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 with we discussed Peter's theory that without government housing policy, the bubble never would have formed and we never would have had the financial crisis.
Reason: As anybody that studies housing policy knows, housing is always local. What impacts the price of a home can be a new school being built as much as it can be large national trends...
Wallison: A Whole Foods for example.
Reason: ...absolutely, a Whole Foods being built nearby can definitely increase the value of your home. When you dig into some of the data on where in the country a lot of these new homes were being built they were highly concentrated in Arizona, in Florida, in California, and Nevada. One common denominator between all these places is land use rules. Land use restrictions that concentrated a lot of developments and it’s been argued that really it’s more the land use restrictions that caused housing prices in these local areas to be driven up. More so than the Community Reinvestment Act or affordable housing goals. And it was those land use states that actually led the national bubble. How does this work into your analysis?
Wallison: I don’t accept that. I can’t deny that land use restrictions do cause home prices to go up, but I think over a much longer period. I think that a real example of this is home ownership. Home ownership in the United States stayed at about 64% for the 30 years up to 1995. Between 1995 and 2004 home ownership went up 5%. So for 30 years no matter what the US government did, all the benefits that it bestowed on housing up until 1995, nothing happened to change the home ownership rate. But between 1995 and 2004 the home ownership rate went up 5%, which was huge. And why is that?. It’s because of the government, through Fannie and Freddie and others, was providing loans to people who before that had not had access to mortgage credit. And that was through the affordable housing requirements, through CRA, and through FHA and so forth.
Reason: Fair enough, but the government on its own can’t cause a housing bubble with affordable housing goals. It can subsidize credit but there still has to be money that comes from somewhere. People still have to choose buy the homes, taking on the debt. Investors still have to purchase mortgage-backed securities. The government can create incentives for those things, but it doesn’t cause them to happen. So what role do you give to Wall Street in your story of wha caused of the crisis?
Wallison: Wall Street did what Wall Street always does. They are great salesmen. They are great at devising new ways of selling assets and investments to customers. Let’s talk about the bubble and look at the bubble as a key element of what happened here. In about the year 2002-2003, it seems that investors began to realize that mortgage backed securities based on subprime loans were yielding a lot because they were risky, but because bubbles have the effect of suppressing delinquencies and defaults these securities were not showing the kinds of losses that one would expect from a risky instrument. Now some really smart people, or people with long backgrounds in housing, might have said “well of course, when a bubble is growing you will not see many delinquencies; you’d better get out before the bubble collapses.” But most people don’t think in those terms.
Reason: You’re accusing major financial institutions of some measure of incompetence or lack of knowledge in what they were doing.
Wallison: Yes. But my point is that they do not have special foresight.
Reason: Documentaries like The Inside Job paint a picture that focuses more heavily on accusations of fraud. There are a number of individuals arguing that, actually, these financial institutions knew very well that they could package these mortgages into complex securities and derivatives and sell these to very unsophisticated investors and that there was a little bit more of a malicious attitude to it. You completely disagree with this?
Wallison: Yes, I completely disagree. It’s very easy to say that people should have known what was happening, but for the reasons I just suggested, very, very few people would have recognized a bubble. For example, in transcripts of the [Federal Reserve’s] Open Market Committee meeting in August of 2006—a few months before the financial crisis began—members said, “Well, there’s really no danger here of any problems in the financial system as a result of these subprime mortgages. I just don’t see it happening. There aren’t that many defaults. It’s not that much of a problem.” Now, this is the Fed. They have access to all the data that was available in the financial system. They get very good reports from the best economists this country can produce, before they have these meetings. They are themselves experienced observers of the housing markets, at least as experienced as managers of banks, of other financial institutions, and yet they didn’t realize they were looking at a housing bubble. So people like to say, “Well, the banks obviously knew that they were selling junk.” It’s not true that they knew they were selling junk. The Fed didn’t know that there was all that junk out there. And in addition, the banks got in trouble because they kept the stuff. If they’d actually sold it off, they wouldn’t have been in any trouble. So they kept it because they believed that these mortgages were sound investments.
