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The supporters of the Dodd-Frank Act in Congress and elsewhere regularly claim that any change or reform of that law will open the U.S. economy to another financial crisis. This view is based on the fallacious idea that the 2008 crisis was the result of insufficient regulation of the financial system, especially banks.
On its face, this view is inherently implausible because it cannot explain why in the 10 years between 1997 and 2007, we had a nationwide decline in mortgage underwriting standards, an unprecedented housing price bubble, and a financial crisis when the bubble collapsed in 2008. None of these things had ever happened in the 75 years since the Great Depression, which is the only comparable event in American history. During all these years, we had the same financial regulatory system — indeed, bank regulation had been tightened during this period — and the same government-controlled housing finance system.
In reality, the crisis was caused by the government’s housing policies, beginning with the enactment in 1992 of what were called the Affordable Housing Goals. The goals required Fannie Mae and Freddie Mac, two government-backed mortgage companies, to meet annual quotas of low- and moderate-income (LMI) mortgages when they bought mortgages from banks or other originators. Fannie and Freddie did not make mortgage loans; they operated a secondary market in mortgages by acquiring them from banks and other mortgage originators.
Initially, the quota was 30 percent — i.e., in any year, at least 30 percent of all mortgages Fannie and Freddie acquired had to have been made to LMI borrowers who were at or below median income where they lived. The U.S. Department of Housing and Urban Development (HUD) was given authority to administer the goals, and through the Clinton and Bush administrations the goals were raised aggressively. By 2008, 56 percent of all mortgages Fannie and Freddie acquired had to meet the LMI quota.
Before the Affordable Housing Goals were adopted, Fannie and Freddie were well-known for buying only prime mortgages, and in fact it was that policy that Congress wanted to change by enacting the goals in 1992. The thought at the time was that it would be easier for low- and moderate-income borrowers to buy homes if Fannie and Freddie could be compelled by the quotas to lower their underwriting standards.
That certainly worked. By the mid-1990s, Fannie and Freddie had abandoned their policy of accepting only mortgages with 10 percent down payments. They had to; they couldn’t find enough borrowers among those below median income who could make a 10 percent down payment. This was followed by reductions in FICO credit scores and increases in allowable debt-to-income ratios for borrowers as Fannie and Freddie struggled to meet the increasing goals between 1992 and 2008.
The great error in this policy was the failure to understand that Fannie and Freddie — as the dominant players in the housing finance markets — set the underwriting standards for the market as a whole. Mortgage lending is a competitive business, and as Fannie and Freddie lowered their underwriting standards lenders found that the two government-backed mortgage companies would accept mortgages that they had never accepted before. If competing lenders would make these mortgages, and if the government-sponsored enterprises (GSEs) would buy them, these underwriting standards would become the minimum standards for the market as a whole. Pretty soon, people who formerly had insufficient funds to make a 10 percent down payment were able to buy a home by borrowing almost the entire cost from a bank. The underwriting standards that were initially intended to help LMI borrowers had spread to the wider market.
The decline in underwriting standards caused housing prices to rise. If a potential buyer has $10,000 and the underwriting standard requires a 10 percent down payment, the buyer can acquire a $100,000 home. But if underwriting standards decline and the required down payment becomes 5 percent, the buyer can purchase a $200,000 home. Instead of borrowing $90,000, he now borrows $190,000. This additional borrowing, which people in the field call leverage, bids up housing prices. As a result, between 1997 and 2007, an unprecedented housing price bubble grew in the United States, with home prices rising almost 10 percent per year.
Why would a bank make a loan with only a 3 percent or even zero down payment? Two reasons: First, home prices were rising so fast in the late 1990s and early 2000s that a year later the home would be worth 10 percent more, and thus could be sold to recover the mortgage loan if the buyer defaulted. Alternatively, the bank figured it could sell that loan to Fannie or Freddie, and both of them needed loans to borrowers below median income — no matter how risky — so they could meet the Affordable Housing Goals.
By 2008, just before the financial crisis, more than a majority of all mortgages in the U.S. financial system were subprime, required low or no down payment, or were otherwise risky. Of those loans, 76 percent were on the books of government agencies, principally Fannie and Freddie. This shows, beyond question, that it was the government that created the demand for these mortgages.
Finally, in 2007 and 2008, when home prices had gotten so high that no amount of concessionary lending could get borrowers to take on the loans, the bubble’s growth flattened and began to decline. Then, as Warren Buffett famously said, “when the tide goes out you can see who’s swimming naked.” A deluge of defaulted mortgages hit the financial system, buyers of mortgages and mortgage-backed securities that were not guaranteed by the government disappeared, and financial firms that had bought these mortgages or the mortgage-backed securities were left holding the bag. Fannie and Freddie became insolvent, were taken over by the government, and were bailed out by the taxpayers for $187 billion. The outcome was a financial crisis in 2008 and a deep recession that ended in June 2009.
