What Caused The Economic Downturn

“Your congressman is trying to make mortgages more expensive. Ask him why he opposes the American dream of home ownership.”

So said a Fannie Mae sponsored commercial issued in response to some in the federal government calling for increased regulation or competition. Unfortunately, even after a $200 billion bailout and Fannie Mae going into federal conservatorship - along with the ripple effect largely responsible for the $800 billion "rescue" bill - expensive mortgages are the least of our worries.

What is Fannie Mae? They, coupled with Freddie Mac, are a Government Sponsored Entity (GSE). Which means they are private corporations created and sponsored by the federal government. Fannie was established during the Great Depression in order to provide more liquidity to the mortgage market. They did this by buying up mortgages that other banks made to consumers. They would then resell some of these, while holding on to others. This buying activity allowed banks to make more and more loans, because they didn't have to service them. It was generally thought of as a good idea because banks making lots of loans meant it was easier for average citizens to buy homes. In fact, through these programs, US home ownership steadily rose.

Steadily, that is, until the last decade, during which time home ownership rates increased quickly as interest rates fell and the buying and selling of loans increased. There were other entities that competed against Fannie Mae and Freddie Mac in the mortgage buying market, but, as the director of the Congressional Budget Office Dan Crippen said, "The debt and mortgage-backed securities of GSEs are more valuable to investors than similar private securities because of the perception of a government guarantee."

This government-induced value made Fannie Mae very profitable. So profitable that they were able to pay their executives tens of millions of dollars in salaries and bonuses. They were also able to use those profits to lobby Congressional leaders with millions of dollars.

As competition grew, Fannie became more aggressive in what kinds of loans they would buy. They had begun to lose market share to competitors, and naturally wanted to retake the lead. But they also had other motivators beyond profits,

“Fannie Mae faced the danger that the market would pass us by,”

“We were afraid that lenders would be selling products we weren’t buying and Congress would feel like we weren’t fulfilling our mission. The market was changing, and it’s our job to buy loans, so we had to change as well.”

And what was the underlying mission that Fannie felt pressure to fulfill? Artificially facilitate mortgages to ever more and more people. As a result, between 2005 and 2007 Fannie guaranteed three times as many risky loans (loans made without documentation of income or savings) as it had in all earlier years combined. And that doesn't even include subprime loans.

During this same period, it became apparent to some members of Congress and the financial industries that Fannie Mae was in danger. But because of Fannie's government mandated "mission" - facilitate more mortgage loans, no matter what - all attempts to regulate or otherwise reign Fannie in were defeated. Despite sharp warnings from officials like Federal Reserve Chairman Alan Greenspan,

"Enabling these institutions to increase in size...we are placing the total financial system of the future at a substantial risk."

And increase in size they did. By July of this year they owned or guaranteed half of the $12 Trillion mortgage industry. Their scope meant just about every mortgage lender in the country, both large and small, relied on Fannie and Freddie to help them continue to make loans. Worse yet, because of the government-backed nature of the GSE's,"

Although banks are typically prohibited from concentrating their money in the stock or bonds of any one company, those regulations create an exemption for debt issued by Fannie Mae and Freddie Mac, which have long been considered the safest of investments."

Not only were banks heavily reliant upon Fannie, but they were allowed to dangerously leverage themselves because Fannie was backed by the government.

So we set up a program whereby the federal government can influence the market (making it behave contrary to its nature), force that program to expand until it dominates that market, and then induce excessive risk taking because it's backed by the very same government.

That is what caused the economic crisis. It wasn't greed. It wasn't capitalism.

It was government.