The 2008 financial crisis and the ensuing legislation and regulation under Dodd-Frank have been at the center legal and economic scholarship since the onset of the crisis. How financial actors are to navigate new and uncharted regulatory territory has generally taken center stage. But what if that entire regulatory scheme hinges on the wrong premises? What if the explanation for the financial crisis is improperly Wall Street focused? Such is the contention of Peter J. Wallison, a dissenting member of the Financial Crisis Inquiry Commission and scholar at the American Enterprise Institute in his most recent book Hidden in Plain Sight. In his book, Wallison contends that the 2008 financial crisis and ensuing recession can be traced to the Federal Government’s housing policy, that the affects of the collapsing housing market were mishandled by the Federal Government, and most of all, that Wall Street was simply acting as Wall Street was supposed to act. 1
If such contentions are true, then Wall Street has been improperly demonized as the culprit responsible for the 2008 financial crisis and ensuing recession. Furthermore, the Federal Government’s regulatory efforts are improperly aimed at Wall Street banks while housing policy innocently drifts back to the pre-recession standards that created the 1997-2007 housing bubble in the first place. For these reasons, Wallison’s arguments deserve a summary and attention in a blog devoted to Business law.
The commonly accepted narrative is that Wall Street banks took on unacceptable risks by holding large positions in Private Mortgaged Backed Securities (PMBSs) consisting of subprime mortgages. This narrative blames Wall Street demand and greed for driving down mortgage underwriting standards and creating a housing bubble. When the bubble burst, Wall Street banks were left holding these “toxic assets,” causing devastating losses that brought down the entire stock market. Wallison’s book shifts the blame to Federal Housing policy, asserting that housing policy drove the explosion in subprime lending, created the housing bubble and ensuing financial crisis. 2
Under Wallison’s analysis, the seeds of the financial crisis are traceable to the Congressionally enacted “affordable housing” goals given to two government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac in 1992. ((Id. at 128.)) These goals instituted quotas for the GSEs, requiring that a specific number of the mortgages underwritten or acquired by the GSEs be made to low-income Americans. To meet these quotas, underwriting standards had to be lowered, leading to the explosion in subprime lending. Over the next fifteen years, through both the Clinton and Bush administrations, quotas increased such that more than half of the loans on Freddie and Fannies books were subprime. As of 2008, 76% of all non-traditional Mortgages (mostly subprime) in the United States were on Fannie and Freddies’ books. ((Id. at 130.))
Wallison goes on to argue that Government housing and banking policy drove the private market into the subprime lending business and fostered the market for private mortgage backed securities. Freddie and Fannie effectively set underwriting standards for the entire market. The private markets needed to adjust their standards simply to keep up. 3 Further, government policies encouraged the private lenders to make subprime loans. The office of Housing and Urban Development employed a Fair Lending Best Practices Initiative that encouraged private lenders to increase the number of loans to low-income and minority homeowners, necessitating the adoption of subprime underwriting standards. 4 Further, in 1995, the Clinton administration tightened requirements under the Community Reinvestment Act, forcing banks to make subprime loans that would otherwise not make in order to maintain their status as government insured lenders. 5
Securitization of mortgages allows lenders to spread the risks of mortgages and secure funding to make more mortgages. Fannie and Freddie securitized mortgages, but also acquired PMBSs, which the government permitted to count towards reaching their fair housing quotas, driving demand for PMBSs. ((Id. at 185.)) Furthermore, government regulations made PMBSs an attractive asset for banks. The risk-based capital requirements applicable to Banks, known as Basel I, requires banks to hold 8% capital against commercial loans, 4% against residential mortgages, but only 1.6% against PMBSs. 6 Thus, PMBSs were favorable assets for private banks to hold. In sum, Wallison argues that Wall Street responded as Wall Street should, by making profitable investments, making loans and acquiring assets that facilitated federal housing goals. Wall Street simply acted in accordance with government policy, capitalizing on a government created housing bubble, making profitable loans that allowed the US to reach 70% homeownership at the peak of the bubble. 7
The next step in Wallison’s analysis blames government accounting policies for forcing Wall Street banks to record unprecedented losses. In 2007, when the bubble became unsustainable, housing values dropped, homeowners defaulted on their mortgages in record numbers. With the cash flows of PMBSs uncertain, the market dried up completely. Without any movement, those PMBSs appeared to be worth next to nothing in spite of the future cash flows that would be generated by non-defaulting mortgages. ((Id. at 290-291.)) Generally accepted accounting standards require banks to mark those securities to market on their balance sheets. So when the market for PMBSs halted, Wall Street Banks had to take massive hits, creating a liquidity crisis for banks like Bear Stearns and Lehman Brothers. In Wallison’s analysis, the mark-to-market requirement forced Wall Street banks to take larger hits than necessary, because the value of PMBSs was uncertain without a liquid market. As Wallison notes, only once FASB changed the rule in the spring of 2009 was the stock market able to begin a recovery. 8 In time, most PMBSs regained 90% of the value they appeared to lose in 2007-2008.
