Hidden in Plain Sight

Hidden in Plain SigHt Hidden in Plain SigHt What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again Peter J. Wallison encounter Books New York • London © 2015 by Peter J. Wallison All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of Encounter Books, 900 Broadway, Suite 601, New York, New York 10003. First American edition published in 2015 by Encounter Books, an activity of Encounter for Culture and Education, Inc., a nonprofit, tax-exempt corporation. Encounter Books website address: www.encounterbooks.com Manufactured in the United States and printed on acid-free paper. The paper used in this publication meets the minimum requirements of ansi/niso z39.48‒1992 (r 1997) (Permanence of Paper). FIRST american edition library of congress cataloging-in-publication data Wallison, Peter J. Hidden in plain sight : what really caused the world’s worst financial crisis and why it could happen again / by Peter J. Wallison. pages cm Includes bibliographical references and index. ISBN 978-1-59403-770-2 (hard cover : alk. paper) — ISBN 978-1-59403-771-9 (ebook) 1. Housing—Finance—Government policy—United States. 2. Mortgage loans—Government policy—United States. 3. Subprime mortgage loans—Government policy—United States. 4. Financial crises—Government policy—United States. 5. United States—Economic policy—2001–2009. I. Title. HD7293.Z9W35 2015 332.7'20973090511—dc23 2014005179 produced by wilsted & taylor publishing services Copy editing: Nancy Evans Design: Yvonne Tsang Composition: Nancy Koerner Charts: Evan Winslow Smith For my amazing grandchildren, with love Skylar Allegra Alex Henry and Elodie ContentS Preface xi Acknowledgments xvii Part I The Basics 1 introduction 3 What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again 2 the Difference between Prime and nontraditional Mortgages 27 The Importance of Sound Underwriting Standards 3 the Financial Crisis inquiry Commission report and other Explanations for the Crisis 41 Why Conventional Explanations for the Crisis Are Inadequate 4 a short History of Housing Finance in the U.s. 100 How and Why Housing Finance Was Substantially Changed in 1992 Part II GovernmenT housinG Policies Take effecT 5 HUD’s Central role 125 How HUD Used the Affordable-Housing Goals to Reduce Underwriting Standards 6 the Decline in Underwriting standards 160 How the Affordable-Housing Goals Forced an Increase in Nontraditional Mortgages 7 Force Fed 182 Why the Affordable-Housing Goals, and Not Market Share or Profit, Were the Sole Reason the GSEs Acquired Nontraditional Mortgages 8 Going Viral 219 Why and How Reduced Underwriting Standards Spread to the Wider Market Part III The financial crisis and Its acceleranTs 9 the Great Housing Price Bubble 237 How Loosened Underwriting Standards Stimulated Its Growth 10 Flying Blind into a storm 248 How the GSEs’ Failure to Disclose Their Acquisition of Nontraditional Mortgages Magnified the Crisis 11 31 Million nontraditional Mortgages Precipitate a Crisis 265 Why Even Government-Backed Mortgage Securities Were Contributors 12 Fair-Value accounting scales Up the Crisis 278 How Mark-to-Market Accounting Made Financial Firms Look Weak or Unstable Part IV from Bad To Worse 13 From Bad to Worse 307 How Government Blunders Turned a Mortgage Meltdown Into an Investor Panic and Financial Crisis 14 the False narrative and the Future 342 Why the Failure to Understand the Causes of the Crisis May Lead to Another Notes 363 Index 393 PrefaCe Far from being a failure of free market capitalism, the Depression was a failure of government. Unfortunately, that failure did not end with the Great Depression. In practice, just as during the Depression, far from promoting stability, the government has itself been the major single source of instability. miltoN frieDman Political contests often force the crystallization of answers to difficult political issues, and so it was with the question of responsibility for the financial crisis in the 2008 presidential election. In their second 2008 presidential debate, almost three weeks after Lehman Broth- ers had filed for bankruptcy, John McCain and Barack Obama laid out sharply divergent views of the causes of the financial convulsion that was then dominating the public’s concerns. The debate was in a town-hall format, and a member of the audience named Oliver Clark asked a question that was undoubtedly on the mind of every viewer that night: Clark: Well, Senators, through this economic crisis, most of the people that I know have had a difficult time. I was wondering what it is that’s going to actually help these people out? Senator mcCain: Well, thank you, Oliver, that’s an excellent question. But you know, one of the real catalysts, really xi xii ⋅ preface the match that lit this fire, was