Recently 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 are 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. In the first part of this interview we discussed Peter’s theory that the financial crisis would not have been possible without government housing policy. In the second part of this interview Peter defended his view that housing policy played the central role in the housing bubble and subsequent crisis by refuting many other proposed causes of the crisis.
Reason: So 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 response, as a way to keep the financial crisis from happening again. Even though we are in a weak economy now, are we headed in the right or wrong direction in terms of financial services regulation?
Wallison: The Dodd-Frank Act 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 that question than they gave in their report. The FCIC’s conclusion was that the financial system wasn’t sufficiently regulated; more regulation was needed. That, however, is wrong. From my perspective, what really happened was a mortgage meltdown. As a result of government housing policy a lot of people were able to get mortgages who otherwise couldn’t get mortgage credit, and they couldn’t sustain the mortgages when the bubble stopped growing… In addition, Fannie Mae and Freddie Mac did not make clear that they were buying subprime and other risky loans and in effect contributing those to the bubble. They were hiding their weak loans. That’s why their key officers during much of this period were recently charged by the SEC with misleading investors.
Reason: Let’s talk about that for a moment then. The SEC recently charged six former Fannie Mae and Freddie Mac executives with fraud, claiming that they had some intimate knowledge of the dangerous mortgages that their government-sponsored enterprises were purchasing during the heart of the build up to the financial crisis. Does this SEC lawsuit against those executives signal some wider acceptance of the idea that Freddie Mae and Freddie Mac had a significant role in the crisis?
Wallison: The obvious point is yes, of course it does. What it means is that the government is finally beginning to recognize that Fannie and Freddie had some major responsibility for the crisis. Fannie and Freddie didn’t disclose what they were doing, so people such as risk managers at private sector firms could look at the data and say, “Well, I don’t see that there’s very much risk here. What I see is that housing prices are going up and as far as I can tell, these are all prime mortgages. There isn’t very much risk of losses when this bubble comes to an end.”
Reason: You don’t think this is just another SEC lawsuit similar to the many other ones they’ve filed simply for the political cover of having filed the lawsuit but without serious intention to pursue it?
Wallison: Well, I think they did a lot more than just that. I wouldn’t minimize what the SEC has done here. The reason the SEC sued the officers of Fannie and Freddie, rather than suing Fannie and Freddie themselves, is interesting in itself because Fannie and Freddie are now owned by the taxpayers. It would be foolish for them to try to recover any money from the taxpayers for something the taxpayers are already having to pay for. But in any event, in connection with this lawsuit, they did something very interesting. They had both Fannie Mae and Freddie Mac sign non-prosecution agreements. The SEC said, “We will not prosecute you, but you have to agree that you will provide us all the information that we need to pursue the suits against your former officers and you will admit that the facts on which we are basing these lawsuits are accurate.” That publication of facts essentially corroborated my dissent from the Financial Crisis Inquiry Commission. The whole basis of my dissent was that there were so many subprime mortgages that were on the books of government agencies in 2008 as the result of government housing policy, and that they caused the mortgage meltdown. And what did the SEC argue? They said there were all these terrible mortgages on the books of Freddie Mae and Freddie Mac—sub-prime and other very weak mortgages—which they did not disclose. That’s what caused them to become insolvent, and caused their shareholders huge losses.
Reason: Okay, so if you believe the SEC is corroborating your view on the cause of the crisis and that, thus, the Dodd-Frank Act is not the correct response to the financial crisis, what should we be doing to counteract some of the problems that led to the financial crisis?
Wallison: Well, I think that the first thing we should do is repeal the Dodd-Frank Act, almost in its entirety. There might be a few things in the Act that are worth doing, but most of them are just inhibiting the growth in the economy.
Reason: What do you mean when you say Dodd-Frank is slowing economic growth?