Reason: We’ve had Fannie Mae and Freddie Mac for much longer than the past couple of decades. And we didn’t wind up with the financial crisis that occurred in the past decade. You’ve articulated that there were major changes made to the way that they operated in the 90’s. So it was the changes that happened in the 1990’s to housing policy that contributed to the build-up of the housing bubble then leading into the financial crisis. But if we look in the 90’s to try and find some significant changes that happened on Wall Street itself, we can see that there were a lot of formerly private partnerships that had become public companies. Corporate governance models changed substantially in the 90’s. The Gramm-Leach-Bliley Act allowed for investment banks and commercial banks to come together under one roof, without putting in place good resolution procedures in case complex firms got into trouble. So we can add significant changes to the way Wall Street operated in the 90’s to the story of the crisis. If that had not had happened, would we have still had the financial crisis?
Wallison: Oh, of course. Even if we assume that it was the private sector’s fault, that it was the private sector that caused the financial crisis, who got in trouble in the financial crisis? Big banks and big investment banks. After Gramm-Leach-Bliley [in 1999], banks could affiliate with investment banks. But they didn’t do so. There were no connections between the Citis, the JP Morgans, which are banks, and the Goldman Sachses, the Morgan Stanleys, the Merrill Lynches, which are investment banks. Now there are, because the government allowed Bear Stearns to be acquired by JP Morgan Chase, and Bank of America to acquire Merrill Lynch. But before that, they were completely separate from one another. So the banks got into trouble in the financial crisis by buying these very poor quality loans and believing, I think, that they were good quality loans. They held onto them and suffered major losses. The investment banks (who were completely separate from the banks) did the same thing. So if Glass-Steagall were still in effect, and had not been modified by Gramm-Leach-Bliley it wouldn’t have changed a thing. Glass-Steagall was irrelevant to the financial crisis, because even though banks and investment banks could have affiliated, they didn’t. They remained as competitors.
Reason: There is a complex system of rules for the way banks are supposed to manage their capital, manage their risks, known as the Basel capital requirements. The Basel capital requirements allowed banks to hold securities that held mortgages at significantly lower levels of capital than against other assets, incentivizing capital to flow into the investment of mortgages, on the idea that these were incredibly safe. Had the risk weights for the way that banks were supposed to measure their risk been equal, and not distortionary, would there have been as much money flowing to finance these mortgages that the government wanted to and allow it to happen one way or another?
Wallison: We probably would have had the same financial crisis, but the banks wouldn’t have been so central. That is, the commercial banks were central to the crisis because their Basel capital requirements created incentives for them to invest in AAA mortgage-backed securities. Incidentally, that meant that they only had to carry 1.6 percent capital against mortgage-backed securities, whereas they had to hold 8 percent capital against a commercial loan. So that was a big swing between the two. But what it would have meant, I think, is that those mortgages and mortgage-backed securities would have been sold to non-banks. There would have been a much more balanced market. In other words, there wouldn’t have been a reason for banks to preferentially hold mortgage-backed securities because they wouldn’t have had the capital advantages of doing so. So there still would have been a market, because the elements of a market were still there—that is to say, the delinquencies and defaults were suppressed by the growth of the bubble—so investors still would have wanted these instruments, but the Basel rules really concentrated them in the banking system. I call it “herding the banks” into what turned out to be very poor quality mortgages. That makes it worthwhile to think about whether regulation [like the Dodd-Frank Act] is actually a useful thing. I am very doubtful about that.
Reason: So your argument is that there would have been a housing bubble, one way or another, even without the Basel rules pushing capital. It would have come from elsewhere. But ultimately we did have the Basel rules, we did have these investments did sit at a lot of major financial institutions. And then when those mortgages began to default en masse, the subprime mortgage crisis began to surface in 2007 and there were all these fears of insolvency, there were all these liquidity fears. However, we did not have very good resolution systems put in place to at least provide some sense of measure of calm to financial markets about what would happen if a firm became insolvent. Those fears led to the bailout of non-commercial bank Bear Stearns and the attempt to bail out Lehman Brothers and eventually TARP to bailout all the banks. If we had had a robust resolution process, maybe not the one that was in Dodd-Frank, or a different chapter of the bankruptcy code that would have allowed for a more rapid way of handling counterparties to take apart such a complex firm (like a Bear Stearns) if it went bankrupt? Do you think that we would have had as much panic in the financial markets?
Wallison: It’s very hard to assess that counterfactual, but here’s the way I would look at it: The reason that Bear Stearns was taken over, the reason why it was rescued, is the government is traditionally reluctant to allow financial failures to happen. The Fed in particular is afraid, always afraid, that there will be some sort of massive break-down if a large institution fails. So their instinct is always to rescue these institutions. Bear Stearns would have been rescued no matter what. I think we have a very good resolution system right now through bankruptcy. The resolution system set up by Dodd-Frank is far inferior because it creates uncertainty for creditors.
