Douglas Holtz-Eakin was one of three members of the Financial Crisis Inquiry Commission who joined together to author a dissenting view from the majority report. He talked to Mortgage Banking about the work of the commission and some of its findings.
Mortgage Banking
March 2011
By Robert Stowe England
Douglas Holtz-Eakin is a member of the Financial Crisis Inquiry Commission (FCIC) and one of three who filed a jointly authored dissent to the majority report released on Jan. 27, 2011. Commission Vice Chairman Bill Thomas and commissioner Keith Hennessey were the other members who joined in this dissent.
The trio of dissenters identified the following causes of the crisis: a credit bubble, the housing bubble, nontraditional mortgages, credit ratings and securitizations, concentrated correlated risk at financial institutions, leverage and liquidity risk, contagion risk, a common shock, then financial shock and panic leading to a full-blown economic crisis.
An economist and policy guru, Holtz-Eakin is president of the American Action Forum, a conservative policy institute in Washington, D.C. During President George W. Bush’s first term, he was the chief economist for the president’s Council of Economic Advisers, where he helped formulate policies addressing the 2000-2001 recession and the aftermath of the terrorist attacks of Sept. 11, 2001.
Holtz-Eakin was director of the Congressional Budget Office (CBO) from 2003 to 2005, where he assisted Congress on the 2003 tax cuts, the Medicare prescription drug bill and Social Security reform. During 2007 and 2008, he was director of domestic and economic policy for Sen. John McCain’s (R-Arizona) presidential campaign. Following the 2008 election, Holtz-Eakin became president of DHE Consulting LLC, an economic and policy consulting firm based in Washington. He has held positions in several Washington-based think tanks as well.
Holtz-Eakin earned his undergraduate degree at Denison University and his doctorate at Princeton University. He began his professional career at Columbia University in 1985 and moved to Syracuse University from 1990 to 2001. At Syracuse, he served as chairman of the Department of Economics and was associate director of the Center for Policy Research.
(Mortgage Banking caught up with Holtz-Eakin just after the release of The Financial Crisis Inquiry Report.
Q: One fundamental finding of a majority on the commission was that if the Federal Reserve had banned certain mortgage products, we would not have had a financial crisis. What is your response to that?
A: When the housing bubble burst, as it would have inevitably, the traditional mortgages [also] fell apart. And we found the same concentration of housing risk on the same balance sheets at the same financial institutions with the same opacity. You can’t rule out that we wouldn’t have still had the same thing [with bans on some mortgage products]. So, I disagree.
Q: Could you explain your dissent from the majority report?
A: We tried to lay out very critically our disagreement in the following fashion. No. 1, we think that simple narratives might be appealing but are not [a] response to our charter, which was to identify the causes of the financial crisis. So, a simple narrative that says it was Wall Street greed left unregulated by Washington just doesn’t fit the facts, in our view. Neither does the view that it’s all urban housing policy.
We end up with more complicated narratives. We end up with our list of 10 things that we think were necessary to have the crisis. Our test was: If we didn’t have these things, would there have been a financial crisis? So, we came up with the 10. We come up with, in our view, a laundry list. So, that’s one level of disagreement.
Then there are some specifics. They [the majority] point heavily toward things like derivatives. There were derivatives certainly involved in the financial crisis. Outside of some credit default swaps and maybe some CDOs [collateralized debt obligations], the notion that derivatives caused the financial crisis is far too sweeping and incorrect. Pork-belly futures didn’t do a darn thing. [This explanation of the crisis] is not very precise.
The repeal of Glass-Steagall [which separated traditional banking from investment banking] had nothing to do with the financial crisis, in our view.
The U.S.-centric focus on [bank regulatory] supervision, we think, misses the point. We had the same housing bubble problem in Spain, and the Fed wasn’t in charge of their mortgage lending standards. We had the same government takeovers in the United Kingdom with the Northern Trust. The [U.K.’s Financial Services Authority provides] a very different supervisory regime than in the U.S. All of that suggests that deeper forces were at play than just the U.S. [mortgage] origination and safety-and-soundness regulatory regime. So, we do take issue with some of the particulars of their view of the universe.
Q: The majority report places a lot of blame on the Federal Reserve, former Fed Chairman Alan Greenspan and current Fed Chairman Ben Bernanke. What is wrong with this argument?
A: Well, No. 1: There are two things that are involved. One of them is monetary policy. The second is lending standards. And we talked to some extent about the monetary policy piece [in our dissent]. We acknowledge that that’s a big debate.
A: The majority didn’t think that monetary policy had much of an impact.