This isn’t to say that the banks were blameless; they were profiting from the sale of deficient mortgages, but the reason they could sell them was because Fannie and Freddie and other government agencies were buying them to meet government quotas.
To address this problem, the financial regulators did not need any more authority. They had plenty of authority and plenty of visibility into the banks to know what the banks were doing. They didn’t stop the fun or take away the punchbowl because they knew Congress liked what was happening. More people were buying homes and housing prices were rising, making everyone feel richer.
But after the carnival came to an end, the only thing the Obama administration and the congressional majority could think of was to pile more regulation on the financial system. No one, either among the regulators or in Congress, wanted to take the blame, or even find out the truth, so the banks became the scapegoat and Dodd-Frank was fastened onto the American economy.
George W. Bush was the only person in authority during this period who has come close to making an honest assessment of what happened. He said in his memoirs, “I was pleased to see the ownership society grow. But the exuberance of the moment masked the underlying risk.”
The winners write the history, and the incoming Obama administration and the Democratic supermajority in Congress blamed the crisis on insufficient regulation of the private financial sector. This narrative, although factually unsupported, gave rise to the Dodd-Frank Act, which imposed significant new regulation on the U.S. financial system but did virtually nothing to reform the government policies that gave rise to the financial crisis.
Today, Fannie and Freddie and other government agencies are again buying mortgages with only 3 percent down payments. Homebuyers are borrowing the rest of the cost of the home. As a result, housing prices are rising on the same trajectory that they marked out in the mid-1990s. If we don’t change our housing policies, we are headed to another financial crisis.
Meanwhile, the Dodd-Frank Act — the wrong reform for a crisis caused by the government’s housing policies — caused an unprecedented decline in U.S. economic growth. Enacted in 2010, hurriedly as the Democrats realized that they were going to lose their supermajorities in the House and Senate in that year’s elections, the act called for almost 400 new financial rules.
It can only be imagined what uncertainties this created in the financial community and the kind of conservative management that ensued as banks and other financial entities contemplated what those regulations might involve. One immediately obvious effect was the decline in the formation of new banks; from an average of about 100 per year before the financial crisis, the number of new bank formations declined to five, three and one in each of the years after Dodd-Frank was enacted. Clearly, the new regulation and the compliance costs involved made banking so unprofitable that almost no one wanted to start a new bank.
The effects of these requirements on the economy are clear; there can be no other explanation for the historically slow recovery of the U.S. economy from the recession that followed the financial crisis. In the entire Obama administration, there were only four major pieces of legislation or financial policy that were large enough to affect the growth of the economy — President Obama’s Economic Recovery and Reinvestment Act of 2009, the Accordable Care Act of 2010 (ACA), the Fed’s efforts, over several years, through “Quantitative Easing” (QE), to lower long-term interest rates, and the Dodd-Frank Act. The Economic Recovery Act, which alone pumped $831 billion into the economy, as well as the ACA and the Fed’s QEs should all have been stimulative, because they all added major liquidity to the U.S. economy. But if they were, the effect was overwhelmed by the Dodd-Frank Act, which added an unprecedented degree of new regulation to the financial system. For the seven years following the enactment of Dodd-Frank, U.S. economic growth has averaged less than 2 percent, and the recovery from the 2009 recession has been slowest in 50 years.
This is almost certainly because the regulations imposed by the Dodd-Frank Act, which reduced capital investment, increased uncertainty, and suppressed what John Maynard Keynes called the “animal spirits” of participants in the economy.
After the 2016 election, when Donald Trump was elected on a platform of repealing Dodd-Frank and reducing regulation generally, the stock market indexes suddenly started to rise, even though nothing material had actually been done. This has continued despite the absence of any substantial legislative changes in taxation or regulation. One explanation could be the possibility of major tax reform, but the more likely reason is the sense in the business community that there will be a general reduction in regulation, which averaged over 3000 new regulations per year during the Obama presidency.
The danger, however, is that as long as the public fails to recognize that the government’s housing policies — and not lack of regulation — caused the financial crisis, we will continue the same policies that brought on the financial crisis 10 years ago.
Peter J. Wallison is a senior fellow at the American Enterprise Institute. He was a dissenting member of the Financial Crisis Inquiry Commission, a ten-member commission that was created to investigate the causes of the financial crisis. He also served as White House counsel for President Ronald Reagan and is a former general counsel of the U.S. Department of the Treasury. He is writing a book about the growth of the administrative state.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 The causes of the 2008 financial crisis, from beginning to end, are detailed in my book, “Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why it Could Happen Again,” Encounter Books, 2015
 George W. Bush, “Decision Points,” (Crown Publishers, 2010), p449
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