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Wallison: I will dispute the idea that we had to bail out Wall Street for this reason. The government bailed out Wall Street on the theory that all of these firms were interconnected. That’s the term you used, and that’s in fact the term that was used initially in the Bear Stearns bailout that occurred in March 2008. OK, well, what does that mean? What it means, according to the government, is that if one of these large companies fails, it drags down others. That is, if Bear Stearns failed, then what it owed to all the others would cause all the others to fail, or many others to fail. So they bailed out Bear Stearns. But when we came to Lehman Brothers, they reversed their policy and didn’t bail [them] out.
What do we learn from Lehman Brothers? Yes, there was chaos after Lehman Brothers failed, no question about it. No one is denying that. But did any other company fail as the result of Lehman Brothers being unable to meet its obligations? The answer to that question is no, with the exception of one instance, and that is a money market mutual fund by the name of the Primary Reserve Fund. Primary Reserve Fund held on to some Lehman Brothers paper which it probably would have sold much earlier but for the fact that it believed the government was going to bail out Lehman Brothers the way it bailed out Bear Stearns, and [that] therefore the Primary Reserve Fund would not suffer any losses on this Lehman debt. That was the only example.
Every other institution that got into any kind of trouble—and we can talk about Wachovia, Citi, WaMu, even Merrill Lynch and Goldman Sachs, Morgan Stanley, and AIG—all of those institutions, which have been the ones that have been somehow aided by the government or had to be acquired by a healthier institution, all of those were not affected in any way by Lehman Brothers.
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reason: Even by the turmoil that the Lehman Brothers collapse caused to the financial markets? Lehman went into bankruptcy in the middle of September 2008. By the time that the bailout was passed and initiated in October, Wachovia, Washington Mutual, and other institutions had already started to fail.
Wallison: Yes, there was chaos. Investors ran from all of these large financial institutions. That is what happened. As a result they hoarded cash because they wanted to be very sure they had the cash when their depositors or other investors came for it. And that’s what the financial crisis was: You couldn’t get financing…for anything, because these large financial institutions were hoarding cash. But was that caused by Lehman being unable to pay its debt? No, that was caused by what I call, and what scholars have always called, a “common shock.”
The reason that it is different from interconnection is that a common shock refers to a case in which a very widespread asset of some kind—and in this case we’re talking about mortgage-backed securities backed by these low-quality or subprime mortgages—suddenly plunges in value. And when it does, it causes all other financial institutions that are holding these instruments, these assets, to look weaker. Their capital goes down and their liquidity goes down because they can no longer use these mortgage-backed securities for financing purposes—that is, for liquidity purposes. It was the common shock that caused all of them to look very, very weak, and when Lehman failed, then people panicked because all of these other institutions had looked very weak.
So if we had avoided the common shock, the interconnections would have meant nothing. In other words, if Lehman had failed in an economy in which people were not worried about all the other financial institutions because of the common shock, it would have had no effect whatsoever.
You had pointed correctly to what actually did happen, but that was because all of these institutions had been weakened well in advance by the decline in the value of mortgages. Interconnection is an excuse that the government used, was picked up happily, readily, avidly by the media, and broadcast as the reason. But when we look at Lehman Brothers and what happened after Lehman Brothers, we can see that nothing that Lehman Brothers did by failing (except for the Primary Reserve Fund) had any significant effect on all of these other firms, such as AIG, Citi, and so forth.
reason: We’re three years past the heart of the financial crisis and Congress has put in place the Dodd-Frank Act, signed by President Obama in 2010, as a way to keep the financial crisis from happening again. Are we headed in the right or wrong direction in terms of financial services regulation?
Wallison: Let’s talk first about the Dodd-Frank Act, because this is the perfect example of how a false narrative that misinterprets what happened in the financial crisis can result in bad legislation.
It seemed to me that the purpose of the Financial Crisis Inquiry Commission was to do an honest job of looking at what really happened in the financial crisis, and if they’d done an honest job, we would have had a different answer to what happened in the financial crisis. They didn’t. They essentially followed the left’s analysis of what happened, which is lack of regulation, predatory lending, greed on Wall Street. So if that is in fact the cause of the financial crisis—Congress decided that before the FCIC even reported, so they went right ahead and legislated anyway—but if that was really the cause of the financial crisis, then of course you’d have the Dodd-Frank Act, which imposes huge regulation on the financial system. If the financial system wasn’t sufficiently regulated, then you want to regulate them more. That, however, is wrong.
From my perspective, what really happened was a result of government housing policy causing, enabling, a lot of people to get mortgages who otherwise couldn’t get these mortgages. And then they couldn’t sustain the mortgages when the bubble that was growing stopped growing. And as a result, we had the financial crisis.
reason: Is there anything in Dodd-Frank that is causing separate, perverse impacts on the U.S. economy today?