“In my opinion, a financial crisis is not only a likely consequence of implicit (government) subsidies for risky lending but a necessary one because that is when implicit guarantees ultimately become real-life bailouts and trigger the taxpayer payments necessary to fund Washington’s longstanding lending goals…
………Mr. Wallison gives taxpayers the inside story of how housing policy was like a siphon hidden inside their wallets—and why it hurt so much.”, Casey B. Mulligan, “Capital Hill Pickpockets”, Wall Street Journal (Mr. Mulligan, an economics professor at the University of Chicago, is the author of “The Redistribution Recession: How Labor Market Distortions Contracted the Economy.”)
Capitol Hill Pickpockets
Risky loans made by Fannie and Freddie were the biggest factor that led to the financial crisis—and the direct result of federal policy.
By Casey B. Mulligan
How much did the federal government contribute to the financial crisis? The question is quantitative, and the answer requires the kind of number crunching and careful thinking than cannot fit into an op-ed or television interview. Peter J. Wallison ’s “Hidden in Plain Sight,” is the book that answers the question most meticulously of any written since 2008.
At this point, seven years on, most readers of this newspaper will recognize that the federal government’s role has been to force American taxpayers to subsidize trillions of dollars of risky lending. But each reader of Mr. Wallison’s book will come away a bit embarrassed at having neglected or forgot about one or more of Washington’s many contributions to the financial crisis.
Subsidies for risky lending had subtle, off-budget beginnings. Taxpayers were implicitly guaranteeing banks and financial institutions, especially Fannie Mae and Freddie Mac, but with few explicit charges against the U.S. Treasury between the savings-and-loan crisis of the 1980s and ’90s and the peak of the more recent housing cycle. Middle- and upper-income households were also implicitly paying extra for, or receiving less value from, their bank products and services because banks were tasked by the federal government to pursue goals like lending to low-income households with poor credit, rather than creating value in the marketplace. These extra costs were absent from the federal budget, too.
Mr. Wallison, backed with calculations made by former Fannie Mae chief credit officer Edward Pinto, primarily points to risky lending by the two government-sponsored entities (GSEs). Moreover, he argues that the risky loans were the single biggest factor that led to the crisis and were the direct result of federal policy.
As part of its regulation of Fannie and Freddie, the Department of Housing and Urban Development created increasingly ambitious affordable-housing goals that could only be achieved with lax underwriting criteria for the GSEs. (The criteria also set a new low standard for the rest of the mortgage industry, Mr. Wallison says.) To illustrate this policy, Mr. Wallison cites numerous documents from Fannie and Freddie in which officials state that they must acquire more nonprime loans (or buy them bundled as mortgage-backed securities) in order to meet HUD’s requirements. To name one: During a 2004 staff presentation, Fannie’s chief financial officer said, “We project extreme difficulty meeting our minority goals in 2005 [and beyond]. . . . There is only one place to change the market and acquire the business in sufficient size—subprime.”
Hidden in Plain Sight
By Peter J. Wallison
Encounter, 411 pages, $27.99
From an economic point of view, a weakness of the book is the degree to which Mr. Wallison relies on such documents rather than demonstrating how incentives fit together with actions. For example, in making the case that GSE regulation was the single biggest factor behind the financial crisis, Mr. Wallison might have measured how taxpayer funds that ultimately went to Fannie and Freddie compared with funds for other bailouts. To show how GSE executives were reacting to HUD’s goals, he might have presented simulations of how sticking to prime loans—and thus failing to meet affordable-housing targets—might have affected the compensation of the key GSE executives and the costs that would eventually be absorbed by taxpayers.
The author, a former general counsel for the Reagan Treasury Department and a dissenting member of the Financial Crisis Inquiry Commission, does use economics to show why we should doubt the commission’s claim that nonprime loans acquired in 2004-07 primarily served the purposes of maximizing GSE profits and market share. By 2006, if not earlier, GSE officials saw nonprime loans as negative-cash-flow deals, not to mention the losses they would generate in future years as a consequence of the loans’ high default rates. Moreover, the GSEs did little to “fight for market share” in 2004-06. Instead, they increased the guarantee fees (measured in basis points) that are part of what determines the fraction of mortgages that a GSE can acquire, thereby deliberately reducing GSE market share.
Another factor that contributed to risky lending and thereby the crisis, Mr. Wallison argues, was the Community Reinvestment Act as amended in 1989. The act requires depository institutions to make a sufficient number and amount of loans to low-income borrowers in their area. Large banks were particularly deferential to the Community Reinvestment Act because conspicuous support for the law’s objectives was critical for getting mergers and new products approved by regulators.
But Mr. Wallison is too subtle when he tries to explain how the Community Reinvestment Act helped lead to financial-institution insolvency. Here the credit-default swaps are key. As banks sold off their nonprime loans—motivated in part by the Community Reinvestment Act—the swaps were vehicles for concentrating the risky part of the portfolio in a few institutions, like Bear Stearns and AIG, where federal officials felt compelled to inject federal dollars.
Fannie and Freddie were ultimately absorbed by the federal government, and the Congressional Budget Office estimates that their mortgage activities (on the books in 2009 as a result of transactions in that year and the several years prior) cost federal taxpayers about $300 billion. The Troubled Asset Relief Program of 2008 was a $700 billion federal program. Taxpayers had to support the insurer AIG with $180 billion when no one else in the world wanted to. Billions more were spent bailing out Bear Stearns and other financial institutions. Taxpayers would have tolerated few if any of these actions if there had been no financial crisis or a closely imminent threat of one.
In my opinion, a financial crisis is not only a likely consequence of implicit subsidies for risky lending but a necessary one because that is when implicit guarantees ultimately become real-life bailouts and trigger the taxpayer payments necessary to fund Washington’s longstanding lending goals. Mr. Wallison gives taxpayers the inside story of how housing policy was like a siphon hidden inside their wallets—and why it hurt so much.
Mr. Mulligan, an economics professor at the University of Chicago, is the author of “The Redistribution Recession: How Labor Market Distortions Contracted the Economy.”