Q: I find that curious, but we think it contributed. We didn’t think it was the cause of the bubble alone. And then you have to ask the question: Suppose the Fed used its powers to cut off some of the nontraditional lending? OK. Some of those nontraditional borrowers could have gotten traditional mortgages and some of them would have. There was a housing bubble. They wanted to buy houses. They were counting on the same price appreciation. They might have put a little more money down. It might have slowed it some at the margin. But financing alone was not causing the bubble. They would have gotten a different sort of mortgage for some of them.
Perhaps some unknowable fraction would not have had mortgages, would not have bought houses. What would that have done? Well, probably it would have pricked the bubble sooner, because the demand would have dropped sooner. There would have been the same housing price declines. That means that everybody who up to that point had borrowed in hopes of flipping the house would have the same problems and those mortgages would go bad, and the securities built from those mortgages would go bad. Those would be what were traditionally perceived to be prime securities and triple-A-rated, maybe even GSE [government-sponsored enterprise] agency securities. They still would have gone bad.
We would have had the same difficulties because of the securitization process and understanding just what the exposures were at some of the banks. That would have raised some of the same counterparty concerns and same common shock concerns that we saw. I don’t think you can say we wouldn’t have had a financial crisis.
Q: The majority’s findings seem to assume that the regulators had all the authority in the world to do whatever they needed to do, and didn’t do it. And in the case of the Securities and Exchange Commission [SEC], at least, that just is clearly not true and probably not true in the case of the Fed and the banking regulators.
A: They have a [more-versus-less] view of regulation when, in fact, that’s quite naïve. I also think this suffers the same seat-of-[the-pants] hindsight that these things often do. If you are a regulator, and suppose you want to regulate the balance sheet of banks--you say they were carrying too much risk. They had too much leverage--[the two] are inter-related. I couldn’t seem to get them to understand that risk and leverage are not distinct categories.
But put that aside. There was an active discussion in 2005 and 2006 about whether we were really in a bubble and were housing prices unsustainable. It wasn’t that people were unaware; there was not a clear view. The notion that regulators in that moment would have said, “We understand better [than you what’s coming in] the future. Those [assets] are riskier than you believe. You can’t hold as many of them as you think. And we’re going to impose these standards on you”--that presumes a foresight on the part of regulators that’s just unbelievable to me.
Q: What if the Feds made that decision and got it wrong?
A: [Laughs] Yes. It’s a very naïve view of the way the supervisory process would work. Again, we disagree.
Q: Did the Securities and Exchange Commission really have the authority to make the investment banks raise capital or lower their leverage?
A: They would have been hard pressed. You know that. They did not have a strong safety-and-soundness regime in the investment banks. They just didn’t. Here’s the other thing that’s a problem. Suppose they had said, “Well, we’re going to do something [about this].” On paper, the investment banks were in compliance with something tougher than the Basel [capital] standards. How are you going to make the case that it’s got to be even tougher yet, when the investment banks are satisfying international standards that are less stringent? That’s tough to do.
Q: And curiously and ironically, perhaps, U.S. investment banks in 2004 voluntarily adopted a new international capital standard when pressed by the European Commission.
A: [The investment banks] needed a consolidated supervisor, and they went to the SEC and said, “Please do it.”
Q: And they voluntarily adopted a capital regime that was weaker than what the individual investment banks were following on their own?
A: Yep. There’s a second point that I at least think merits reflection for anyone who thinks this is all about capital regulation. Perhaps they could have done [better] supervision of Bear Stearns or a Lehman [Brothers] or some of the weaker investment banks. But, put that aside. In a panic, when we get to 2008, you have a well-capitalized, well-run [investment bank like] Goldman Sachs. They have good risk-management regimes. [Yet,] they are in trouble.
It is the nature of the financial entity that, in a panic, the mismatch between the duration of their assets and liabilities shows up and their intermediation at risk shows up. In a panic, when people want liquidity and people don’t want to take risks, your assets go to zero in value. You’re in trouble no matter what. There’s nothing about a capital standard that is going to save you in a panic. So, once we get to the panic, it’s over. The only capital standard that will save you is 100 percent capital. So, forget it.
Q: And no one has 100 percent capital to back assets.
A: And that’s what I think is so wrong with the [view that relies] heavily on [an approach that says] it’s the regulator’s fault. No matter what I think of the consolidated supervisory regime out of the SEC, once the panic hits, it doesn’t matter.
Q: Of course, the SEC abandoned that regime because it proved to be worthless.
A: And because there weren’t any investment banks anymore.
