Today, the Financial Crisis Inquiry Commission continues its fourth round of hearings on the origins of the recession, with the current and former Treasury secretaries, Timothy Geithner and Henry Paulson, speaking on the shadow banking system — comprising financial companies like Goldman Sachs that are technically not banks because they do not take deposits.
In his prepared testimony, Paulson cites governmental homeownership policy as the underlying reason for the housing bubble and ensuing credit crunch:
Underlying the crisis was the housing bubble, and it is clear that several policy decisions shaped the home mortgage market. Excesses in that market eventually led to a significant decline in home prices and a surge of loan defaults which caused tremendous losses in the financial system, triggered a contraction of credit, and put many Americans — quite literally — out on the street. These excesses were driven in large part by housing policy. From 1994 to 2006, home ownership soared from an already spectacular 64 percent of U.S. households to a staggering 69 percent due to the combined weight of a number of government policies and programs. Fannie Mae and Freddie Mac, the government sponsored enterprises (GSEs) comprised a central part of U.S. housing policy. The GSEs operated under an inherently flawed model of private profit backed by public support, which encouraged risky revenue seeking and ultimately led to significant taxpayer losses.
The United States has always encouraged home ownership, and rightly so. Home ownership builds wealth, stabilizes neighborhoods, creates jobs, and promotes economic growth. But it must be pursued responsibly. The right person must be matched to the right house (and consequently the right home loan), and in the years before the crisis we lost that discipline. The overstimulation of the housing market caused by government policy was exacerbated by other problems in that market.
Geithner, in his prepared remarks, instead focuses on regulation:
Nearly eight decades ago, after a series of banking crises led to the Great Depression, the United States put in place broad protections over the financial system. These reforms — deposit insurance, prudential rules to limit risk-taking by banks, and improved transparency and investor protection in our securities markets — alongside the Federal Reserve’s role as lender of last resort, laid the foundation for a more stable banking industry for several decades.
Over time, however, the financial system outgrew those protections. A large parallel financial system emerged outside of the framework of protections established for traditional banks. A great diversity of financial institutions emerged to provide banking services to individuals and companies, and they were allowed to operate without being subject to the same constraints applied to traditional banks. The shift in mortgage lending away from banks, the growth of the relative importance of non bank financial institutions, the increase in the size of investment banks, and the emergence of a range of specialized financing vehicles are all manifestations of this phenomenon.
Of the two, I think Paulson’s are the more interesting comments. Realistically, I fear there is only so much that the government can do in regulatory terms to stop Wall Street from blowing bubbles in the pursuit of profit — in that Washington can do nothing to shut down Wall Street’s trillion-dollar motive to seek outsize returns. But the Hill can turn off the tap of money and credit at the source of those outsize returns. Rising homeownership combined with and stoked by cheap credit not only put millions of people in homes, but created millions of new funding and securitization streams for Wall Street. If getting rid of Fannie and Freddie removes the government subsidy to that pipeline, in a way, housing market reform could be a bigger deal for the banks than the Dodd bill.