The Great Regulation Caused the Great Recession

There are so many canards about our dear, departed Great Recession of 2007 to 2009. Some favorites:

Deregulation caused it.

The government had to bail out Wall Street from its own mess.

The stimulus bill of 2009 stopped an economic free fall and forestalled a second Great Depression. (This last is why Hillary Clinton, on the stump, gives President Obama an “A” for his economic policy.)

The thing about canards is that they cannot help but contain a pointer toward the facts. Their evasiveness and stridency create a sort of outline, in shadow, of the very reality that it is the point of canards to suppress and obscure. Prevarication, as Shakespeare had it, protests too much.

For some reason, the Great Recession gave canards an especially wide berth. Perhaps it was the grimness of the circumstances. Economic certainty was in short supply during the sharp downturn. Perhaps it comforted Americans more to hear capitalism blamed, as in Franklin D. Roosevelt’s 1930s, with an edge of anti-intellectualism and bullying. For people experiencing economic privation, the simple truth about what was really going might have been too much to bear.

One of the effects of this state of affairs was that startling opportunities arose in the area of intellectual originality. An analyst who wished to marshal, sift through, and present evidence about the crisis could develop cogent explanations of the first significance, and do so alone. The nation would then have something like a prophecy on its hands: a demonstration of clarity distinguished by both its importance and its uniqueness. Such are the stakes when dubious narratives run their course. Canards call forth corrections—at least in intellectual cultures that make space for freedom.

Peter J. Wallison’s aptly titled book appears to be the vehicle that the cunning of our nation’s reason has alighted upon to establish, at long last, a proper understanding of what the devil happened to our beloved American economy in the first decade of the 2000s. Recall that those were the opening years of what was supposed to be our promising new millennium—the one that President Bill Clinton kept saying he was building a bridge to. Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again rewrites from scratch the potted history of the crisis that has been handed to us for years now, and does so with clear warrant from a lode of the best available evidence.

The book is so straightforward and so connected to the weight of the relevant information that it states its thesis many times, yet each time in a new way that illuminates another facet of the matter at hand. The thesis of Hidden in Plain Sight can be found, first, in Wallison’s statement that:

The 1997-2007 housing bubble would not have reached its dizzying heights or lasted as long, nor would the ensuing financial crisis have ensued, but for the role played by the housing policies of the U.S. government.

Second, his explanation of why the bubble lasted so long:

Housing bubbles deflate when delinquencies and defaults begin to appear in unusual numbers. . . . One by one, investors cash in and leave. . . . The reason for this longevity [of 1997-2007] is that one major participant in the market was not in it for profit and was not worried about the risks to itself or to those it was controlling. . . . [T]his was an insider who kept buying, injecting more money into the market. In the end, this insider never sold. . . . Instead, it held onto the assets as they fell in value because it was not in the game for the profits it could reap. This insider was the U.S. government pursuing a social policy.

Last, his summary of what caused the crisis: the demand on the part of the GSEs (government-sponsored enterprises, the federally exhorted and assured mortgage agencies) and other buyers around the world for exposure to non-traditional mortgages.

The great housing bubble that stalked the economy in the run-up to the Great Recession, the whole thing, was a creature of federal regulation. It was Great Regulation—of home purchases—that caused the Great Recession. Furthermore, the role played by the market was that of hero. The market, specifically Wall Street, was the white knight that came riding in, and figured out a way to pop the bubble and cashier the regulations, which enabled the arduous recovery we have been in since 2009.

If this interpretive sequence is grossly unfamiliar to us, the conventional wisdom is to blame. The conventional wisdom cannot survive Wallison’s evidence, that is how extensive it is.

The story begins in 1970. In that year, Congress brought into being a creature called “Freddie Mac” and authorized it and an existing outfit, “Fannie Mae,” to buy, on the secondary market, mortgages that were not explicitly guaranteed by the federal government. The idea was that housing finance would be easier for the masses in this country if there was a duo of big government-backed purchasers of mortgage debt originated by ordinary banks. Fannie and its cousin had an unusually cushy relationship with Washington. These GSEs, exempt from U.S. securities laws, also enjoyed a line of credit from no less a source than the U.S. Treasury.

No big deal, perhaps, even through the house-price explosion of the 1970s. Unless the GSEs really wanted to exploit their advantages, they might sit on their hands. Their employees, after all, were quasi-federal and probably more interested in keeping their jobs, pushing paper, and drawing a salary, while leaving parlays in the markets to the pros in the real estate sector.

