Last week, the Financial Crisis Inquiry Commission — formed to investigate the 2008 market panic — began its work. Naturally, the first thing it did was haul in four Wall Street grandees, who obligingly apologized for their sins.
The episode neatly fit the now-embedded narrative that the crisis was all about Wall Street. But this is like going into a dark room after a fire and refusing to shine a light in more than one corner.
That corner may be a wreck, but the seeds of this catastrophe were sown by government, not by Wall Street.
A recent article by Peter Wallison, a Treasury official in the Reagan administration, makes the point especially clear. In fact, government culpability was even greater than previously known.
Writing in The Wall Street Journal, Wallison revealed that Edward Pinto, former Fannie Mae credit manager, discovered that both Fannie and its sister entity, Freddie Mac, routinely exaggerated the quality of the mortgages they were buying.
As early as 1993, the two government-sponsored enterprises began buying up mortgages with subprime and Alt-A characteristics and reporting them as "prime." This was no doubt in response to government affordable housing rules, which created pressure to push mortgage credit farther down the income scale.
In any case, Fan and Fred's misreporting distorted the perception of everyone who bought and sold securities backed by these mortgages. As the housing sector careered toward its inevitable crash, no one knew the extent to which bad loans had poisoned the financial system.
Fannie and Freddie, then implicitly backed by the government — now the backing is explicit — were huge players in this market. Wallison notes that in 2008, there were 26 million subprime or Alt-A mortgages outstanding. Ten million were held or guaranteed by Fan and Fred, 5.2 million by other government entities, and 1.4 million by the top four U.S. banks.
An additional 7.7 million subprime and Alt-A loans were pooled by Wall Street to support mortgage-backed bonds. Despite the low quality and high risk of the underlying loans, most of those bonds were rated AAA, marking them as safe investments.
How could that happen? Wallison points out the statistical models used by the rating agencies assumed that losses from subprime and Alt-A loans would be "within the historical range for the number of high-risk loans known to be outstanding."
But thanks to the misrepresentations by Fannie and Freddie, the number of high-risk loans outstanding was much larger than anyone knew. Eventually, default rates and losses exploded. Fannie and Freddie's subterfuge, says Wallison, was a principal cause of the meltdown.
Wallison is now in a position to pursue the issue further: He's a member of the 10-person financial crisis panel, which will spend the next year studying the panic and diagnosing its causes.
Wallison's article suggests some fruitful lines of questioning.
Was there criminal culpability in what Fannie and Freddie did? Was it fraud, or something worse?
Why didn’t the rating agencies catch the problem?
The rating agencies — companies that supposedly tell people whether bonds are investment grade or risky — are already viewed, rightly, as a major contributor to the meltdown. They picked through stinky piles of subprime paper and stamped it AAA.
Financial consultant and banking analyst Bert Ely suggests the fraud, er, misrepresentation, by Fan and Fred doesn't absolve the agencies, since they have access to non-public information.
"What did they not know that they should have known?" Ely said. "Maybe they just relied on Fannie and Freddie and didn't dig in."
The Wallison article also puts a different light on a recent move by Treasury, which lifted a $400 billion limit on how much taxpayers will have to shovel into Fan and Fred because of all their bad mortgages. With the cap removed, Treasury is admitting that the taxpayers' liability is much higher than once believed.
At the top of the to-do list for the financial crisis commission should be finding out who was responsible for lying to the public about the mortgages bought by Fan and Fred, using money backed up by taxpayers.