Wallison: The Dodd-Frank Act is an extraordinary piece of legislation. We’re not talking about an ordinary law that responds to a very narrow set of circumstances. [Dodd-Frank] 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—insurance companies, finance companies, securities firms, hedge funds, and 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 the firm has to be very strictly—“stringently” is the statutory term—regulated. Well, that gives the government and particularly the Fed enormous authority over the entire financial system. It is also the kind of law that causes the hearts of entrepreneurs to freeze because you do not know what kind of restrictions the regulators will impose, and you don’t know what positions the government is going to take in regulating securities, commodities, derivatives, consumer relationships, and banking. And so business people are waiting to see what the regulations require. While they are waiting, during this period of uncertainty, they are not hiring. So, from my perspective, the Dodd-Frank Act is the principal cause of the weak recovery that we are still struggling through.
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 strongly from the last recession as it normally does after recession?
Wallison: Yes, it is the reaction to the financial crisis, principally the Dodd-Frank Act, that has caused today’s economy to be as weak as it is. Other than that, if we had just let the housing market decline, let prices fall to the level where people are willing to come in and buy, that is where the bottom is found, then we would be experiencing a strong 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.
Reason: There are a lot of underlying trends related to education, slow downs in growth of the labor force, manufacturing, and an end to the “low-hanging fruit” in innovation as George Mason economist Tyler Cowen puts it. Do you think these are just side issues that have nothing to do with today’s weak economy?
Wallison: Oh, I think all of those things have something to do with today’s weak economy; I just don’t think they are very important compared to government regulation. The US economy is very flexible and very dynamic. We rely on people to have ideas and those ideas drive the economy…. There is constant revolution, creative destruction going on inside our system. We can’t really say that this problem, or that problem, or inflexibilities or changes in the global trading relationships are troubling over the long term. All of that should be overcome over time by the dynamism of a free market, where people are not constrained by the government regulation to function in certain patterns. What can’t be overcome is the heavy hand of regulation.
Reason: Okay then, I feel we’ve only sort of scratched the surface on Dodd-Frank, how else might the landmark financial services law potentially be causing problems?
Wallison: There are lots of ways. The Volcker rule will prevent banks and their affiliates from proprietary trading in debt securities, which will reduce liquidity in the debt markets. The Consumer Financial Protection Bureau will impose huge regulatory costs on small business, the swaps regulations will make it difficult for firms to manage their risks, or at least make that more expensive. One of the most significant ways has to do with the government-sponsored enterprises Fannie Mae and Freddie Mac, and the Federal Housing Administration. The Dodd-Frank Act has provisions which make those three agencies the dominant players in the housing market. And as long as they dominate the housing market, no private sector securitizers will come in and compete with them; you cannot compete with a government agency which has credit resources that you cannot approach As long as the Dodd-Frank Act is in existence, and provides advantages to these government agencies, there isn’t going to be a full recovery in the housing market and private securitization will not revive.
Reason: In what ways specifically does the Dodd-Frank Act prevent housing recovery?
Wallison: Well, the most important thing the Dodd-Frank Act does in that area is it sks regulators to develop a mechanism called the “Qualified Residential Mortgage” or QRM. And it says that if you are not offering a Qualified Residential Mortgage, if you’re not securitizing a Qualified Residential Mortgage, then you have to retain 5 percent of the risk of that mortgage. Now, the FHA, Fannie Mae, and Freddie Mac are exempt from that requirement, under the regulations that have been proposed by the regulators under that provision. Which means that unless a private securitizer of mortgages is securitizing only these QRMs, then he starts off at a 5 percent disadvantage in terms of Fannie Mae and FHA. Now you’re also penalizing the private sector person who’s trying to compete with them.
Reason: In what ways specifically does the Dodd-Frank Act prevent housing recovery?
