Wallison - Hidden in plain sight : what really caused the worlds worst financial crisis and why it could happen again

HIDDEN IN PLAIN SIGHT

2015 by Peter J. Wallison

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FIRST AMERICAN EDITION

LIBRARY OF CONGRESS CATALOGING-IN-PUBLICATION DATA

Wallison, Peter J.

Hidden in plain sight : what really caused the worlds worst financial crisis and why it could happen again / by Peter J. Wallison.

pages cm

Includes bibliographical references and index.

ISBN 978-1-59403-771-9 (ebook)

1. HousingFinanceGovernment policyUnited States. 2. Mortgage loansGovernment policyUnited States. 3. Subprime mortgage loansGovernment policyUnited States. 4. Financial crisesGovernment policyUnited States. 5. United StatesEconomic policy20012009. I. Title.

HD7293.Z9W35 2015

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2014005179

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For my amazing grandchildren, with love

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Elodie

CONTENTS

What Really Caused the Worlds Worst Financial Crisis and Why It Could Happen Again

The Importance of Sound Underwriting Standards

Why Conventional Explanations for the Crisis Are Inadequate

How and Why Housing Finance Was Substantially Changed in 1992

How HUD Used the Affordable-Housing Goals to Reduce Underwriting Standards

How the Affordable-Housing Goals Forced an Increase in Nontraditional Mortgages

Why the Affordable-Housing Goals, and Not Market Share or Profit, Were the Sole Reason the GSEs Acquired Nontraditional Mortgages

Why and How Reduced Underwriting Standards Spread to the Wider Market

How Loosened Underwriting Standards Stimulated Its Growth

How the GSEs Failure to Disclose Their Acquisition of Nontraditional Mortgages Magnified the Crisis

Why Even Government-Backed Mortgage Securities Were Contributors

How Mark-to-Market Accounting Made Financial Firms Look Weak or Unstable

How Government Blunders Turned a Mortgage Meltdown Into an Investor Panic and Financial Crisis

Why the Failure to Understand the Causes of the Crisis May Lead to Another

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

Political contests often force the crystallization of answers to difficult political issues, and so it was with the question of responsibility for the financial crisis in the 2008 presidential election. In their second 2008 presidential debate, almost three weeks after Lehman Brothers had filed for bankruptcy, John McCain and Barack Obama laid out sharply divergent views of the causes of the financial convulsion that was then dominating the publics concerns. The debate was in a town-hall format, and a member of the audience named Oliver Clark asked a question that was undoubtedly on the mind of every viewer that night:

Clark: Well, Senators, through this economic crisis, most of the people that I know have had a difficult time.... I was wondering what it is thats going to actually help these people out?

Senator McCain: Well, thank you, Oliver, thats an excellent question.... But you know, one of the real catalysts, really the match that lit this fire, was Fannie Mae and Freddie Mac... theyre the ones that, with the encouragement of Sen. Obama and his cronies and his friends in Washington, that went out and made all these risky loans, gave them to people who could never afford to pay back...

Then it was Obamas turn.

Senator Obama: Lets, first of all, understand that the biggest problem in this whole process was the deregulation of the financial system.... Senator McCain, as recently as March, bragged about the fact that he is a deregulator.... A year ago, I went to Wall Street and said weve got to reregulate, and nothing happened. And Senator McCain during that period said that we should keep on deregulating because thats how the free enterprise system works.

Although neither candidate answered the question that Oliver Clark had asked, their exchange, with remarkable economy, effectively framed the issues both in 2008 and today: was the financial crisis the result of government action, as John McCain contended, or of insufficient regulation, as Barack Obama claimed?

Since this debate, the stage has belonged to Obama and the Democrats, who gained control of the presidency and Congress in 2008, and their narrative about the causes of the financial crisis was adopted by the media and embedded in the popular mind. Dozens of books, television documentaries, and films have told the easy story of greed on Wall Street or excessive and uncontrolled risk-taking by the private sectorthe expected result of what the media has caricatured as laissez-faire capitalism. To the extent that government has been blamed for the crisis, it has been for failing to halt the abuses of the private sector.

The inevitable outcome of this perspective was the Dodd-Frank Wall Street Reform and Consumer Protection Act, compares the recovery of gross domestic product (GDP) per capita since the recession ended in June 2009 with the recoveries following recessions since 1960.

Unfortunately, Dodd-Frank may provide a glimpse of the future. As long as the financial crisis is seen in this lightas the result of insufficient regulation of the private sectorthere will be no end to the pressure from the left for further and more stringent regulation. As this is being written, proposals to break up the largest banks, reinstate Glass-Steagall in its original form, and resume government support for subprime mortgage loans are circulating in Congress. These ideas are likely to find public support as long as the prevailing view of the financial crisis is that it was caused by the risk-taking and greed of the private sector.

For that reason, the question of what caused the financial crisis is still very relevant today. If the crisis were the result of government policies, as described in this book, the Dodd-Frank Act was an illegitimate response to the crisis and many of its unnecessary and damaging restrictions should be repealed. Similarly, proposals and regulations based on a false narrative about the causes of the financial crisis should also be seen as misplaced and unfounded.