The 5 Myths Within Allan Sloan's Myth About the Crisis

On June 13, Fortune published an article by Allan Sloan entitled The 5 Myths of the Great Financial Meltdown. Much of what Sloan had to say made sense, especially his comments about the Volcker Rule and the taxpayers' continuing liability for decisions to bail out failing financial institutions. But in his Myth No. 5, copied below, Sloan went off the rails, arguing that we should abandon efforts to find out what caused the financial crisis. That doesn't make much sense if we are to avoid another one, especially when the conventional view of what caused the financial crisis has saddled the financial system with the Dodd-Frank Act and the painfully slow economic growth it has caused. In reality, there were five myths embedded in Sloan's Myth No. 5.

Sloan's Myth No. 5: It's the government's fault.

Yes, there were plenty of reckless and immoral borrowers taking out mortgages they knew (or should have known) they couldn't afford. And yes, you can make a case that the federal government's zeal to increase homeownership levels was partly responsible for lowering lending standards. But the idea that the government is primarily to blame for this whole mess is delusional. It was the private market -- not government programs -- that made, packaged, and sold most of these wretched loans without regard to their quality. The packaging, combined with credit default swaps and other esoteric derivatives, spread the contagion throughout the world. That's why what initially seemed to be a large but containable U.S. mortgage problem touched off a worldwide financial crisis.

We've had more than enough shrieking and demonizing since this mess erupted in 2007. It's time that we stopped trying to blame "the other" -- be it poor people or rich people or Wall Street or community organizers -- for the problems that almost sank the world financial system.

It's time -- after five years, it's well past time -- for us to stop pointing fingers at one another, and to fix the excesses that almost sank us. The market sure didn't work very well. The government regulation solutions, like the Volcker Rule and Dodd-Frank "resolution rules," aren't going to work very well. We need common sense, like the Hoenig Rule, and markets (as opposed to a zillion regulators) that can enforce discipline on institutions that will not be too big to be allowed to fail.

Those, my friends, are the lessons of the past five years. Let's hope that at some point we'll finally learn them.

Five Myths in Myth No. 5

Myth No. 1. It is delusional to believe that the government was primarily to blame for the financial crisis.

Such a delusion is possible only if you are unwilling to look at the actual numbers. By 2008, there were 28 million subprime or other nonprime loans in the U.S. financial system. This amounted to half of all mortgages. Of this 28 million, 74 percent were on the books of Fannie Mae, Freddie Mac, FHA and other government agencies or government regulated entities. This shows where the demand for these mortgages actually came from. It would be worthwhile to look at the data before calling something a delusion.

Myth No. 2. It was the private market -- not government programs -- that made, packaged, and sold most of these wretched loans without regard to their quality.

Since government agencies and others regulated by the government held 74 percent of the subprime and other nonprime loans that caused the mortgage meltdown, the private sector was responsible for 26 percent. Mr. Sloan blames this 26 percent for the financial crisis. That's what sounds delusional.

Myth No. 3. The packaging of subprime loans by the private sector, combined with credit default swaps and other esoteric derivatives, spread the contagion throughout the world.

There is very little evidence that credit default swaps and other esoteric derivatives had any significant role in the financial crisis. Only one firm, AIG, was driven into insolvency by participating in the credit default swap market, and that's because a subsidiary made the classic mistake of failing to hedge its risks. It's certainly true that the private sector packaged subprime loans, but the largest buyers were Fannie and Freddie.

Myth No. 4. It's time -- after five years, it's well past time -- for us to stop pointing fingers at one another, and to fix the excesses that almost sank us.

It should be obvious that we can't fix the "excesses" unless we establish what they were. As long as people seem to think it's delusional to blame the government, we will not get to the root of the problem. As with the Dodd-Frank Act, we'll adopt policies that completely miss the point by imposing additional costs and regulations on the private financial system without fixing the housing policies that actually caused the mess.

Myth No. 5. We need common sense, like the Hoenig Rule, and markets (as opposed to a zillion regulators) that can enforce discipline on institutions that will not be too big to be allowed to fail.

The Hoenig plan, as Sloan describes it, would break up banks by function rather than by size. That sounds like an interesting idea, but the problem with the big banks is their size, not their activities. Because of their size, the regulators think that they are too big to bail, and if it looks like one or more of them will fail there will be efforts to bail out the creditors so as not to create disruption in the economy. This means they look less risky to creditors, and as a result they have substantially lower funding costs than their smaller competitors. The competitive advantages this creates is the problem with large banks, not the particular functions they perform. We are not going to solve the too-big-to-fail problem until the regulators themselves stop acting to prevent big bank failures.