Who Really Caused The Great Recession - Part 2: Fannie and Freddie Perform The Great Escape

Yesterday, we reviewed the first part of this two part series, which tries to identify the real culprits behind the Great Recession. Not those that profited it from it, like mortgage brokers, Washington politicians and their insider trading, Wall Street, banks, etc. Not those that eventually were burned by their poor business and bad ethics decisions.

No, we want to find out the true root causes of the Great Recession, what was the real underlying force that resulted in all of the financial industry shenanigans, shenanigans that could not have happened unless that root cause of the problem was not present. Without the root cause, the Great Recession does not occur.

The basis of yesterday's discussion was a chapter from a new book, "Duped America," by Richard Bernstein. Mr. Bernstein makes a very convincing argument that the Great Recession's root cause was very simply Democratic politicians' abusive manipulation and shameful, selfish misuse of Fannie Mae, Freddie Mac, the Federal Housing Authority, and Federal government housing policy since the Carter Presidency.

Today we turn to an extensive interview that was published in the June, 2012 issue of Reason magazine. The interviewee was Peter Wallison of the American Enterprise Institute. Wallison had previously worked as White House counsel and Treasury Department general counsel during the Reagan Presidency.

He also served on the Financial Crisis Inquiry Commission (FCIC) which was supposed to come up with the definitive answers to what caused the Great Recession but which ended up with a split set of answers, split along Democrats and Republicans. Thus, Mr.Wallison has been around the issue of government for a long time.

On the one year anniversary of the FCIC publishing its findings, Mr. Wallison had the following to say about the root causes of the Great Recession:

• He disagrees with the overall FCIC findings that the recession was caused by a mixture of deregulation, Wall Street greed, predatory lending, and many other things.
• He advances the theory that these conclusions was reached by many on the Commission before the actual Commission investigation took place and that the subsequent investigation was used only to confirm their biased answers.
• Like Bernstein, he blames Fannie and Freddie as the primary culprits because: "The government's housing policy was intended to provide financing to people who were unable for one reason or another - mostly lack of resources - to get mortgage credit."
• He also attributes the birth of the recession to the Carter administration's passage of the Community Reinvestment Act (CRA) which put the Housing and Urban Development organizations in charge of this effort to get unqualified Americans into a mortgage arrangement and a home.
• He states that by 2008, there were about 28 million subprime, weak mortgages in effect in the country. That was about half of ALL mortgages that were in effect and of that 28 million, 20.4 million of them were on the books of various government agencies. The 20.4 is a whopping 36% of all mortgages and almost 70% of the weak mortgages.
• He concludes that the 20.4 million bad mortgages existed as a result of the CRA and would not have existed at all if the free market had been allowed to operate naturally.
• Mr. Wallison is very careful in explaining his conclusions. He is not saying that government housing policy caused the Great Recession. The subtlety to his findings and analyses is that without the intrusive government housing policies that evolved directly from the CRA, the financial meltdown and recession would not have happened.
• The government's creation of 20 million weak mortgages and the eventual collapse of many of them led to the financial weaknesses throughout the financial system and the economy as a whole.
• These weaknesses reverberated back through the banks and other financial institutions when those mortgages could not be paid.
• He disputes the theory that big banks had to be bailed out since when Lehman Brothers collapsed without getting a government bailout, no other major banks collapsed as a result. The results of Lehman's collapse were messy and inconvenient for the industry but not fatal, disputing the call and need for the bank bailouts.
• He concludes that since the Great Recession was caused by government housing policy and mismanagement via Fannie and Freddie. He then correctly points out that Fannie and Freddie were not addressed at all in the Dodd-Frank financial industry reform legislation, and thus, the root cause of the Great Recession has not been addressed or resolved by the legislation since these two government disasters escaped any kind of attention within the legislation.
• Given the failure of Dodd-Frank to address failed government housing polices, we unnecessarily ended up with massive new Federal government regulation forced onto the entire economy, beyond just banks, regulation that will waste more economic time and resources like every other massive Federal government bureaucracy without solving the original problem.
• With any type of regulation, especially massive new regulations from this bill, massive uncertainty is introduced into the market which freezes economic growth and vitality.
• One example that he gives in the interview goes back to Fannie and Freddie. Since they are not covered by the regulations introduced by Dodd-Frank, they have a built in competitive advantage to any private sector financial entity that wants to get into the mortgage industry. This depresses competition and strengthens the very causes of the Great Recession, Fannie and Freddie.
• As a result, with no new entrants to compete with the Federal government in the housing industry, Mr. Wallison concludes the housing industry will not recover any time soon and that the status quo we are living with, a mortgage and housing industry dominated by an inept set of government agencies (Fannie and Freddie), will continue to drag down the economy.

Thus, Mr. Wallison basically comes to the same conclusion we reached yesterday. The Community Reinvestment Act from the late 1970s started the ill fated government housing policies that resulted in over 20 million faux mortgages that would never have been created in a regulation free market that weakened the overall financial system and economy when these faux mortgages began it naturally implode which led to the political class misdiagnosing the causes of the financial meltdown, either intentionally or unintentionally, which led to the Dodd-Frank legislation which excluded the culprits from their legislation's reach (Freddie, Fannie, and government housing policy) which restricts competition in today's housing market which suppresses housing demand which depresses economic activity.

A straight line from cause to effect. A long straight line but still a straight line.

Mr. Wallison does not address the greed of Wall Street bankers, the greed of community bankers, the greed of mortgage lenders, the deception of securitization and the bundling of mortgages, the deceptive lending practices, etc. These actions probably all occurred.

But he correctly points out that none of these actions, behaviors and greed happen if the political class, through the Federal government, does not foster and encourage the creation of weak mortgages for political gain and then makes the American taxpayer assume all of the risk until the house of cards collapses.

The sad part is once the cards collapse, the political class misdiagnoses the cause of the collapse and leaves the original root causes in place for the next housing and financial collapse. In the meantime, their solution, Dodd-Frank, ends up crippling the economy into the foreseeable future and leaves the seeds of a second Great Recession firmly in place.



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