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How Government Failure Caused the Great Recession
...Bank misregulation, in particular the international Basel capital rules, including a U.S. adaptation to them—the 2001 Recourse Rule—and the outsourcing of risk assessment by regulators to government-sanctioned rating agencies incentivized (not merely “allowed”) the creation and highly-leveraged systemic accumulation of the highest yielding AAA- and AA-rated securities among banks globally. ...

...Continually increasing leverage—driven largely by Fannie Mae and Freddie Mac credit policies and the political obsession with taking credit for increased homeownership—into the U.S. mortgage system. Reduced down payments and loosened underwriting standards were a matter of government policy throughout the housing boom. The two nearby charts illustrate the leverage trends from 2001 to 2007—residential mortgage debt as a share of GDP rose from less than 50 percent in 2001 to almost 75 percent by 2007 (top chart); and the percent of residential real estate sales volume with loan-to-value ratios of 97 percent or higher (down payments of 3 percent or less) increased from about 10 percent in 2001 to almost 40 percent by 2007 (bottom chart). Taken together, these graphs show that housing leverage was increasing to historically unprecedented levels by 2007 at the same time that the quality of housing debt was deteriorating considerably due to an erosion of sound underwriting standards and lower down payments, as discussed above....

...The enlargement of the riskier subprime and Alt-A mortgage markets by Fannie and Freddie through the abandonment of proven credit standards (e.g., dropping proof of income requirements) during the 2004-2007 period, and their combined accumulation of a $1.6 trillion portfolio of these loans to meet the affordable housing goals Congress mandated....

...The FDIC, Federal Reserve, Treasury Department, and Congress undertook explicit or implicit creditor bailouts for large financial institutions starting in the 1980s (First Pennsylvania, Continental Illinois, the thrift industry, the Farm Credit System, etc.) and continuing to 2008 (Bear Stearns). These regulatory decisions led to an absence of creditor discipline of financial institution leverage and risk-taking (especially at Fannie and Freddie) and the “too big to fail” expectation of a government bailout....

...The increase in FDIC deposit insurance from $40,000 to $100,000 per account in 1980 combined with the unchecked expansion of coverage up to $50 million under the Certificate of Deposit Account Registry Service beginning in 2003. These regulatory errors of commission and omission reduced the incentives of business, institutional, and high net-worth depositors to monitor and discipline excessive bank leverage and risk-taking....

...Artificially low and sometimes negative real federal funds rates from 2001 to 2005—a result of expansionary Fed monetary policy—fueled the subprime and Alt-A mortgage boom and widened the asset-liability maturity gap for banks (see chart below). Most subprime and Alt-A mortgages carried low initial rates made possible by low federal funds rates, which spurred borrower demand for these mortgages. ...