The Financial Crisis III. How Do We Sort Out What Happened?

 

The Financial Crisis in 2008 was one of the most disruptive events in U.S. history.  It is crucial that we understand what caused it so that we can recover from it more fully and avoid a recurrence.  My favorite books about the crisis are: The Financial Crisis and the Free Market Cure by John Allison, President of the CATO Institute and former CEO of the large financial services company, BB&T;  Bull By the Horns by Sheila Bair, Chair of the FDIC from 2006-2011; and Hidden in Plain Sight by Peter Wallison, an economics policy scholar at AEI and former member of the FCIC.
CaptureNot surprisingly, these three very well informed individuals have somewhat different points of view.
Mr. Wallison says that the government’s affordable housing policies caused the financial crisis by essentially requiring the GSEs Fannie Mae and Freddie Mac to acquire increasingly large numbers of subprime mortgages.  The financial power of the GSEs forced private lenders to lower their own lending standards in order to compete (this last assertion is in dispute). When the resulting housing bubble burst, large numbers of subprime mortgages defaulted causing huge losses for both GSEs and private financial institutions alike.
Ms. Bair says that “the subprime lending abuses could have been avoided if the Federal Reserve Board had simply used the authority it had since 1994 under the Home Ownership Equity Protection Act to promulgate mortgage lending standards across the board.”  In March 2007 she testified strongly in favor of the Fed issuing an anti-predatory lending regulation under HOEPA and was rebuffed by the Fed.  As FDIC Chair she constantly urged, largely without success, that other federal agencies use their regulatory powers to curtail the abuses of private lenders.
Mr. Allison agrees with Mr. Wallison that “the whole origination market relaxed its standards to compete with Freddie and Fannie.”  However he goes on to say that “the investment banks (including Bear Stearns and Lehman Brothers) magnified the misallocation of credit to the housing market.  They created a series of financial innovations (CDOs, derivatives, etc.) that leveraged an already overleveraged product. … Investment bankers unquestionably made irrational decisions based on pragmatic, short-term thinking. … Those who made these mistakes should have been fired and their companies allowed to fail.”
Can these disparate points of view be melded into a coherent framework for the financial crisis which suggests a way forward from where we are today?  I will attempt to do this in my next post.

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