Q: Right, they’re gone. On another point, Congress set up this commission. There was no criticism of Congress coming out of the commission’s report. One thing Congress never seemed to consider is that as a result of Glass-Steagall, you have investment banks without really a strong prudential regulator and you had the commercial banks that did have the strong prudential regulators. This was a hole in prudential regulation that no one in Congress seemed to notice. Wasn’t that something Congress missed in its oversight?
A: Yes, there’s no question. Congress did this; [that is, Congress, when it passed the Glass-Steagall Act of 1933, separating investment banking from commercial banking, they left investment banks without a strong prudential regulator, while subsequent Congresses have not addressed this hole in regulation].There’s no doubt about it.
Q: Given that the credit bubble is the first of your 10 causes of the financial crisis, it would appear you’re saying the credit bubble caused the housing bubble.
A: They are closely related is a better way of saying it.
Q: What forces do you see causing the credit bubble? Part of it, I guess, is the so-called savings glut in some nations created by the imbalance in the global financial system.
A: We place that as the primary force behind it. This is the Bernanke global savings glut.
Q: Didn’t Alan Greenspan also talk about the conundrum about how long-term interest rates remained low from the global savings glut even when short-term rates were raised?
A: We’re open to the notion that Fed policy contributed. We view that debate as essentially unresolved. There are some, like [professor of economics] John Taylor [at Stanford University], who feel strongly it was the Fed and only the Fed. That debate will get solved somewhere in the future.
Q: Or it will be debated forever. Did you consider the impact of all the policies in the United States to promote homeownership, as well as other incentives, including capital standards encouraging mortgage lending and securitization? Did this contribute to the bubble?
A: We certainly, I think, simply concluded that government policy was part of the issue. But we don’t think it’s the only thing. There are some of the things that people point to, like the Community Reinvestment Act [CRA] but we just don’t think the timing fits. The mortgage infrastructure had been there a long time.
So, there’s lot of policies that supported housing. There’s no question about that. As a nation, we’ve pushed people toward houses for a long time. But someone raised the question: Why now did we get the bubble? We didn’t change the mortgage infrastructure. We didn’t change the Community Reinvestment Act. We did change the affordable-housing goals. We think that contributed.
Q: By the time the 2000s came around, the affordable-housing goals were so high, they were a 50 percent in 2000, rising to 56 percent in the years running up to the crisis. Given the size of Fannie and Freddie, you would think there would be lots of loans and lots of risky lending. Plus, they were the largest purchasers of private-label mortgage-backed securities [MBS] at the same time. So, all of this was pouring money into the housing market.
A: We’re not disagreeing with that. But still there are some questions about timing on how aggressively Fannie [Mae] and Freddie [Mac] moved into the purchase of [private mortgage-backed securities], whether they led Wall Street or essentially followed it.
[Commission members] Heather Murren and Peter Wallison went back and forth at length on this in the commission. I don’t think Peter made a compelling case that it was Fannie and Freddie driven by the affordable-housing goals exclusively that really pushed the big purchase on nontraditional mortgages.
We said very clearly in our dissent that we think there was this involvement [by Fannie and Freddie] in nontraditional mortgages. We’re just not willing to accept the notion that it was exclusively Fannie and Freddie and government policy.
Q: Did you look into the financial innovation known as the collateralized debt obligation of asset-backed securities [ABS]? Did this fuel more money into the market? Apparently American institutional investors were no longer interested in purchasing the mezzanine tranches of mortgage-backed securities somewhere around 2003. This was when the triple B mezzanine tranches were being incorporated into triple A collateralized debt obligations (CDOs) of ABS. These CDOs were mostly sold to overseas buyers. Suddenly, when we should have seen a market correction, the CDOs of ABS became an engine of funds flowing toward the U.S. mortgage market.
A: We looked at various kinds of securitization. I think there are some members of the commission who would be close to that view. But I leave you with the notion that in the end, the housing bubble is a real bubble. It is the purchase of physical assets at higher prices. And the nature of the financing that went into it did not drive the bubble exclusively. I think it extended it a little bit. I’m willing to accept that.
Q: Fannie and Freddie, when they went through their accounting scandals, they pulled back because the regulators were worried about their systemic risk. Yet, Congress refused to pass GSE reform at that time. It was not until late July 2008 that a reform package got through both houses and made it into the law. If GSE reform had passed in 2005, just after the accounting scandals, would that have ameliorated the credit bubble?
A: Who knows? Maybe. If international lenders believed that U.S. housing was a safe asset at those yields, which channel they went through to get them probably doesn’t matter that much.