Reason: So you’d argue we could use the current bankrupt rules for all major firms on Wall Street?
Wallison: Now, there’s a difference between the rules for [commercial] banks and the rules for investment banks. In the banking field, they don’t allow large institutions ever to fail. It just doesn’t happen. What the FDIC does is take institutions that are failing and merge them with healthy institutions. That’s why we have these gigantic banks right now, because all these mergers have taken place over time. Now, no one expected an investment bank would ever be rescued. And Bear Stearns should have been allowed to go into the normal bankruptcy process. But the government did not let them do that because they were so afraid of the consequences of Bear Stearns’ failure. My view is that if Bear Stearns had been allowed to go bankrupt, we wouldn’t have had a financial crisis; instead, immediately afterward all other institutions that were in danger would have started raising capital to protect themselves against the possibility that another financial institution might fail or that they themselves would have had some sort of difficulty if their depositors or their creditors wanted to withdraw their funds.
Reason: Given that we did bail out Bear Stearns, should we have also bailed out Lehman Brothers?
Wallison: Sure. Once the government has established a policy like that, you have to continue it.
Reason: Is that just because the financial community was now expecting bailouts and had grown too big and interconnected? Were we ultimately destined to bailout Wall Street no matter what?
Wallison: Well, 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 Sterns 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. What else can interconnected mean? That is, if Bear Sterns 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 Sterns, but when we came to Lehman Brothers, they reversed their policy and didn’t bail out Lehman Brothers. 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 being Lehman Brothers being unable to meet its obligations? And 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 commercial 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 Sterns, and therefore the Primary Reserve Fund would not suffer any losses on this Lehman debt. So that was the only example. Every other institution that got into any kind of trouble—and we can talk about Wachovia, Citi, WaMu, even Merill Lynch, 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. None of those were affected in any significant way by the Lehman Brothers bankruptcy.
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 in October, Wachovia and Washington Mutual had collapsed—specifically because their depositors and their creditors did not believe in their solvency in a post-Lehman environment. And this was even though they weren’t directly exposed to large-scale Lehman-related losses. Assuming for a moment that the market turmoil in September 2008 was the fault of Lehman Brothers and not government inconsistency, if Lehman hadn’t caused all the instability in the financial market, maybe Wachovia and WaMu would still be around. You don’t think they had anything to do with Lehman?
Wallison: Anthony, that’s a really good question and it deserves some parsing because we’re talking only about interconnections. The question is: was Lehman’s failure the cause of the problems at these other institutions because of their interconnections with Lehman? I’m trying to make clear that what people mean by interconnections is this: if a large financial institution cannot pay its debts because it has gone into bankruptcy, it will drag down other firms. That isn’t what happened after Lehman failed. Yes, there was chaos. Investors ran from all of these large financial institutions. That is what happened. As a result, these firms hoarded cash because they wanted to be very sure they had the cash when their depositors or other investors came for it, and that was the financial crisis: Financing was hard to get...for anything. Because these large financial institutions were hoarding cash. But was that was that caused by Lehman being unable to pay its debts? No, that was caused by what I call, and what scholars have always called, a common shock.
Reason: Could you explain common shock briefly for our readers?
Wallison: A common shock refers to a case in which a widely held asset-- and in this case we’re talking about mortgage-backed securities backed by these low quality or sub-prime mortgages—suddenly plunges in value. And when it does, it causes all financial institutions that are holding these assets to look weaker. Their capital goes down and their liquidity tightens because they can no longer use these mortgage-backed securities for financing—that is, for liquidity purposes. It was a common shock that caused all of them to look very, very weak, and when Lehman failed, people panicked because all of these other institutions also looked very weak, like Lehman. 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 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 for the financial crisis. But when we look at Lehman Brothers, and what happened after Lehman Brothers, we can see that Lehman Brothers’ failure—except for the Primary Reserve Fund—had no significant effect on other firms, such as AIG, Citi, and so forth.
In the final part of this interview, we discuss the Congressional response to the financial crisis, the recent SEC lawsuit against former Fannie Mae and Freddie Mac executives, and how the Dodd-Frank Act is impacting the economy.