Wallison further asserts that the Government’s behavior and rhetoric turned a housing crisis into a financial crisis. The government’s contribution to JP Morgan’s acquisition of Bear Stearns in the spring of 2008 created moral hazard, sending a message that it would not let investment banks fail due to their mark-downs of PMBSs. 9 Believing that the government would not let them fail, banks like Lehman Brothers did not take drastic moves to shore up additional capital during the summer of 2008. 10 Yet, the government let Lehman Brothers go bankrupt and wrongly asserted that it legally could not step in. 11
The commonly accepted narrative, and the motivation for the government’s participation in the Bear Stearns – JP Morgan deal was that the banks were too large and interconnected to be permitted to fail. Wallison argues that this is analysis is misguided, that interconnectedness did not bring down the financial system. 12 Firstly, if the banks were too interconnected to be permitted to fail, why bail out Bear Stearns and not Lehman Brothers. Secondly, the Lehman Bankruptcy did not bring down its fellow banks. As Wallison posits, the mark-downs suffered by Lehman Brothers caused a common shock among investors, causing them to flee the market in droves. 13. Had they not been forced to mark PMBSs to fair market value, when that value was indeterminable, their would have been no common shock, and the stock market decreases would have been limited. The housing crisis would not have led to a systematic financial crisis.
Wallison’s conclusion aims to show that a misguided understanding of the financial crisis as led to an improper clampdown on Wall Street, while the government continues to support risky housing policies. Wallison first points to the fact that the Government framed its TARP funds as a bailout meant to keep the banks from failing, when in reality TARP funds gave banks liquidity in the face of a frozen PMBS market. He urges that this narrative portrayed the government as saving Wall Street, giving it license to regulate as strongly as it liked. ((Id. at 322-23.)) Secondly, Wallison argues that Dodd-Frank is based on the incorrect theory that financial institutions are so interconnected that they must be unscrupulously regulated. ((Id. at 344-45.)) Such regulation has drastically slowed economic recovery. But most importantly, Wallison asserts that Wall Street was simply acting as a critical piece in the Federal government’s housing policy, playing its role in facilitating the American Dream of homeownership for millions of Americans. Most importantly, Wallison highlights that Federal-housing policy has not changed much, continuing to encourage low underwriting standards and risky mortgages as part of its fair housing social policy. A clampdown on Wall Street will do nothing to prevent another housing bubble if, the housing policy continues to be irresponsible. 14
Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why it Could Happen Again, (Encounter Books, 2014). ↩
Id. at 133. ↩
Id. at 137. ↩
Id. at 147. ↩
Id. at 18-19. ↩
See Id. at 219. ↩
Id. at 339. ↩
Id. at 323. ↩
Id. at 326. ↩
Id. at 329. ↩
Id. at 344-46. ↩
Id. at 346 ↩
Id. at 360-61. ↩