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What Went Wrong
...What caused the economic disaster that we are now facing? While there are a number of factors, the core of the disaster was the expansion of the subprime mortgage market. Lenders, left to their own devices, tend not to make highly risky loans. These highly risky loans are called subprime mortgages (because the borrowers are below what the lender considers optimum credit rating). These loans are to people with poor or no credit history, or who cannot document their earnings (you know, like with paycheck stubs or statements from their business's accountant).

In 1977, something called the Community Reinvestment Act was passed by Congress to deal with the claim of "redlining"--that lenders were reluctant to lend money in minority neighborhoods. It wasn't that the lenders were racists; they looked at the value of homes in the poorest neighborhoods and were reluctant to take risks. The CRA, however, had little in the way of teeth.

In 1992, the Federal Reserve Bank of Boston released a study that claimed that there was lending discrimination against blacks going on, because they compared lending rates for whites and blacks with equivalent incomes, and found that blacks were less likely to get loans. But other economists have since pointed out that whites and blacks with equivalent incomes have very different net worths. Whites with the same income tend to have much higher net worth than blacks at that level.

Throughout the 1990s, ACORN pressured banks throughout the Chicago area to get more lending to subprime borrowers....

...The Clinton Administration's efforts to expand lending to blacks and Hispanics, while well intentioned, required more subprime mortgage lending. The most effective way to do this was to change Fannie Mae and Freddie Mac's underwriting rules...

...These two GSEs (government sponsored enterprises), because they buy a big chunk of privately originated mortgages, are in a position to substantially change the risk equation. If Bank of America knows that a $720,000 mortgage to a guy making $14,000 a year is so risky that Fannie Mae isn't going to buy this mortgage, then they have to carry the risk on this paper--and they won't do very many such mortgages. If they know that Fannie Mae likely will buy it, why not? They make some money on the loan origination, they earn interest as long as they carry the paper--and then they can sell it to Fannie Mae. And the change in underwriting rules did change the equation--dramatically....

...What happens when you dramatically expand the number of people buying homes? It drives up prices. What happens prices of houses start rising? Why, people start speculating--and not millionaires who can afford to make six mortgages while a house sits vacant, but people who were told that they could buy a house, wait three months, and resell it for $40,000 more. Some did, at the start of this tulip bulb mania. And those at the end discovered what happens when the boom slows even a little--you end up a with a house you paid too much for, and that you can't sell for what you paid, and you can't rent it for enough to cover the mortgage.

The separation of loan origination from long-term loan servicing created an incentive to make a lot of loans--then sell them to someone else while the potato was still hot. Golden West S&L, for example, was sold by Herbert and Marion Sandler to Wachovia for $24.2 billion just as the bubble was hitting its peak. (The details are in this May 9, 2006 San Francisco Chronicle article.) They then took their $2.4 billion that they personal received, and used it to fund Democratic activities....

...Third warning: a November 11, 2003 Wall Street Journal editorial about the housing finance market. White House chief economist N. Gregory Mankiw argued for stronger regulation of Fannie Mae, because of the risks to taxpayers. And who argued against? “Congressman Barney Frank criticized Mr. Mankiw because he is worried about the tiny little matter of safety and soundness rather than ‘concern about housing.’ But as Mr. Mankiw pointed out, most of the federal subsidy for the companies goes to enrich private investors and executives, not poor home-owners.”

The following sentence from that 2003 editorial is especially prescient: “One weakness of democracy is that it tends to ignore problems before they erupt into crises. The risk portfolios of Fannie Mae and Freddie Mac are a classic example.”...