Unconvincing Analyses of the Causes of the Financial Crisis: Frontline and AEI

This past week I have encountered two unconvincing analyses about the causes of the U.S. housing crash and the financial crisis of 2008.  One is the contained in the first part of the PBS Frontline documentary, Money, Power and Wall Street, and the other is an American Enterprise Institute (“AEI”) paper by Peter Wallison and Edward Pinto, “Free Fall: How Government Policies Brought Down the Housing Market.”

The Frontline documentary appears to argue that it was derivatives and their lack of regulation which caused the crisis.  The documentary’s argument is a little bit confused, since it jumps from edited interview to edited interview, some of which appear to be placed somewhat out of context.  Also, the documentary does not take note of the regulatory differences between credit default swaps (“CDS”), and securities backed by actual mortgage loans or synthetic collateralized debt obligations (“CDOs”), whose payment streams included flows from CDS.  

A bigger flaw than confusion over what is an “unregulated” derivative as opposed to a security is the documentary’s lack of analysis as to what caused the housing bubble, at least in the first two parts that have aired (the last two parts air tomorrow).  It does not make a convincing case that it was all due to derivatives or securitization.

As far as regulation is concerned, the problem was not solely, or even primarily, that CDS were unregulated instruments; after all, the major players were subject to regulation.  There was a failure by the regulators to use their existing authority; the documentary could have usefully explored why that was.  Also, it could have explored the role of monetary policy, the activities of mortgage brokers and lenders, the flawed ratings of the less, but plenty, risky tranches of CDOs, and the desire of many homeowners to borrow against the appreciated value of their homes in order to finance their desired consumption.  Beyond that, the documentary could have addressed the housing bubble in European countries and the reasons for the buildup of exposures of many banks to AIG in connection with CDS.  Even more ambitiously, the documentary could have compared the U.S. banking system and mortgage practices with those of Canada, whose major banks fared better during the financial crisis than U.S. banks.

In other words, what Wall Street did with CDS and securities backed by mortgages, along with some of the unseemly practices that have been documented with respect to synthetic CDOs, were part of what fueled the financial crisis, but they are not the whole story.  If one’s analysis is limited to what Frontline has presented so far about the crisis, then one may be led to expect that more stringent regulation on OTC derivatives is all that is needed to prevent another crisis from occurring.

The AEI paper, on the other hand, ignores derivatives and CDOs and firmly puts the blame for the housing boom and bust on government policy.  In particular, Wallison and Pinto’s culprits are Fannie Mae and Freddie Mac, government mandated affordable housing goals, and the 30-year mortgage and the tax deductibility of mortgage interest payments.  The data that Wallison and Pinto use to attempt to demonstrate that Fannie Mae and Freddie Mac’s participation in risky mortgages have been subject to serious criticism.  Also, many dispute that government mandates, such as the Community Reinvestment Act, had much to do with the financial crisis.  As far as 30-year mortgages are concerned, those have been around in the U.S. for a long time without causing the housing boom of the magnitude we saw in the last decade. 

Fannie Mae and Freddie Mac did play a role in the financial crisis, but Wallison and Pinto are not convincing that they are the main culprits.  Again, how can you ignore monetary policy, the lack of regulatory action in the face of an obvious real estate bubble and lowering of credit standards, and the frenzied activity of Wall Street firms in mortgage related products?  This is not to say that government subsidies to the housing sector are not something that should be looked at.  Indeed they should, but the political difficulty of reducing the credit and tax preferences to housing are politically difficult to change.  For example, the deductibility of interest on home mortgages was something that the Tax Reform Act of 1986 did not change while it eliminated the deductibility of interest for consumer and student loans.  Everyone knew that this would create an incentive for individuals to take out loans backed by their primary residence.

As with much of what has been written about the financial crisis, these two recent analyses take a myopic view of what happened.  In truth, the financial crisis was over determined; it is easy to point to various failures as the cause.  There will be debate about the root causes, and the definitive analysis accepted by most people will be elusive.  But it is disheartening to see two flawed analyses, which many people will take seriously, even if some of the issues raised are legitimate.