BOOK REVIEW: Bad History, Worse Policy: How a False Narrative about the Financial Crisis Led to the Dodd-Frank Act

Author: Peter J. Wallison, March 2013

The American Enterprise Institute

Peter J. Wallison is a prolific writer and a lucid thinker on matters involving banking, insurance, and government regulation. In his latest work, Bad History, Worse Policy: How a False Narrative about the Financial Crisis Led to the Dodd-Frank Act, Wallison begins with a careful and persuasive analysis of the financial crisis of 2007/08 and its causes. He then reviews the provisions of the partially-implemented Dodd-Frank Act and the reasons this massive Act must be reformed, if not eliminated. This compilation of 30 essays, written between 2004 and 2012, is a must-read book for anyone interested in a thoughtful analysis of the causes of the financial crisis and the flawed legislation that has arisen from it.

Wallison notes that it is extremely difficult to change a “narrative” once it has become widely established, and this is the case with regard to the financial crisis.

Like the narrative for the Great Depression … the financial crisis narrative was simple and wrong. In this telling, the crisis was caused by irresponsible private-sector risk-taking, greed on Wall Street, and predatory lending by unscrupulous and unregulated mortgage originators. To this, during the 2008 presidential debates, then-candidate Obama added “Republican deregulation….”

Recently, this narrative has been subject to growing criticism from scholars and other analysts. Bad History, Worse Policy is probably the most recent and comprehensive challenge.

Wallison writes with a clear and convincing style – almost like a trial lawyer methodically laying out his case.  The author pokes several holes in the conventional wisdom regarding the causes of the financial crisis, noting:

There was little deregulation preceding the crisis, and it had minimal impact on it.
The rescue of Bear Stearns was unnecessary and even unhelpful because it led the market to expect a rescue of Lehman Brothers.
The collapse of Lehman Brothers was not the cause of the market chaos that ensued. That was caused by a “common shock,” experienced simultaneously.
The role of derivatives – specifically credit default swaps (CDSs) – was minor.  The total amount of CDSs in the market was wildly exaggerated, and the CDS was “far from being a dangerous instrument.”
Mortgage originators can’t create deficient loans unless they have willing buyers. Those buyers were, to a large extent, government agencies or banks pressured to purchase by government regulations.

What caused the financial crisis in the view of Wallison? “[I]n pursuit of a social policy to increase homeownership, the U.S. government became a willing buyer of an unprecedented number of subprime and other high-risk mortgages. This created a housing bubble of unprecedented size and duration….” The foundation for this huge bubble comprised millions of weak, subprime loans that were enmeshed within securities held by banks throughout the world. When financial institutions suddenly realized the magnitude of the subprime foundation underlying their investments, a “common shock” brought them to their knees.

The financial crisis and its causes consume the first 325 pages of Bad History, Worse Policy. The rest of this 580-page book is devoted to the Dodd-Frank Act and the need to reform it. In Wallison’s view Dodd-Frank is deeply flawed because it was predicated on the false narrative that is outlined in the first part of the book.

In particular, Wallison takes aim at Dodd-Frank’s Consumer Financial Protection Bureau, noting that its broad reach could impact “every firm of whatever size that had financial dealing with consumers – from check cashers to retailers….” He is troubled by the notion that the Bureau could deny complex financial products to certain people, even if those products are otherwise beneficial.

In the view of Wallison, Dodd-Frank is problematic in several other ways:

The designation of certain entities as “systemically important financial institutions” may be interpreted by the market as “too big to fail,” and may give such entities an “aura of government concern….” In addition, asks Wallison, how do we determine in advance that a firm is systemically important?
Dodd-Frank’s “Volker rule” prohibits banks from trading assets for their own account rather than as a service to their customers. This, Wallison fears, will lead banks to concentrate investments too heavily in real estate financing.
The Dodd-Frank legislation contains other elements that will impede banks in securitizing mortgage loans. These impediments include a 5 percent risk-retention provision, complex “qualified mortgage” provisions, and new conflict-of-interest provisions.

In a single review there is far too much content to mention. This highly-recommended book is well-suited for scholars and advanced students in the field of economics, law, and political science. In addition, it should be required reading for every member of the United States Congress.