Wallison: The simplest way this occurs is through additional costs added to the mortgage finance process. Many originators, particularly banks are leaving the business because of all the new regulations that they expect they will have to comply with, especially regulations from the new CFPB. Even some of the largest banks are withdrawing from the market. In addition, the act creates a new concept, called a Qualified Mortgage or QM. Eventually, all mortgages will have to be QMs, which means essentially that the originator has the burden of proving that the borrower could afford the mortgage. If the originator flunks that test, the penalties are substantial, and can give the borrower a defense to foreclosure. As banks and other originators withdraw from the market, mortgages are getting harder to find. That is one of the ways Dodd-Frank is preventing a housing recovery, Perhaps the most important thing the Dodd-Frank Act does in this area is it asks regulators to develop a mortgage called a “Qualified Residential Mortgage” or QRM. This is basically a template for a high quality mortgage. , If you’re not securitizing QRMs, you have to retain 5 percent of the risk of the mortgages in the pool you sell. This can be quite expensive in terms of capital requirements for private sector securitizers and will probably limit them to QRMs, which will be a narrow segment of the market. It also means that only the largest banks will be able to do private securitization, because you need a large balance sheet to carry these 5% slices for as long as 30 years. The FHA, Fannie Mae, and Freddie Mac are exempt from this requirement under the act and the regulations that have been proposed by the regulators who are implementing the act. This widens the gap between private securtizers and the GSEs and FHA.
Reason: What is the practical outcome of this environment that is so dangerous?
Wallison: So that means all the [conforming, lower quality non-QRM] mortgages are going to flow to Fannie Mae, Freddie Mac and FHA. Private securitizers will be limited to QRMs, which will be a small part of the market. I think this will reduce competition.
Reason: So it sounds like your primary critique of the way Dodd-Frank addresses mortgage financing is that it’s going to be encouraging more low-quality loans to be underwritten and it’s going to concentrate most of the financing within large financial institutions.
Wallison: Yes, that’s right. That’s the way it’s likely to work out. We have to see how the QRM definition comes out, but the likelihood is that it will mean that only the largest banks are going to be able to securitize non-QRMs and most mortgages will continue to go through Fannie Mae, Freddie Mac and FHA. That will make it difficult for us to get to a competitive housing finance system that drives down mortgage costs and encourages innovation . That’s just a very, very unlikely result if Dodd-Frank remains in effect.
Reason: How would we avoid this scenario going forward?
Wallison: Repealing Dodd-Frank will make it possible for us to have a fully private mortgage finance system. Then what we should do is encourage private sector securitization of mortgages by significantly reducing the role of Fannie Mae, Freddie Mac and FHA. Fannie Mae and Freddie Mac can gradually be privatized; that’s not difficult to do by reducing what is called their conforming loan limits, which is the maximum size of the mortgages that they can buy. If over five or six or seven years, I don’t care how long it is, if we consistently lower the conforming loan limit, eventually they become irrelevant. The private sector will be able to come in and take over the portions of the market from which they withdraw. It should be done with statute that specifies when the limits will be reduced, so that the private sector will be able to prepare for competition in these areas.
Reason: So our housing finance system should be completely free market…
Reason: …you should be able to originate whatever mortgage you want, if you’re a bank you’re just taking the risk….
Wallison: And you price it accordingly.
Reason: You price it accordingly and these mortgages can be securitized in anyway desired, just so long as everybody knows what’s in those mortgages or what’s in those mortgage-backed securities.
Wallison: That’s right… well, actually, I do think there needs to be some government regulation here because there is a problem I see with securitization. As a bubble grows-- and this is a very normal thing to happen in our economy-- as a bubble grows it tends to suppress delinquencies in defaults. People get the sense that there aren’t any risks or the risks are reduced. Subprime mortgages and other poor quality mortgages look like they are not risky. As a result of that, we can have the same kind of thing develop in a private market as happened when the government was contributing to it. So I think there ought to be a minimum standard for mortgages that are securitized. I think that banks or anyone else should be able to buy whole mortgages of any quality as long as they hold these mortgages in their portfolios. But if they want to sell into the market then the mortgage should meet certain standardized tests for quality.
