During the same time-frame, the financial industry was creating sophisticated new securities with risk properties that no one understood! Supposedly, the innovations would compensate for the absurdity of the loans being made. Financial innovations always lead to the same boom/bust scenario, and we were not disappointed this time. The last time this happened was in the 1980s when "junk bonds" were introduced. The scenario was the same, the market grossly under-estimated the real risks associated with the new securities, and the market tanked. Once the real risks were revealed, the market began to function normally. This is precisely what happened with junk bonds, and it is eventually what will happen with subprime loans.
Government sponsored enterprises
The confluence of these events was further aggravated by the unique character of Fannie Mae and Freddie Mac. They are government sponsored enterprises (GSE), neither private nor public institutions. They are supposed to provide liquidity in the mortgage market by buying mortgages from lenders, packaging those loans and reselling them as mortgage-backed securities (MBS). They use the proceeds from selling the MBS to buy the mortgages from lenders, which puts new money to loan for more mortgages back in the lender's hands.
Freddie and Fannie were enthusiastic supporters of the housing bubble, and they were exempt (can you believe this?) from the capital requirements that governed private banks. Since they are GSEs, the market implicitly assumed they were guaranteed by the federal government. There were no legal guarantees, but in the end they were de facto guaranteed by the government's takeover. The exemption from capital requirements and the assumption of federal guarantees encouraged Fannie and Freddie to take preposterous risks.
When outsiders noticed the precarious situation in Freddie and Fannie in 2004/2005, the Bush administration refused to act and Congress actively stopped every attempt to regulate Freddie and Fannie, even after Franklin Raines (one of Obama's economic advisors) was fired, and then regulators brought civil charges that he and two others manipulated Fannie's books to increase their bonuses. The three received $115 million in bonus payments. Why did Congress stop the reform? Because Freddie and Fannie made huge campaign donations to Congress, and they were created by Congress. If Freddie and Fannie had been purely private institutions, Congress would have been more than happy to increase the regulation.
The reason the government has been forced to intervene is the problem created by "financial contagion." This is demonstrated by the impact of the crisis on the insurance company AIG. AIG is impacted two ways. It insured some of the MBS and the value of all of its other unrelated assets declined as a result of the crisis.
Bob Martin is Emeritus professor of economics at Centre College. E-mail him at firstname.lastname@example.org.