But then the government started to exhort the GSEs, to flog them, to soup up their “mission.” The seeds were sown with the Community Reinvestment Act of 1977. The CRA required banks to increase their provision of mortgages in poor neighborhoods. The act was a dead-letter through the Reagan-Bush years, until one of the major Democratic gadflies in Congress, Representative Henry Gonzalez of Texas, moved in 1992 to put some oomph behind the CRA.

Representative Gonzalez began the process, carried forward in the Clinton administration, of pressuring banks and the GSEs who bought their mortgages to see to it that there was significant mortgage lending to historically underrepresented homebuyers, mainly members of various minority groups. Sticks more than carrots were involved. It became clear to banks that their mergers would not win approval unless they had plenty of low-income mortgages to show in their histories. The GSEs were told to have 30 percent of their purchases in the mortgage “shortage” areas.

In the Clinton era, the caboose of the presidential Cabinet, the Department of Housing and Urban Development, found in the CRA/Henry Gonzalez enthusiasm a cause of its own. Under the push of then-Secretary Andrew Cuomo (today the Governor of New York), HUD outlined a series of goals and “subgoals” that would increasingly require the GSEs to see that over half their purchases on the secondary mortgage market covered the mortgages of buyers typically unable to afford a home.

Before this, mortgage lending had been a clear-cut affair. You either qualified for a mortgage on settled and obvious terms or you didn’t. A qualified borrower put 20 percent down, had a decent credit score, had income to clear a mortgage payment by a healthy amount, and furnished information bearing upon the prospect of amortization—documentation regarding income, employment, payment history, and assets.

Meeting the ever-ratcheting affordable-housing goals and subgoals churned out by HUD meant that standards had to plummet. Down payments of far less than 20 percent had to be deemed acceptable—one could even come and borrow the down payment, nonsense in theory but true in fact by the 2000s. Credit scores and income-to-loan ratios would have to be ignored. The easiest route to these results was the preferred one: documentation went uncollected.

The GSEs made it clear to the mortgage originators—not “shadow banks” as the slur goes, but regular banks—that the GSEs needed the loosened standards in order to get clear of the federal heat. Banks had their own reasons to make nice with the regulatory establishment. There was compliance all around, in the form of unprecedented lending to people who would not have qualified for a mortgage under the normal criteria used up to that point. Even so, HUD and the GSEs had to coax into prominence a special private bank that would focus its business on NTMs—non-traditional (that is, deficient) mortgages. This was Countrywide. Countrywide charged a high fee for this governmental service. Right before the crash, its CEO was the highest paid executive in the land.

When George W. Bush entered the White House in 2001, talk started to flow of limiting if not shutting down the GSEs. Perversely, this only increased their willingness to comply with HUD’s accelerated schedule to meet the subgoals. Would Republicans really want to hamper the GSEs if millions of heretofore impecunious Americans were getting set up in homes, any number of them McMansions? By 2008, the GSEs were holding the incomprehensible number of 24 million NTMs, representing a theoretical equity value of $5 trillion. Meanwhile legions of the American poor had left their rentals and were staring at the walls in their spacious new homes. The demand for homes became so intense that residence prices doubled nationally.

No free market in this story—only government. No deregulation—only regulation. And the magnitudes are not large, but huge. The only person ever to collect all this information, even in significant part, was Edward Pinto, Wallison’s associate at the American Enterprise Institute, as Wallison prepared to serve as one of 10 members of the congressionally chartered Financial Crisis Inquiry Commission in 2010. The FCIC report of the following year would prove a whitewash. Hidden in Plain Sight is Wallison’s revenge.

The market detected that something was off, in the Bush II years, and began to develop financial instruments that would insure against a fall in house prices and the mass defaults that could come in tow. These were the credit-default swaps often contained within the collateralized debt obligations, the “big shorts” that Wall Street concocted as the bubble grew. They paid off if an institution’s holding of mortgage paper (so much of it processed via the GSEs) lost value.

Shrewdly Wallison sees that it was creating these instruments that, by breaking into the government’s affordable housing game (as underway since 1992), was responsible for stopping the nonsense. Otherwise the scenario could have gone on indefinitely, with the nation’s poor relocated to tracts of Garage Mahals far outside of places like Las Vegas and into the interior of Florida. The credit-default swaps were means of “price discovery,” as the term of art goes, which the market used to discern the true exchange value of American housing units, despite all the noise and distortion that was coming from government intervention on the home-purchase side.

