’t an absurdity from their point of view if their real aim was to socialize the financial services industry. For that purpose, Dodd-Frank was just the ticket.
As Mr. Wallison’s title suggests, the leftists created what Mr. Obama calls a “narrative” to explain the 2008 fiasco, one that of course absolved government of any blame. They proclaimed, with loud support from their cheerleaders in the press, that the blame lay with “Wall Street” and greedy bankers. Hence the proper solution was to take banking further under the government’s wing by making the largest institutions subject to new, coercive powers from their regulators—in essence, making them de facto wards of the state.
That Congress being what it was, the massive measure was whooped through with little regard for niceties like public hearings and serious debate.
Mr. Obama quickly and happily signed, to the great delight of the authors, Senator Christopher Dodd and Congressman Barney Frank. It is a sad irony that the two had played key roles in causing the 2008 meltdown through their staunch defense over the years of those two toxic security factories, Fannie Mae and Freddie Mac. House Speaker Nancy Pelosi and Senate Majority Leader Harry Reid shared in the jollity at the signing, having themselves steamrolled the legislation through Congress.
THE TRUE STORY, which Mr. Wallison tells in a clear and forthright style, began in the 1990s when “affordable housing” legislation of the Clinton era pressed banks to lower their mortgage lending standards to make home ownership available to people with limited means. Banks submitted to the pressure because Mr. Clinton provided them with a way to unload questionable paper. The standards of government-sponsored enterprises (GSEs) Fannie and Freddie, which provided a secondary market for mortgages, were also lowered by regulators at the Department of Housing and Urban Development (chief of whom was a Democratic Party wunderkind named Andrew Cuomo, now governor of New York).
Soon, the mortgage business was humming, and the lack of oversight was such that it attracted fly-by-night mortgage originators to add even more toxicity to the normal flow of bank lending. No one, least of all the Clintonites, worried about the risks. Homebuilders were ecstatic, as were real estate agents, who watched home prices and their fees climb rapidly. Fannie, the larger of the two GSEs, contrived the idea of packaging mortgages together and selling “mortgage-backed securities” (MBSs), a practice soon emulated by private banks. With triple-A ratings, the MBSs circulated throughout the globe. But because of the lax standards dictated by Washington, they were laced with sub-prime mortgages made to borrowers with a high risk of default. Mr. Wallison and others, including the Wall Street Journal, began warning of Fannie and Freddie’s binging over a decade ago. But they were ignored in Washington, partly because Fannie and Freddie were mobbed up in politics. Among their best friends were Chris Dodd and Barney Frank.
Meanwhile, the Federal Reserve was goosing the money supply, creating a housing bubble. With housing prices going up, no one worried much about those sub-prime mortgages. But when prices broke in 2006, the sub-primes started going bad. Holders of that great mass of MBSs became uncertain of their worth and the market froze, leaving banks with billions of dollars in temporarily unmarketable assets. The rest—Bear Stearns’ bailout, Lehman’s failure, the stock market crash, the government takeover of Fannie and Freddie, the panic at the Treasury and Fed, the Troubled Asset Relief Program (TARP)—is history.
WHICH BRINGS Mr. Wallison to the real meat of his book: a discussion of the inanities of Dodd-Frank. Since the whole fiasco was caused by the private sector in the narrative concocted by Obama, Pelosi, Reid, and company, their answer was greater government control over financial services. The gremlins in the Senate back offices raced their word processors at flank speed to churn out well over 2,000 pages of new requirements, which, when enrolled as a law, came out to 849 densely packed pages.
It mandated 398 new regulations and 67 studies. “By September 2012—more than two years after enactment—regulators have completed only 131 final rules (32.9 percent),” Mr. Wallison writes. He observes that the law’s mandates are so open-ended that there are serious questions about whether they represent an unconstitutional delegation of legislative authority.
Aside from lacking intelligibility and perhaps constitutionality, the Dodd-Frank measures have problems of substance that are becoming more and more evident as they are put into play. The act created a Financial Stability Oversight Council (FSOC), a 10-member body made up of the heads of regulatory agencies and industry representatives, and chaired by the secretary of the treasury. It oversees a Financial Stability Board (FSB), which in the last two years has designated a list of Too-Big-to-Fail banks (TBTFs). These Systemically Important Financial Institutions (SIFIs)—a total of 28 U.S. and foreign-based banks, including Citi, J.P. Morgan, and Wells Fargo—are too large to go bankrupt, so the FSB is now empowered to “resolve” their problems if they get into trouble.
The FSOC and FSB effectively represent a de facto government takeover of the nation’s largest banks. At any time, the FSB can take charge of a SIFI bank simply by exercising its “orderly liquidation authority.” The bank has no right to challenge this in court or elsewhere.
Such draconian power was awarded to the government by congressional leftists on grounds that the failure of one large bank would have knock-on effects on all the other banks that were its counter-parties or creditors. Hence, the entire banking system could come unglued. They concocted the term “systemic importance” from this assumption, which was backed, of course, by the usual coterie of economists who worship the gods of power.
But Mr. Wallison makes a strong case that this assumption, supposedly a lesson learned from the 2008 meltdown, is false. The meltdown was caused by many institutions’ discoveries that they were holding vast amounts of toxic assets. It was not caused by the failure of one “systemically important” institution.
Lehman Brothers, the only institution allowed to fail in 2008, would certainly be on the “systemically important” list were it still around. It had systemic linkages throughout the world, and it was thrown into bankruptcy. But as Mr. Wallison asserts and the historical record affirms, the Lehman bankruptcy had virtually no knock-on effects: “the collapse of Lehman showed that almost all financial institutions can survive the failure of a large firm even in the midst of a severe common shock.”
The designation of those 28 international banks as “systemically important,” of course, implied that they would be bailed out by the government, i.e., taxpayers, as part of the process of “orderly resolution.” We saw plenty of that in 2008. This creates, as Mr. Wallison notes, a “moral hazard” in that those doing business with them are apt to be less cautious. That same blasé attitude applies to staffers making the banks’ own investments. Hence the greater likelihood of failure.
Moreover, the government imprimatur gives the large banks a cost advantage over their non-SIFI brethren in attracting investment. The amount of government subsidy this represents has been variously estimated. Bloomberg News has put it at $83 billion a year, based on a study by two economists, one of whom, Kenichi Ueda, is on the staff of the International Monetary Fund. Federal Reserve chairman Ben Bernanke disputed these assertions under questioning during his semi-annual report to Congress in February. But it does seem that as Dodd-Frank seeps into the system, big banks are getting bigger and non-SIFIs are getting bigger headaches.
The strongest support of the Wallison theory is offered by Fannie and Freddie. Their implied backing from the U.S. government allowed them to out-compete fully private entities and swallow up half the mortgage industry before they came a cropper. And they have cost the taxpayers dearly during their time in government receivership.
So what Mr. Wallison has recorded is, in essence, a coup. The leftists in the 2009–10 Congress and in the Obama administration teamed up to gain effective control of American banking. The Federal Reserve under the leadership of Ben Bernanke was a willing co-conspirator. Mr. Wallison says that the only solution to all the problems this has created for the present, and particularly the future, is total repeal of Dodd-Frank. He couldn’t be more right.