From the February 2009 issue of Research Magazine • Subscribe!

Sage Counseling

Peter Wallison warned about a government bailout -- nine years before Freddie and Fannie failed.

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Peter J. Wallison didn't need a crystal ball to foresee the train wreck that was approaching.

For years, the former White House counsel and general counsel to the U.S. Treasury in the 1980s had been focusing on deregulation of the financial markets -- paying particular attention to GSEs Fannie Mae and Freddie Mac.

By the late '90s, it became obvious to him that the rise of Fannie and Freddie would spell calamity for the U.S. financial system.

"It was a prescription for disaster, as I said in 1999. And by 2007, the deed was done. Here were two shareholder-owned institutions, seen as backed by the government that could raise as much money as they want and take as much risk as they want because nobody worries about it. And that, of course, is what happened," says Wallison, 67, now a scholar at the American Enterprise Institute for Public Policy Research.

He continues. "If you're going to create a government-backed program in which a private-sector organization is raising money to do something the government wants them to do, you're creating [a virtual] thrift industry. Even though the thrift industry failed, we were watching a new thrift industry grow right before our eyes. Fannie Mae and Freddie Mac were two gigantic S&Ls."

Thus, government's "destructive policies" are at the root of the housing crash, which led to bad loans, the credit crisis -- and finally to an unprecedented financial cataclysm, says Wallison, who, at the Treasury, worked on creating legislation that would eventually allow bank holding companies to enter other areas, like the securities business.

A Republican since age 14 working as a page in the House of Representatives, Wallison's current role, at conservative think tank AEI in Washington, D.C., is academic reformer on a variety of financial market issues. Mainly, he concentrates on deregulation of the securities and insurance industries; and he is perhaps the best known critic of Fannie and Freddie.

To the oft-posed question -- "Where were the regulators when this terrible chain of financial events was building?" -- he has this to say:

"Banks are the most heavily regulated institutions in our society -- and it was the banks that brought all this stuff on. When institutions are regulated -- especially banks, where deposits are seen as insured by the government -- there's a great deal of moral hazard. It's a mistake to think the regulators would have stopped this from happening...Regulators don't have any idea what they're looking for -- and it's a shameful thing."

Growing up in Queens, New York, the Brooklyn native was told regularly: "You should become a lawyer!"

"Guess I sounded like I knew what I was talking about!" he says, with a friendly chuckle.

Christopher DeMuth, AEI president from 1986 through December 2008, calls Wallison "a man of high principle who's not afraid to take on controversial issues. The work he did on Fannie Mae and Freddie Mac was very penetrating -- and, as we now know, all too prescient."

Wallison's way to clean up the whole financial-economic mess? Part I: "It's very distasteful to me, but getting out of where we are today requires government action. It has to take much more risk and take more of the bad assets onto its balance sheet, and refinance many mortgages," he says.

"Banks don't feel they've seen the bottom of the losses. And as long as they're worried, they're not going to loan. They'll hoard cash and tighten credit standards. Then organizations won't be able to get credit. They'll fail, lay off people, those people will default -- and on and on," says Wallison, who divides his time among D.C., Colorado and New York City.

Part 2 of his solution, Wallison finds even more unpalatable: "How the government will extract itself from what it's doing will be very, very difficult," he says. "There's the problem of preventing those who want to regulate more from winning the day. Democrats are in control, so the likelihood is they'll win the fight."

He began his dynamic career, Harvard law degree in hand, as special assistant to New York's Governor Nelson A. Rockefeller; when Rockefeller was elected vice president, Wallison became his counsel. After that, practicing law at Rogers & Wells, he specialized in the financial services industry.

In 1981, he moved up to General Counsel of the Treasury under President Ronald Reagan. An early task was overseeing a report about the Secret Service and the Reagan assassination attempt. Then he started to work, increasingly, on bank and securities regulatory issues. When Reagan was re-elected, he began as counsel to the President.

With an office in the West Wing, Wallison experienced Reagan as "an absolutely amazing man and very concerned about the dignity of people around him."

All went well for Wallison until the Iran Contra affair, when he was accused of trying to manipulate Reagan's testimony to the investigatory Tower Board. Ultimately, Wallison says, he was found to be "just doing [his] job."

But at the end of the Iran Contra matter, he was asked to leave his post. Chief of staff Donald Regan had been replaced by Howard Baker, and he'd brought in his own counsel. "It was horrific because at the time," Wallison says, "it looked as though I had somehow been involved in the Iran Contra thing."

He returned to practicing law, spending the next 13 years as a partner at Gibson, Dunn & Crutcher. In 1998, retired, he joined AEI as a research scholar.

The attorney's latest book is Competitive Equity: Better Ways to Organize Mutual Funds (AEI Press-2007). Due this spring: Better Parties, Better Candidates, Better Government (AEI Press).

Going forward, Wallison is calling for regulation via "market discipline." His proposal is for regulators to "create metrics and indicators, which would be published quarterly, so that people in the markets understand the risks. If we had more data available, we wouldn't have to rely on the regulators -- which, in my view, is a very thin reed."

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PHOTO BY KIM COOK

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