'The Financial Crisis Was the Result of Government Housing Policy'

The American Enterprise Institute's Peter Wallison on how government, not greed, was the essential ingredient in the 2008 meltdown.


In January 2011, a bipartisan, 10-member, government-created body called the Financial Crisis Inquiry Commission (FCIC) issued a comprehensive report assigning blame for the 2008 financial meltdown. The main culprits: "widespread failures in financial regulation and supervision," "dramatic failures of corporate governance and risk management at many systemically important financial institutions," "a combination of excessive borrowing, risky investments, and lack of transparency," a government that "was ill prepared for the crisis," and "a systemic breakdown in accountability and ethics."

The four Republicans on the FCIC issued two dissents from the commission's findings, the splashiest of which was a 93-page solo response from American Enterprise Institute (AEI) scholar Peter Wallison. The crisis, Wallison said, was caused mainly by the systemic failures of government housing policy.

Some of the public response to Wallison's dissent was withering. Stanford University political scientist Francis Fukuyama, in a January interview with the online-only publication The Browser, charged that it "takes what is a very complex crisis that has multiple roots and lays it all at the door of Fannie and Freddie and government intervention. It seems to me transparently designed to exonerate free markets.…But this crisis has proved that financial markets are not self-regulating. To draw from this complex analysis that particular conclusion I just find astonishing."

Fukuyama was not alone. New York Times columnist Joe Nocera had previously called Wallison's work "loony" and accused him of helping to concoct "what has since become a Republican meme." Even the free market George Mason University economist Russ Roberts took Wallison to task for downplaying the role of investment banks.

Wallison, who co-directs AEI's financial policy studies program, is unrepentant. "Instead of pursuing a thorough study," he says, "the commission's majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions."

Wallison, who served as White House counsel and Treasury Department general counsel during the Reagan administration, sat down with Reason Foundation Director of Economic Research Anthony Randazzo on the one-year anniversary of the FCIC report in January discuss about the causes of the 2008 financial crisis, what to do about Fannie Mae and Freddie Mac, and the implications of the Dodd-Frank Act, among other topics. To watch a video version of this interview, go to reason.tv.

reason: The Financial Crisis Inquiry Commission, which you were on, found that the crisis was caused by a mixture of deregulation, Wall Street greed, predatory lending, and many other things. Why do you disagree?

Peter Wallison: There's absolutely no evidence for anything that the majority of the commission put in their report. The financial crisis was the result of government housing policy.

reason: So are Freddie and Fannie the chief culprits?

Wallison: Fannie Mae and Freddie Mac were the implementers of a substantial portion of the government's housing policy. Basically, the government's housing policy was intended to provide financing to people who were unable for one reason or another—mostly lack of resources—to get mortgage credit. And Fannie and Freddie were agents that the government worked through. However, they also used something called the Community Reinvestment Act. HUD [the Department of Housing and Urban Development], which was basically in charge of all of these programs, also had its own program which involved the mortgage bankers' association, and there were other HUD programs that encouraged the granting of mortgages to people who didn't have the financial resources to support them. 

In the end, by 2008 there were 28 million subprime or very weak mortgages. Those are known as Alt-A mortgages. That's half, incidentally, of all mortgages in the financial system. Of that 28 million, 20.4 million were on the books of government agencies like Fannie Mae and Freddie Mac and the FHA [Federal Housing Administration] and other government agencies and banks that were holding them as a requirement of the Community Reinvestment Act, which applied to banks. So that's why I say that the government's housing policy was responsible for creating these mortgages. They never would have been created without the government demanding that they be created and providing the funds to buy them.

reason: Stanford political economist Francis Fukuyama recently said that your dissent to the commission's report was "transparently designed to exonerate free markets." Did the crisis have nothing to do with free markets?

Wallison: You know, I'm sorry that Francis Fukuyama has lost his skill at analysis. I actually was pretty impressed with what he's written in the past, but here he really doesn't understand at all what I was saying in my dissent and probably hasn't taken the trouble to read it. 

My point was [that] without the government's housing policy, there would never have been a financial crisis. That's not exactly the same thing as saying that government housing policy caused the financial crisis. It's stating it another way—that is, but for the government's housing policy, there wouldn't have been a financial crisis. Without the creation of all of the subprime and other weak mortgages, we wouldn't have had a mortgage meltdown that ultimately was the cause of the weakness in the financial system. Because many, many banks and other financial institutions were holding these very weak mortgages, and when they began to fail that's when we had what is called the mortgage meltdown, and that led directly to the financial crisis. So I am not exonerating the private sector. The private sector was a factor.

reason: Many economists have claimed that it was the interconnectedness of Wall Street that forced the government to come in and bail it out. 

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.

(Interview continues below video.)

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?

Wallison: Of course. The Dodd-Frank Act is an extraordinary piece of legislation. I mean, we're not talking about an ordinary act that responds to a very narrow set of circumstances. You could think, for example, of the Federal Deposit Insurance Corporation Improvement Act, which was adopted in 1991 after the S&L [savings and loan] collapse. That was directed specifically at the problems that were seen as causing the S&L collapse. So it focused on the banking industry, it focused on S&Ls, it focused on those institutions that insured deposits and then tried to write restrictions based on that. People said, now we won't have any banking crises anymore because we've got this wonderful law in place. 

