Is Another Financial Crisis On the Way?

We didn't learn the lessons of the last crisis. Does that mean we're doomed to repeat it?

Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again, by Peter J. Wallison, Encounter Books, 356 pages, $27.99

Eight years after the nation's financial system began its rapid slide into calamity, we all know why. Greedy Wall Street operators, aided by the repeal of the 1933 Glass-Steagall Act and only feebly regulated by the Bush administration, ran wild in the pursuit of greater profits for the rich. Eventually many big banks failed and were bailed out by taxpayers. But in 2010, President Barack Obama and the Democratic Congress took bold action to create powerful new government regulatory machinery. Still, much more regulation is needed to forestall future damage.

This narrative of the economic debacle is heavily promoted in the mainstream media and by regulators. But in Hidden in Plain Sight, financial scholar Peter Wallison argues that the story is laughably false. Worse yet, he says, the true causes of the debacle have not been dealt with, and there is every reason to believe that the same thing can happen all over again.

Wallison, a co-director of financial policy studies at the American Enterprise Institute, is one of the nation's top historians and analysts of financial structure and regulation. During the early Reagan years he was general counsel of the Treasury Department, where he learned a lot about markets and regulation. Happily he was not a participant in any part of the 1997-2009 financial disaster that is the subject of this book. He was, however, a member of the largely misguided Financial Crisis Inquiry Commission of 2009-2010, and he dissented from that body's final report.

Wallison's story of the run-up to the 2007 collapse begins with the Democratic Congress of 1992 and the 1993 arrival of the Clinton administration. The same years saw the rise of onetime Clinton roommate and political operator James A. Johnson to the chairmanship of the Federal National Mortgage Association (Fannie Mae). Wallison pays little attention to Johnson's career, but Johnson worked energetically and successfully to prevent Congress from privatizing Fannie Mae after the Republicans took control in 1995. He mobilized support on the left by buying millions of mortgages that increasingly departed downward from Fannie's historic underwriting standards. This subprime mortgage purchase binge is central to Wallison's story.

Here's the quick version. In 1992 Congress set "affordable housing" goals for Fannie Mae and its savings-and-loan counterpart, Freddie Mac (together known as the Government-Sponsored Enterprises, or GSEs). That year a manageable 30 percent of Fannie's portfolio qualified as "affordable housing." In 1997 the Department of Housing and Urban Development (HUD), as authorized by Congress, increased the required fraction to 42 percent. In 2001, under President George W. Bush, HUD increased the goal to 50 percent. In 2008 it upped the goal to 56 percent.

To find enough "nontraditional mortgages" to meet these increasing requirements, Fannie and Freddie bought increasingly lower-quality mortgage paper. Mortgages with three percent down payments sufficed for a while, but by 2000 the two GSEs were buying mortgages with zero down payments, credit rating scores below 660, and debt-to-income ratios as high as 38 percent. By 2008, half of the nation's home mortgages-32 million of them-were subprime, and 76 percent of those were owned by the GSEs.

As the two GSEs defined substandard lending ever downward and marketed pools of such mortgage paper to Wall Street investors, financial firms came to adopt the same lax standards for their Private Mortgage Backed Securities (PMBS). Investors bought billions of dollars' worth of those privately issued securities, believing they were backed by quality collateral. Market players also believed that GSE issues were backed by implicit federal government guarantees.

"With all these new buyers entering the market because of the affordable housing goals, together with the loosened underwriting standards the goals produced, housing prices began to rise," Wallison writes. "By 2000, the developing bubble was already larger than any bubble in U.S. history, and it kept rising until 2007…when it finally topped out, and housing prices began to fall."

With housing prices falling, financial regulation came into play. Regulators required "mark to market" valuation of housing assets-that is, institutions had to value them at their current market price. But suddenly there was no rational market to take a price from. Frightened investors dumped housing paper. Financial credit regulators, who had previously considered GSE paper almost risk-free, started requiring banks to have more capital. But the financial firms that held or stood behind $2 trillion in PMBS could hardly float new stock issues when much of their assets were rapidly shrinking in value.

Wallison notes some other factors in the crash, but this is the heart of his story. Between 1995 and 2008, Wallison writes, the government and investors following federal incentives "spread Non-Traditional Mortgages throughout the financial system, degraded underwriting standards, built an enormous and unprecedented housing bubble, and ultimately precipitated a massive mortgage meltdown. The result was a financial crisis."

How Washington and the mainstream media responded to that financial crisis occupies a large portion of the book. Wallison shows that the response was founded on two large ideas. The first was the belief that without large capital inflows from the Treasury and the Fed, the whole "interconnected" financial system would have fallen apart and the world as we know it would have come to an end. The second was that lax financial regulation allowed this crisis to happen, and therefore the financial sector should be subject to more muscular controls.

Wallison's views on three issues are worth exploring in detail. A major argument on the left, recently advanced on behalf of Sen. Elizabeth Warren's proposed 2014 financial legislation, is that the 1999 "repeal" of the 1933 Glass-Steagall Act removed the restrictions that kept investment banks from using commercial bank deposits to speculate in an unregulated marketplace. Wallison authoritatively refutes this contention. He points out that while the 1999 act allowed affiliates of commercial banks to engage in investment banking (and other financial activities), the 1933 Glass-Steagall firewall protecting insured deposits against speculative investing is still in full effect.

The second issue is the March 2008 forced merger of the investment firm Bear Stearns with JP­MorganChase, greased by $29 billion in Fed-supplied capital. Wallison shows that there was never any need to bail out Bear Stearns in the first place. But he also argues that the Treasury and the Fed's refusal to bail out Lehman Brothers in September 2008, after giving the financial world the impression that the government would bail out "interconnected" firms of that size, "changed the perceptions and ultimately the actions of all major financial players," leaving them "weaker and less prepared to deal with the enormous financial panic that occurred when Lehman was allowed to fail." Wallison accuses Bush-era Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke of, essentially, bungling the management of events in that crucial year.

Finally, Wallison sharply attacks the "false narrative" of the financial crisis offered by activists, politicians, and regulators with a direct interest in sweeping new regulation. We would have done much better, he writes, "if the narrative about the financial crisis had properly located the problems in the reduction of mortgage underwriting standards brought on by the government's housing policies and implemented largely through the affordable housing goals." Continuing belief in this false narrative, evidenced by the Dodd-Frank Act, the Financial Crisis Inquiry Commission's myopic 2010 report, and proposed legislation in the most recent Congress, makes it likely that there will be another financial crisis in the future.

Wallison's book is well-informed, detailed, clear, and sharply focused -though readers unfamiliar with finance will find it thick going in some places. The author's independent point of view makes the book far more reliable than the self-protective accounts published by such actors as Paulson and his Obama-appointed successor, Timothy Geithner. Wallison makes it a point to consider alternative explanations for the crisis, and he convincingly presents the contrary evidence.

Perhaps most useful, Hidden in Plain Sight makes it clear that the next crisis will likely be caused by people peddling-or at least believing-a false narrative about the last one. This book would make a very good text for a business school course titled "Financial Crises: How They're Caused, How They're Made Worse, and How They Can Be Prevented."

Contributing Editor John McClaughry ([e-mail]) is the now-retired founder of Vermont's free market Ethan Allen Institute.