It has been over three years since the height of the financial crisis and the economy is still on unstable ground. As the Dodd-Frank Act is slowly implemented, an ever-widening consensus suggests it will not be an effective response to the causes of the crisis. Some have suggested it does not go far enough to restrict financial activity, while others posit that it completely misses the main causes of the crisis. At the very least Congress, in general, has largely ignored Fannie Mae, Freddie Mac, and housing policy. The extended time since the dust of the Wall Street collapse finally began to settle has also allowed for more in-depth research into the imbalances in the financial sector that ultimately led to economic catastrophe, allowing for previously rock solid theories of what caused the crisis to be re-examined and reconsidered.
So we sat down with Peter Wallison, the Arthur F. Burns Fellow at the American Enterprise Institute and a member of the congressionally appointed Financial Crisis Inquiry Commission (set up to look into the causes of the crisis), to ask him whether his initial hypotheses of what caused the crisis is still holding up, whether we are responding to the aftermath of the crisis well, and what we should be looking for after the 2012 election.
Reason: Peter thanks so much for taking time to talk with us today.
Wallison: Really good to be here, Anthony. Thanks.
Reason: For our readers who are unfamiliar with your views on what caused the financial crisis, you wrote a dissent to official findings of the Financial Crisis Inquiry Commission, which ultimately found that the crisis was caused by a mixture of deregulation, Wall Street greed, predatory lending, and a number other things. Why do you say that this conclusion is wrong?
Wallison: There’s absolutely no evidence of the narrative in the majority report of the Commission. My dissent contains a lot of data, which is evidence that the financial crisis was the result of government housing policy.
Reason: Why do you think that the majority came to such a different outlook, looking at the exact same data?
Wallison: They never looked at the data! That’s the problem. They didn’t want to look at the data. The data disproved the ideological approach that went into this. There were six Democrats and four Republicans on the Financial Crisis Inquiry Commission. The six Democrats were not experts in housing finance by and large—and weren’t interested in knowing what happened. They were interested in confirming the narrative you described.
Reason: What are some of the numbers you are talking about there that they didn’t want to look at?
Wallison: The data was produced by my AEI colleague, Ed Pinto, as a very large memo. I circulated it to the other commissioners because the commission staff itself would not. The memo showed that there were 28 million sub-prime and other low quality mortgages in our financial system in 2008. That’s half, incidentally, of all mortgages in the financial system at the same time. Of those, and this has now been confirmed by the analysis of the SEC in the suits that it recently brought against some of the top officers of Fannie Mae and Freddie Mac, of the 28 million mortgages, 20.4 million were on the books of government agencies like Fannie Mae and Freddie Mac, FHA and other government agencies or by banks that made them as a requirement of the Community Reinvestment Act. So that’s why I say that the government’s housing policy was responsible for creating these mortgages, the housing bubble, and the financial crisis.
Reason: You are often painted as claiming that the government sponsored enterprises, Fannie Mae and Freddie Mac, were the chief culprits of the financial crisis. But earlier you were articulating that it was federal housing policy more generally speaking. Is there a nuance in the way you use those terms?
Wallison: Fannie Mae and Freddie Mac were the implementers of a substantial portion of the government’s housing policy. This policy was intended to provide mortgage financing to people who were unable for one reason or another—mostly lack of resources—to get mortgage credit. Fannie and Freddie were the principal agents that the government’s worked through. The Community Reinvestment Act, applicable to banks and S&Ls, was also a factor. [The Department of Housing and Urban Development], which was basically in charge of Fannie and Freddie's housing goals, also had its own separate program that involved the Mortgage Bankers’ Association. In the end, by 2008, there were 28 million sub-prime or very weak mortgages. They never would have been created without the demand created by the government providing the funds to buy them.
Reason: Stanford political economist Francis Fukuyama recently said in an interview recently that your dissent to the Commission’s report was “transparently designed to exonerate free markets.” So do you argue the crisis 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. He’s just listened to some people on the left who characterize it in certain ways. My point is 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, and that is, if we hadn’t had the government’s housing policy—that is, but for the government’s housing policy—there wouldn’t have been a financial crisis. And the reason is that without the creation of all of the sub-prime and other weak mortgages, we wouldn’t have had a mortgage meltdown that ultimately was the cause of the weakness in the financial system. Seventy-four percent of all these weak mortgages were in the hands of, or the responsibility of, government agencies. That means the private sector, the other side, had about twenty-five percent. So I’m not saying that the private sector is completely without responsibility here, but if the only weak lonas in the financial system were the 25 percent created by the private sector, we would not have had a financial crisis.
Reason: What do you think were some of the contributing factors that led us to the point where housing policy got so off the rails, leading to the buildup of the housing bubble and the subsequent financial crisis?
Wallison: I guess what I would have to say is that a lot of it is ideological. In 1992 congress adopted a law that required Fannie Mae and Freddie Mac to make what were called affordable housing loans. What was an affordable housing loan? It was a loan made to someone who was at or below the median income in the place where he or she lived. Now the original standard imposed in 1992 was that in each year, for all the mortgages that Fannie and Freddie bought from originators, 30 percent of those mortgages had to be made to people who were at or below the median income in the place where they live. However, [the power to set this standard] was given to the Department of Housing and Urban Development, which was ideologically committed to increasing home ownership. Over the years following 1992, Congress, Barney Frank, and others, pressed HUD to expand the affordable housing requirements and so they went from 30 percent in 1992, with a number of intermediate stops, to 50 percent in the year 2000. This was all during the Clinton administration, and then into the Bush administration it went to 55 percent by 2007.
Reason: Barney Frank takes a lot of the heat for failing to see problems at Fannie Mae and Freddie Mac, but you’re hitting on an important point that it wasn’t just the Democrats who were to blame.
Wallison: This is not a partisan argument. Both the Clinton administration and the Bush administration were responsible for pressing Fannie and Freddie to increase these affordable housing loans. If you have a requirement that 50 percent of all of your mortgages have to be made to people at or below the median income that means for every prime mortgage you buy, in effect, you have to buy a mortgage that is riskier because a borrower who is below the median income probably has fewer financial resources, might not have a steady job, has blemished credit, can’t afford the house. That’s what was happening. So for each prime mortgage Fannie and Freddie bought they had to buy a non-prime mortgage of some kind. That’s why by 2008 Fannie and Freddie had a total of about 13 and a half million mortgages they held or guaranteed that were subprime or otherwise low quality. When you add up FHA, the federal home loan banks, and the banks subjected to the Community Reinvestment Act that comes to something over 20 million loans by 2008 that were on the books of government agencies. But the most important factor was the affordable housing requirements for Fannie and Freddie, because they were by far the biggest, had the most money, and did the most damage.
Reason: Affordable housing goals were put in place initially in 1992, but really didn’t start to be implemented until 1994. The Community Reinvestment Act was amended in 1995. So why was it that we didn’t see a significant housing bubble start to form, at least measured against real housing values, until the 2000’s?
Wallison: Well actually it was before the 2000’s. The numbers that I have in my dissent for example show that the bubble began in 1997, using the charts and tables of Professor Robert Schiller of Yale. By the year 2000 we had a bubble that was larger than any previous bubble we had ever had. Now why did it take from 1992 to 1997? Well it does take a while for the bubble psychology to develop.
In the next part of this interview we challenge Peter Wallison’s theory and suggest a number of other causes of the crisis that he responds to.