The Financial Crisis Inquiry Commission report is out, and it also includes two separate dissents. There’s a metaphor contained in the dissent by Peter Wallison of the American Enterprise Institute which does a pretty good jobof describing the majority take and his critique of it:
In a private interview with a few of the members of the Commission (I was not informed of the interview), [Obama economic adviser Larry] Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest i re and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest?
The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, inef ective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises.
The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk [non-traditional mortgages] with a total value over $4.5 trillion. Let’s use a little common sense here: $4.5 trillion in high risk loans was not a “cigarette butt;” they were more like an exploding gasoline truck in that forest. The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to del ate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.
This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary. The appropriate policy choice was to reduce or eliminate the government’s involvement in the residential mortgage markets, not to impose significant new regulation on the financial system