The True Story Behind the Financial Crisis

Expert: Accepted narrative of the 2008 financial crisis is wrong

• February 21, 2013 2:38 pm


Peter Wallison on Wednesday lamented the poor understanding people have of the underlying causes of the financial crisis, arguing that a false narrative of the crisis led to the Dodd-Frank Act and continues to stymie real reform in the financial sector.

Wallison, a member of the Financial Crisis Inquiry Commission and a financial policy expert at the American Enterprise Institute, discussed his recent book Bad History, Worse Policy: How a False Narrative About the Financial Crisis Led to the Dodd-Frank Act during a lunch event hosted by Americans for Tax Reform.

"The Dodd-Frank Act is the most intrusive, the most regulatory, the most comprehensive financial regulation since the New Deal, and there’s really no comparison with the New Deal," he said. "This piece of legislation is truly extraordinary."

Wallison said the narrative of the crisis championed by the press and liberal politicians is that Republican deregulation and greedy big banks are to blame.

The media is suspicious of capitalism, Wallison said. They view it as "Darwinian," the "enemy of equality," and an "inherently unstable system that results in crashes time and time again." Regulatory agencies also have an interest in the conventional narrative. "Whenever they fail, they get more power," Wallison said.

But this narrative is wrong, Wallison argued. "Anyone in the financial industry will tell you it wasn’t financial deregulation," he said, although even the financial institutions themselves did not fully understand the causes of the crisis at the time.

Wallison spent about five minutes outlining his version of the causes of the crisis.

The government created Fannie Mae and Freddie Mac to buy home mortgages from banks in order to free up capital at those banks and permit more loans. And according to a 1992 piece of legislation, 30 percent of the home mortgages that Fannie Mae and Freddie Mac bought had to be from individuals at or below the area’s median income level.

The 1992 legislation also gave the Department of Housing and Urban Development the power to raise the requirement. By 2005, 55 percent of all mortgages bought by the two government-owned mortgage-backing institutions were for low-income individuals .

While Fannie and Freddie could meet the initial 30 percent requirement without too much trouble, the steadily increasing requirement forced the two institutions to lower their underwriting standards for mortgages. They reduced the minimum FICO credit score and began accepting mortgages with no down payment—two of the most important indicators for the quality of a mortgage.

"Over time, these poor quality mortgages stacked up in the financial system," Wallison said. Half of all mortgages in the United States—28 million out of 55 million—were subprime or very low quality by 2008. And of these 28 million loans, three quarters were on the federal government’s books.

A housing bubble had been building since 1997, Wallison said, and when the bubble began to deflate, many of these low-quality mortgages defaulted. Many financial institutions that had bought so-called "mortgage-backed securities" began to struggle.

Private financial institutions did indeed buy these sub-prime mortgages, but the government created the primary market for them, Wallison added.

"When Lehman Brothers collapsed, panic ensued," he said.

Congress enacted the Dodd-Frank financial reform act in response to the crisis. The legislation was an attempt to fix the underlying causes of the crisis—causes that were understood in light of the accepted narrative. Dodd-Frank "implements the left’s view of what was wrong," Wallison said.

"It does not do anything to deal with the government’s involvement in the housing market," he said.

According to the regulations under Dodd-Frank, the lender now has the burden to show that the borrower can afford the mortgage. However, if the lender sells the mortgage to the Federal Housing Administration, Fannie Mae, or Freddie Mac, the lender is no longer liable for selling a bad mortgage.

"So what we are doing here, then, is recreating again the same system that we had before where low quality mortgages are preferentially going to go to the government … because the government wants to increase home ownership for people who otherwise can’t afford homes," Wallison said. He predicted America could have another financial crisis in 10 to 15 years.

"The Republicans at least have begun to see what actually happened … and have recognized that the Dodd-Frank Act was a mistake," Wallison said.

Florida Republican Sen. Marco Rubio attributed the financial collapse to government policies in his response to the president’s State of the Union address. His statement lit up the "left wing blogosphere," Wallison said.

"Look, this is one of the most thoroughly researched topics out there, and every piece of the government-did-it thesis has been refuted," Krugman fumed.

Wallison expressed hope that Dodd-Frank could be substantially changed if Republicans take control of the Senate and presidency in 2016.

"This is not a hopeless case," he said.

Published under: Congress, Dodd-Frank