Fannie Mae and Freddie Mac . they’re the ones that, with the encouragement of Sen. Obama and his cronies and his friends in Washington, that went out and made all these risky loans, gave them to people who could never afford to pay back . Then it was Obama’s turn. Senator obama: Let’s, first of all, understand that the big- gest problem in this whole process was the deregulation of the financial system. Senator McCain, as recently as March, bragged about the fact that he is a deregulator. A year ago, I went to Wall Street and said we’ve got to rereg- ulate, and nothing happened. And Senator McCain during that period said that we should keep on deregulating because that’s how the free enterprise system works. Although neither candidate answered the question that Oliver Clark had asked, their exchange, with remarkable economy, effec- tively framed the issues both in 2008 and today: was the financial crisis the result of government action, as John McCain contended, or of insufficient regulation, as Barack Obama claimed? Since this debate, the stage has belonged to Obama and the Democrats, who gained control of the presidency and Congress in 2008, and their narrative about the causes of the financial crisis was adopted by the media and embedded in the popular mind. Dozens of books, television documentaries, and films have told the easy story of greed on Wall Street or excessive and uncontrolled risk-taking by the private sector—the expected result of what the media has caricatured as “laissez-faire capitalism.” To the extent that government has been blamed for the crisis, it has been for failing to halt the abuses of the private sector. The inevitable outcome of this perspective was the Dodd-Frank Wall Street Reform and Consumer Protection Act,1 by far the most costly and restrictive regulatory legislation since the New Deal. Its regulatory controls and the uncertainties they engendered helped preface ⋅ xiii produce the slowest post-recession U.S. recovery in modern history. Figure P.1 compares the recovery of gross domestic product (GDP) per capita since the recession ended in June 2009 with the recoveries following recessions since 1960. Unfortunately, Dodd-Frank may provide a glimpse of the future. As long as the financial crisis is seen in this light—as the result of insufficient regulation of the private sector—there will be no end to the pressure from the left for further and more stringent regulation. As this is being written, proposals to break up the largest banks, re- instate Glass-Steagall in its original form, and resume government support for subprime mortgage loans are circulating in Congress. These ideas are likely to find public support as long as the prevailing view of the financial crisis is that it was caused by the risk-taking and greed of the private sector. For that reason, the question of what caused the financial crisis is still very relevant today. If the crisis were the result of government 120 115 110 Average of prior cycles 105 100 Real GDP per capita Real GDP per capita (index 100 = cycle peak) 100 = cycle (index Just shy of 2007:Q4 peak; 95 still 12% below average 2007:Q1–2013:Q2 recovery 90 −3 −2 −1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 Quarters after peak Sources: Bureau of Economic Analysis; Census Bureau; authors’ calculations. Adapted from Tyler Atkinson, David Luttrell, and Harvey Rosenblum, “How Bad Was It? The Costs and Consequences of the 2007–09 Financial Crisis,” Staff Papers (Federal Reserve Bank of Dallas) no. 20 (July 2013): 4. Note: The gray area indicates the range of major recessions since 1960, excluding the short 1980 recession. fig. P.1. Current rebound in GDP per capita compared to previous cycles xiv ⋅ preface policies, as described in this book, the Dodd-Frank Act was an illegitimate response to the crisis and many of its unnecessary and damaging restrictions should be repealed. Similarly, proposals and regulations based on a false narrative about the causes of the financial crisis should also be seen as misplaced and unfounded. As demonstrated by Dodd-Frank itself, first impressions are never a sound basis for policy action, and haste in passing significant legislation can have painful consequences. During the Depression era, it was widely believed that the extreme level of unemployment was caused by excessive competition. This, it was thought, drove down prices and wages and forced companies out of business, caus- ing the loss of jobs. Accordingly, some of the most far-reaching and hastily adopted legislation—such as the National Industrial Re- covery Act and the Agricultural Adjustment Act (both ultimately declared unconstitutional)—was designed to protect competitors from price competition.

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