Reason: It sounds a lot like Fannie Mae and Freddie Mac’s conforming loan standards just applied broadly speaking to every financial institution
Wallison: Well the fact is that before 1992, and the adoption of the affordable housing requirements, Fannie and Freddie informally imposed standards on the housing market. They insisted on down payments, 10 to 20 percent. They insisted on good credit scores. They insisted on low debt to income ratios before they would buy a mortgage. That imposed a kind of restraint on the market. The reason they did that is because their charters said that they should not buy mortgages that would not be bought by institutional investors. They had a standard that they had to meet in their charters and they largely stuck with it. So they actually performed a real service while they were doing that. Now I think the whole business model idea of a private company backed by the government is asking for trouble, so we have to get rid of government sponsored enterprises like Fannie Mae and Freddie Mac. But the one thing they did that was of real value to the market was the creation of standards. We can do that by statute, and once we’ve done that then we can open up the market for robust competition.
Reason: That actually sounds like a contradiction. You’ve argued that one of the problems with housing policy was that we had regulators, government officials, people with an idea of what they wanted to create—and they wanted more homeowners they wanted to create an ownership society, as President Bush talked about—and they manipulated the conforming loan limits to me their desired ends, but they created a lot of bad incentives and that distorted the market place. They thought they were right in their ideas. They thought an ownership society was a good thing, but they were wrong. So, given that, is it not dangerous then to say that the idea of regulation in this area is not inherently wrong it’s just the rules were written wrong, and you think you know what would make a good mortgage, so if we just put your plan in place then it will be okay in the future? Doesn’t your solution fall in the same trap as the prior regulators?
Wallison: Well, you know I’m a conservative. I’m a free market advocate, but I think all conservatives recognize that there are market failures and when there is a market failure regulation is appropriate. This is one of those cases—what happens when a bubble begins to grow in a private market and suppresses the normal delinquency and default signals that warn investors to get out. To prevent a market failure, you need a certain amount of regulation, but that’s all. Everything else would be wide open in the housing finance world that I would create. I would also limit FHA to a very small area of activity—helping people who don’t have the wherewithal to become homeowners, at least get them on the track for homeownership, but only for people who are buying low cost homes in areas where there was not a lot of income.
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 with a split Congress, between Republicans and Democrats and the different approaches they want to take to Fannie and Freddie, 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, Freddie Mac, and the FHA. Every Republican presidential candidate has said the cause of the financial crisis was Fannie Mae and Freddie Mac and government housing policy and that Dodd-Frank should be repealed. Now, this is pretty important to me. I happen to know where they got those ideas. And that means that if a Republican is elected president, 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. Once you establish the right narrative, the answers fall out by themselves. And that means you have to repeal the Dodd-Frank Act because it is impairing our recovery, is imposing much regulation on the financial system when it wasn’t at all necessary. It’s an illegitimate act and has to be repealed.
Reason: Are you not concerned you are putting too much faith in the Republicans? After all, the GOP was significantly involved in preventing the reforms to Fannie and Freddie that were proposed in 2004 and 2005, most GOP veterans on the Financial Services Committee in the House and Finance Committee in the Senate have taken contributions from Fannie and Freddie, one of the GOP’s candidates for president did consulting work on behalf of the GSEs, there are even Republican Congressmen who have introduced legislation in the past year that would keep Fannie Mae and Freddie Mac around. You seem pretty confident that the Republicans would make the right steps, but are you not concerned about any of this history?
Wallison: I am concerned about this history and I’m concerned about some of the Republicans who are in Congress today. 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 negative Republican vote in some cases can tie it up so you can’t actually get legislation out. That’s a problem and I would hope for changes in the next Congress. But you simply cannot doubt the power of Fannie and Freddie and the support that comes from the groups like the realtors and the homebuilders, 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 remain very much in business, and they have their own influence on people in Congress. But I must say that if these people [who defend Fannie Mae and Freddie Mac on behalf of their district] 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. Still, it will be infinitely better to have a Republican president who will take the lead on the issue.
See below for links to Part 1 and Part 2 of this interivew: