what caused the financial crisis? the fcic report

Today the Financial Crisis Inquiry Commission released its long-awaited report ( The Financial Crisis Inquiry Report: Financial Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States). The Report of the ten-member, bipartisan Commission, consists of the official report adopted by a majority (six) of the commissioners, including the chairman Phil Angelides (408 pages plus 13 pages of summary, referred to here as “the Report”), a dissenting statement by Republican members, Bill Thomas (vice chairman), Keith Hennessey and Douglas Holtz-Eakin (limited per Commission rules to 26 pages, referred to as the “Thomas dissent”), and a separate dissenting statement by Peter J. Wallison, also limited in length (referred to as the “Wallison dissent”). Mr. Wallison has supplemented his statement with a much longer version separately available.

Obviously a report of this length covers many complicated issues. It is going to be ensnared in adversary politics. Nevertheless, it is very high quality. Together with the thoughtful Thomas dissent, the overall report provides us much considered insight and lessons for the future. It represents two different and not incompatible ways to understand the Crisis. In another time, these views could have been blended into one truly outstanding analysis, but such is the atmosphere in America today, even after the Arizona shootings, that we may be expecting too much to hope for unanimity. Indeed, juxtaposed as they are, the majority and dissenting views provide a case study in themselves on the perplexity of financial crises and how to think about them.

But first let me say a few words about the Wallison dissent.

Mr. Wallison believes that the Commission never seriously tried to understand the real cause of the crisis, that members of the commission were essentially railroaded by closed-door determinations as to what questions would be asked, which hearings to hold and who would be interviewed, and that the interviews were sometimes themselves held behind closed doors. He says that the question he has most frequently been asked is “why Congress bothered to authorize [the Commission] at all” because Congress went ahead anyway and enacted the Dodd-Frank Act without waiting for the report. In Mr. Wallison’s view the real cause of the crisis was the Clinton-Bush-promoted government housing policy from 1997 – 2007. The chief miscreants were the GSEs, Fannie Mae and Freddy Mac, the Community Reinvestment Act (CRA), and subprime lending “best practices.” In this climate, he argues, the GSEs and insured banks facing a CRA gun to their heads were “compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived.”

The Report debunks this tired old shibboleth by correctly noting that CRA requirements were minuscule in proportion to the scale of lending involved, and by noting the fact that private financial institution securitization in the area led to a far, far higher rate of default than that done by the GSEs (which was bad enough itself). Mr. Wallison asserts that “deregulation” in the form of the repeal of the Glass-Steagall Act in 1999 had nothing to do with the crisis. One cannot help but get the feeling that he does not fully appreciate how financial entities mutually interact and interconnect in many complex ways (this is one of the reasons sociologists call the industry “tightly coupled”). And to excuse reckless lending by suggesting that banks were under coercion, when most of the toxic lending was in fact originated not by banks but by financial entities that were not even subject to the constraints Mr. Wallison offers as the excuse, reflects a basic misunderstanding about how the CRA applies and is implemented by banks.

The Wallison dissent also says that AIG was the “only company known to have failed because of its CDS obligations . . . and that firm appears to have been an outlier.” Hence it rejects the claim that credit default swaps had anything to do with the crisis. The fact that AIG was the principal player in the field, that almost all, if not all, the major investment and commercial banks were dependent on AIG being able to honor its commitments, and that the government and taxpayers ultimately had to provide more than $180 billion in support for AIG in order to prevent all the others from failing, is totally lost on Mr. Wallison. Hints at the reason for Mr. Wallison’s almost obsessive focus on the Fannie/Freddy alleged cause of the crisis are to be found in a litany of complaints in the latter part of his dissent about being excluded from interviews, his friend’s American Enterprise Institute paper not being circulated by the Commission. and having only 8 days to read the draft report and decide whether to join it. (Has Mr. Wallison ever worked in a busy law firm or company? The Commission was mandated by Congress to get its work done by a deadline, and was not able to meet the deadline as it was.)

The Report itself and the main, Thomas dissent, however, are both worthy of careful study. Using multiple detailed, factual case studies, the Report works its way through the many factors that led up to the Crisis and it concludes that the Crisis could have been avoided were it not for clear human mistakes. Readers will be familiar with all of the suggested reasons for the Crisis, from the orgy of borrowing and lending to the fraud, self-dealing and denial on the part of many players in the industry. The Report correctly places blame on all of us: borrowers who were out of their depth, lenders who lacked discipline and sometimes honesty, corrupt and mismanaged GSEs (Fannie and Freddy), securitizers and distributors who had neither skin in the game nor any incentive to act in the long term interest of investors, shareholders and taxpayers, weak corporate governance, and a Congress and regulators who had the ability but not the fortitude to take preventive action. Paraphrasing Shakespeare, the Report declares that “the fault lies not in the stars, but in us.”

And so this must be with something as systemic as a financial crisis. It is naive to try to pin blame on any one group, though it is even more naive to try to argue, as does Mr. Wallison, that some of the principal players were somehow innocent or helpless victims! Of course our housing policy was based on unrealistic goals, and the GSE system is badly in need of reform. The Report acknowledges this by describing extensively why these policies have failed. But, as Simon Johnson has recently explained, trying to blame the poor for the crisis is simply absurd.

The Report also rightly notes that despite Dodd-Frank we have a lot left to fix:

Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions.

As Neil Barofsky, the TARP Special Inspector General, said yesterday in his testimony to the House Committee on Oversight and Government Reform (hat tip Jennifer Taub),

In other words, unless and until institutions currently viewed as “too big to fail” are either broken up so that they are no longer perceived to be a threat to the financial system, or a structure is put in place that gives adequate assurance to the market that they will be left to suffer the full consequences of their own recklessness, the prospect of more bailouts will continue to fuel more bad behavior with potentially disastrous results. Thus far, the Dodd-Frank Act appears not to have solved the perception problem.

Whether we have the fortitude to do so remains to be seen.

The Thomas dissent adds more interest to the overall publication. While chiding the main Report for focusing on some aspects that, in the dissenters view were only minor contributors to the crisis (e.g., CRA and the repeal of Glass-Steagall) or are simplistic diagnoses (e.g., “deregulation”), the dissenters ask a number of very valid questions as they try to isolate the “essential” causes (many of which concur with the views expressed in the Report). The dissent rightly notes widely differing conditions–political, institutional, cultural and regulatory–in Europe, where the financial institutions also wrought havoc. One might dispute that these differences were really significant in an increasingly “Americanizing” and tightly coupled world of finance. Nevertheless, it is important to continue exploring these questions. We still don’t have enough answers. The dissent accuses the majority of wanting to give

more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is.

The problem is that to understand systemic crises everything is important and it is very hard to isolate single causes. Even the list of ten “essential causes” enumerated by the Thomas dissent, none of which is disputed in the Report, is inadequate. One has to understand the dynamic story, and indeed the Thomas dissent itself resorts to the same approach when explaining the “Stages of the Crisis.” While not really explaining why a full dissent was necessary (what about a qualified concurrence?), the dissenters nevertheless make interesting and helpful distinctions between types of systemic risk (“contagion” and “common shock”–actually there are more), and they also rightly observe that, until the major financial plunge,

even larger past wealth losses did not bring the global financial system to its knees. The key differences in this case were leverage and risk concentration. Highly correlated housing risk was concentrated in large and highly leveraged institutions in the United States and much of Europe.


The Commission was charged only with investigating the causes of the Crisis, not coming up with policy solutions. We still have much work to do for the future.

Perhaps the Commission is unduly optimistic to make the general assumption that “this financial crisis was avoidable” (majority) and that we can “avoid the next financial crisis” (Wallison). As with oil drilling disasters, it is doubtful that we can ever completely avoid future problems. What we can do is substantially mitigate them and make them manageable. This means reducing potential shocks to the financial system by reducing the scale of the players that operate within it.

On this reform there is implicit and sometimes even explicit agreement among at least nine members of the Commission.

3 comments for “what caused the financial crisis? the fcic report

  1. Anonymous
    January 28, 2011 at 1:48 pm

    Anyone of any politics can have wisdom or insight. What you are supposed to do is read through people’s partisan flashes and forgive them. Here is the truth about the financial crisis. It only requires a little history and a basic understanding of what bank capital requirements and the securities laws were always intended to do:

    Fannie originated with FDR in 1938. It was a macroeconomic development plan to bring the U.S. back from the Depression. FNMA was well conceived, appropriate for the time, and insightful, but long term, it had some risks. Under FNMA, the government agreed to buy up, guarantee and then resell, banks’ loan books, in a process of government (and government-only!) securitization. This allowed banks, at a stressed moment in US history, to evade their bank capital requirements by offloading loans quickly, in a stream, without themselves having to fan out to find private buyers. It also allowed the banks over time to get large, fat and complacent, for now they had to endure few of the ordinary stresses of their own lending businesses. Without FNMA’s automated government assistance, banks normally would consist only of whatever loans they could make, limited by whatever they could resell on the private market. Had Fannie provided less support to the banks, more competing banks with new capital would have sprung up to serve whomever was left unserved by banks who were full up on loans given their available capital, and the U.S. would have had a much more diverse banking industry. But FNMA was still a brilliant and well thought out near-to-mid-term plan, from the point of view of the 30’s. Since there was a lot of room to spare to trust lots more people to make good on loans, coming from the extremely stringent standards of the 30s (Raghuram Rajan in Fault Lines notes that the typical mortgage was for 50% down, for no more than 5 years), FNMA could have been permanent, had it remained only a LIMITED government program. Which a government program inherently is.

    This is where Republicans in the 80s went wrong–they misconstrued the unleashing of Fannie’s debt securitizations as something all of Wall St. could just go off and do as “privatizing Fannie.” They also over-applauded “innovation” (just as left-liberals over-valorize “creativity”). Innovation only meant legislation got easily passed that left Wall Street free to securitize (i.e., computer aggregate, and sell to the public). Unnoticed, layers of buy-sell and caveat emptor by sophisticates were being collapsed. Wall St coopted Fannie’s mortgage securitization forms and processes, and replicated it, herdlike and at high computer speed. They were not innovators. They were copycats. Because these now FNMA-normalized mortgage bond packages looked no different under private management than Fannie’s, and Congress seemed to have approved it all, the public was set up as the sucker on all counts. Mortgage backed securities all looked as Good Housekeeping Seal of Approval approved by the U.S. government, as ever.

    It is one thing for one single government program to securitize legally. It is quite another for everyone to do so. It’s not that government programs are more competent or more honest than private markets. Quite the contrary. The key point is that, as a government program, it is inherently limited. If a program is then “privatized” and its unexamined processes engaged in by everyone under the sun, the potential harm is unlimited.

    The trouble began in 1968 when LBJ pulled an Enron on the nation, so as to get Fannie off the government’s books and into a special purpose entity (SPE), which superficially seemed to free up cash for his Vietnam and Great Society. This too would have been seen as “good” by conservatives thinking Fannie was being “privatized.” Really it was just another way of cooking government books and not inspecting what was really happening. Conservatives seeking budget cuts were being hoodwinked by LBJ.

    FNMA succeeded in helping banks get strong and furnish credit to US citizens who bought homes and built businesses. Perhaps the big banks FDR wanted to see all around him in the smoke-filled room, really were a better plan than the alternative, much more diverse, but also more fly by night, banks. In the 30s no one would have dreamed of departing from the known rules of lending to people who wanted cash while solemnly promising (while crossing their fingers behind them) to repay. Fannie bureaucratized its debt securitization process. Wall St.’s goal throughout was to get what Fannie had. Securities law exemption, plus perfect freedom to construct any black boxes they like, wholly unobserved, for unrestricted sale, to anyone. Plus a 100% government guarantee. Wall St. learned well how to manipulate the then trendy rhetoric of “innovation” and “free markets” to deceive Congress, as effectively as liberals like to write up bad laws because its rhetoric sounds good. FNMA could be safely exempt from securities law not because it was more honest than private actors. And not because it was more competent. FNMA could be exempt from securities law because as a government program it was originally intended to be LIMITED.

    Fannie later became a Washington fiefdom operated by bureaucrats who had forgotten, or perhaps never knew, what business Fannie was in either from the perspective of banking or securities sales. From their point of view, all it did was mint money after a lot of paperwork, that peons in the back room did, and which, after the 90s, was all plugged in to the computer, so that literally everyone could go slack. Paradise for bureaucrats. Also for rentseeking Wall Streeters.

    To securitize debt turns it into equity. This, as the securities law teaches us, is risky, if you do not know the individuals you are accepting the promise to repay from fairly intimately. Securitizations of debt needed to have been scrutinized as heavily as the securities laws say all securities have to be.

  2. January 30, 2011 at 8:48 am

    There clearly should be many changes implemented as far as the regulatory system is concerned and those who contributed directly to the downturn of the economy should be held responsible. By the way this really bears a striking resemblance to the development of the financial crisis in Greece where the EU officials failed to warn the international community despite the fact that they had information about the country’s rising debt as well as irresponsible government spending.

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