Of course, we had a banking crisis again in 2008. But in this case we got a law—the Dodd-Frank Act—which doesn't just cover banks; it doesn't just cover investment banks. It potentially covers the entire financial system, and it turns over to the Federal Reserve the authority to regulate every large financial institution in our system. That is, insurance companies, finance companies, securities firms, hedge funds, God knows what else, because it's very, very broad. The government can decide that any one of these institutions could, because of its interconnections, cause a financial crisis if it fails, so it has to be very strictly—stringently is the statutory term—regulated. 

Well, that is the kind of law that causes the hearts of adventurous entrepreneurs to freeze, because you do not know what kind of restrictions are going to be put on you and you don't know what regulatory positions the government is going to take in the securities area, in the Commodity Futures Trading Commission area, through the banking, through all the other instrumentalities of government. And so you are waiting to see what the regulations require. While you are waiting, during this period of uncertainty, you are not hiring. So from my perspective, the Dodd-Frank Act is the principal cause of the semi-recession that we are still struggling through.

reason: In what ways is the Dodd-Frank Act potentially hurting the housing industry?

Wallison: There are lots of ways, but the most significant way has to do with the government-sponsored enterprises, Fannie Mae and Freddie Mac, the Federal Housing Administration (FHA), the fact that those are not treated at all in the Dodd-Frank Act, but the Dodd-Frank Act has provisions which make those three agencies the dominant players in the housing market. And as long as those are the dominant players in the housing market, no private-sector group is going to come in and compete with them because you cannot compete with a government agency. Government agencies have credit opportunities that you cannot approach, and as a result there's no competition. As long as the Dodd-Frank Act is in existence with the advantages it provides to these government agencies, there isn't going to be a recovery in the housing market. 

reason: The Republicans in Congress have over the past year tried and failed a handful of times to convince the larger Congress to address Fannie Mae and Freddie Mac. It's highly unlikely that they will be addressed in this election year. Do you see any viable path forward to address Fannie Mae and Freddie Mac after the 2012 election?

Wallison: Yes, in fact the 2012 election could make it possible for us to address Fannie Mae [and] Freddie Mac. And the FHA, I might add. 

Every Republican presidential candidate has said the cause of the financial crisis was Fannie Mae and Freddie Mac and government housing policy. Now, this is pretty important to me. I happen to know where they got those ideas. And that means that if a Republican beats Barack Obama in the next election, we will have, at least in the White House, someone who accepts the correct narrative about what happened in this financial crisis. Not that it's greed on Wall Street, not that it's lack of regulation, but that it's the result of the U.S. government's housing policy. Once you establish the right narrative, the answers fall out by themselves. And that means you have to repeal the Dodd-Frank Act because that is impairing our recovery, that is imposing much too much regulation on the financial system when it wasn't at all necessary. It's an illegitimate act and has to be repealed. 

reason: There are people in the Republican Party who were significantly involved in preventing the reforms to Fannie and Freddie proposed in 2004 and 2005. One of the candidates for the Republican nomination, Newt Gingrich, worked for Freddie Mac. There are even people in the House of Representatives who are Republicans who have introduced legislation to keep Fannie Mae and Freddie Mac around. You seem pretty confident that the Republicans would make the right steps, but history offers some cause for concern. 

Wallison: I am concerned about this history, and I'm concerned about these Republicans. I'm not concerned so much about Newt Gingrich because he's flip-flopped on this issue: He's now against Fannie Mae and Freddie Mac. But at the time, he was well compensated for what he did to help Freddie. In fact, he was at AEI. I was attacking Fannie Mae and Freddie Mac at AEI in the 2000s, 2004 to 2007, saying that they were a real risk to the country; meanwhile, two doors down from me, Newt Gingrich was helping them persuade people that they weren't so bad, so we were an ecumenical group, apparently, at AEI.

I am concerned about people who are in Congress today, and that's for two reasons. One is a very technical reason, and that is: The breakdown between Republicans and Democrats on the key committees, on the House Financial Services Committee and on some of the subcommittees, is very, very close. So one Republican in some cases can tie it up so you can't actually get legislation out. That's a problem and I would hope that in the next Congress, the leader, Congressman [John] Boehner (R-Ohio), will change the makeup of the House Financial Services Committee so that there are more Republicans than Democrats and we can overcome the votes of a couple of Republicans who are favorable to Fannie Mae and Freddie Mac. 

You simply cannot overestimate the power of Fannie and Freddie and the ideas that underlie them that come from the groups like the realtors and the home builders and in some cases the securities industry, because they all make a lot of money from Fannie and Freddie. These are interests that are very focused on making sure that Fannie Mae and Freddie Mac and to some extent FHA are very much in business, and they have their own influence on people in Congress. And I must say, giving the people in Congress—even the Republicans in Congress who favor Fannie and Freddie—their due, they can always argue, "Well, in my district we need Fannie and Freddie for this reason or that reason, and I'm afraid that if they were no longer present there wouldn't be any financing for homes in my district." So they can cover themselves with talking for their district, but in fact if these people say they are conservatives, and many of them argue that they are conservatives, they are not conservatives if they are willing to back Fannie and Freddie.

reason: Would you say that today's weak economy is a direct result of the financial crisis, or are there other underlying aspects of why the U.S. economy has not bounced back as strongly from the last recession as it normally does after a recession?

Wallison: I actually believe that it was the reaction to the financial crisis, principally the Dodd-Frank Act, that has caused today's economy to be as weak as it is. Without that, if we had just let the housing market decline, let everything go down to the level where people are willing to come in and start buying, then we would have been in recovery right now. But the government's actions in trying to prevent that from happening, the government's actions in impeding the development of new financing sources for housing, have caused the problem we are in today.