The Financial Crisis IV. Where Do We Go From Here?


“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.                                                                    former Congressman Barney Frank, 2010

“Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.”
                                                   former Federal Reserve Chair, Ben Bernanke, 2010

As I explained in my last post, my views on the financial crisis are most heavily influenced by John Allison, President of the CATO Institute; Sheila Bair, former Chair of the FDIC; and Peter Wallison, a financial policy analyst at the AEI, as follows:

  • The primary cause of the crisis was the affordable housing policy, created by Congress and administered by HUD, under which higher and higher percentages of mortgages acquired by the GSEs Fannie Mae and Freddie Mac had to be made to low and moderate income borrowers. This policy, aided by the very low interest rates maintained by the FED from 2002-2004, created the housing bubble which burst in 2007 leading to an unprecedented number of delinquencies and defaults.
  • Subprime lending abuses could have been avoided if the FED had used the authority it had under the Home Ownership Equity Protection Act of 1994 to require appropriate mortgage lending standards. In other words, lax regulation, but not deregulation, was a major contributor to the crisis.
  • Investment Banks, such as Bear Stearns and Lehman Brothers, magnified the misallocation of credit to the housing market with financial products such as CDOs and derivatives.

Clearly congressional action was needed to address the financial abuses leading up to the crisis.  But the Dodd-Frank Act is an overreaction.  It requires 398 new regulations which are taking a big toll on the economy as shown by the chart below from the American Action Forum.
CaptureDodd-Frank should be scaled back so that its provisions apply only to the very largest financial institutions where the abuses were the greatest.  This can be accomplished with capital requirements which increase proportionally with the size of the institution so that smaller banks are better able to compete with the giants.
Faster economic growth is critical for our future.  It will not only create more jobs and higher paying jobs but will also alleviate our deficit problem by bringing in more tax revenue.  Paring back and streamlining Dodd-Frank would be a big step in the right direction.

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.