Q: The other argument is that if Fannie and Freddie had pulled back from buying private-label MBS, the private-label market would have corrected. They were buying hundreds of billions of dollars of private-label.
A: But they were also selling hundreds of billions of dollars of agency debt to China and European investors. So, they were a conduit [of funds going into the housing sector]. So, in answer to your question, we’ll never know. The question is this: Would restricting one conduit dramatically change that evolution?
Q: So, that will be one of those other questions that may be forever debated.
A: I suspect it will be. When the accounting scandals hit, I testified about the risk posed by Fannie and Freddie. In my view, there is certainly no question that had we rolled back the taxpayer-backed hedge fund [represented by Fannie’s and Freddie’s investment portfolios], the taxpayers would have been better protected.
[There are other questions that we need to answer, too.] How important were some of these moments of psychology in generating the panic you saw in 2008? It certainly, for me, [added to the psychology that promoted panic when former Treasury Secretary] Hank Paulson said I want a bazooka [with new authority for the government to take over Fannie and Freddie and inject capital but] I’m never going to use it. And then, [the fact that he] turned around and pulled the trigger on the very bazooka such a short time later was just shocking. If we never had that happen, how would the world look? Who knows?
Q: What would have happened if he had not used the bazooka?
A: Look, [Fannie and Freddie] were going down. He would have to put them into conservatorship or do something else. They were going down.
Q: They would have gone down, but without the legal authority for the Treasury to put funds into them.
A: We would have invented some authority, believe me.
Q: The six who voted for the majority seem to place a lot of store in the decision not to rescue Lehman, that the regulators could have done it. Yet, the text of the report and other information in books published on the crisis reveal that all the regulators seemed to be doing everything they could in the few months ahead of the crisis. Is it your view that the Federal Reserve and Treasury and the SEC had no other choice but to let Lehman go?
A: My reading of what Mr. Bernanke said when he testified is that it sounded like, in the end, they could have done more, but his judgment and the judgment of those doing the negotiations is that it wouldn’t have changed the outcome, that there was no buyer, that they could have plowed more money into Lehman, but Lehman would have failed anyway. So, all they were going to be doing was throwing good money after bad, and so they didn’t. That was my reading of what he said.
Q: If you look at the details of the negotiations with Barclays Capital (Q: Capital???)(yes re), you will recall that the Financial Services Authority in Britain did not want Barclays assuming liabilities for Lehman’s trades between the time a deal was made and the time the board of directors would vote on the acquisition.
A: And that was going to be a long time.
Q: Yes, it could be 30 to 60 days. And the Fed did not have authority to guarantee the Lehman trades. No one had the authority to do that. So, it was beyond the question of whether the Fed could lend to an entity to buy the bad assets of Lehman’s. This was another hole in regulations that made it difficult for them to act.
A: Right.
Q: So, basically, you do not believe that something could have been done by the regulators to save Lehman?
A: I don’t believe that there was something very easy that could be done that they just didn’t do.
Q: In your dissenting statement to the majority’s report, did you list the 10 points in order of their priority in terms of causing the crisis, from the credit bubble to financial shock?
A: No. They are listed in sort of a loose chronology of how it evolved. None tended to be big or smaller.
Q: But the credit bubble seems to be fundamental to the whole story.
A: You have to build the bubble that builds and breaks to trigger this thing, or you don’t have the trigger. In order to explain this crisis, you have to start there [with a credit bubble].
Q: Where in all that is leverage?
A: I put that under the bucket [of] risk-management practices at these large financial institutions--and leverage is part of your risk. On both capital risk and liquidity risk, there were some stunningly weak performances. I think I will probably never forget the AIG guys not even knowing what their contracts were. So, put the leverage in that bucket.
The AIG guys--their chief financial officer, who was their liquidity risk manager--did not know the contractual obligations they were going to have. And that was just stunning. And the CEO thought he did a great job.
Q: The other interesting thing is that the securitization was supposed to distribute risk but, in practice, it concentrated risk. How high on the list of your 10 reasons is that?
A: Again, the federal regulators failed to investigate the concentration of risk on the balance sheets of very large institutions.
Q: Was the loss of confidence in the investment banking business model due to risk-taking by the Wall Street firms or the failure to adequately regulate them?
A: I think it was that, in a crisis, we went through the issue of both common shock--a lot of common exposure to housing risk--and the notion of contagion--[that] very similar business models are in trouble. You don’t trust that business. I think that’s the primary mechanism that caused them to go down. MB
bio: Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at
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