The arrival of the credit-default swaps introduced skepticism about the immense surge in home prices nationally and, by extension, about the financial instruments that went up in value with the housing market: mortgage-backed securities. People started making withdrawals from funds with these securities. In the summer of 2007, withdrawals caused the first two major mortgage-backed security funds to fail, those housed at France’s BNP Paribas.

It is imperative to note, as Wallison does, that actual mortgage defaults did not precipitate the crash. These were not happening as of the summer of 2007, when home values were still high, and in fact still climbing, enabling millions of deficient, non-traditional buyers of recent years to keep up with their payments by pulling more equity out of their homes. Not government, but the market detected a problem—before mortgage payments were skipped en masse and caused the “music to stop,” to borrow a phrase from Wallison skeptic Alan Blinder.

Now banks were no longer willing to play ball with HUD and the GSEs and underwrite low-quality mortgages. If this meant they would face federal pressure, so be it—it was better than writing bad loans in the teeth of a downturn. Housing values peaked, then started to come down, leaving payers of NTMs to keep up their payments using their own resources, an impossibility given the mortgage terms. The defaults came; the mortgage-backed securities lost value; firms went bust; 2008 happened. And Fannie and Freddie scurried into the arms of federal conservatorship.

After that, in late 2008, the affordable-housing mania of the federal government was over (at least for the time being), allowing the Great Recession to find its trough in early 2009. The distortion had run its course. The recovery we have experienced since then has been a function of the demise of the Great Regulation—that of mandated home-ownership. The recovery has been weak, to be sure, but this has been because employers have had to pay high wages to lure people away from all of the new Obama entitlements (as Casey Mulligan proved in his 2012 book The Redistribution Recession).

His critics say Wallison is a one-note symphony. Surely big events are complex and multi-causal. The knowing statements of the cognoscenti run into a problem, though, and it is empirical. Deregulation caused the Great Recession? The evidence is blindingly the opposite: regulation caused it. Shadow banks (that is, Wall Street institutions) were the crux of the problem? The data show that mortgage-originators—regular banks—piled up all the bad debt mandated by the feds. The shadow banks were the ones who performed a service, initiating the process of price-discovery that stopped the bubble from ever-further expansion. The Federal Reserve was too loose? The few-points drop in the federal funds rate in the early 2000s was chicken feed in comparison to the magnitude of the NTM boom.

Only Wallison, with the assistance of Pinto, has amassed specific, detailed, and relevant evidence in service of his explanation of the crisis. And the evidence points to federal housing policy in the great main.

But aren’t markets supposed to be efficient? How could they for so long let second-raters in the government—at HUD, of all places—drive policies that would one day crash the mighty American economy? That does not sound remotely proportionate.

As Wallison shows, the market’s warning lights did eventually go on. Wall Street stopped the NTM boom in 2007. The bubble lasted 10 years—about seven years longer, by his estimate, than typical bubbles in all sorts of markets. The reason it took so long for that to happen? Fraud, a cover-up: The GSEs misrepresented their holdings of NTMs by a factor of five or more, meeting HUD subgoals by announcing national home-ownership rates as opposed to by opening their books. They faked out the Federal Reserve in particular by only reporting NTMs from NTM specialists such as Countrywide, which represented only a sliver of the real market.

Given their exemption from securities laws, it was a narrowly self-interested move for Fannie and Freddie to make. (The Securities and Exchange Commission filed a surely hopeless lawsuit against GSE principals in 2011.) And as Wallison points out, the GSEs every year (we now know, thanks to Pinto) just barely cleared the immense HUD subgoals. They knew that the whole system stank—that there was no legitimate reason for supporting 24 million deficient borrowers.

Banks were in no position to maintain curiosity in this regard, since if they did, their mergers would not gain approval. Ultimately this going-along-to-get-along would result in insolvency in the banking system. Banking actors followed the only possible course under the circumstances. They made profits (preferably in the form of compensation, as opposed to booked assets or reserves, both of which could be clawed back) while they could, the reductio ad absurdum being Countrywide.

Wallison remains a voice in the wilderness, waved off by the likes of the FCIC majority and Joe Nocera of the New York Times. Today he detects a worrisome reconstitution of the home-affordability cause in government, a cause that has already killed the economy once. Hidden in Plain Sight is not just the most meticulous but the most important book written on the American economy since our unprecedented time of troubles began.