For starters, Fannie Mae and Freddie Mac are "government sponsored enterprises". Though technically privately owned, they have particular privileges granted by the government, they are overseen by Congress, and, most importantly, they have operated with a clear promise that if they failed, they would be bailed out. Hardly a "free market." All the players in the mortgage market knew this from early on. In the early 1990s, Congress eased Fannie and Freddie's lending requirements (to 1/4^th the capital required by regular commercial banks [1]) so as to increase their ability to lend to poor areas. Congress also created a regulatory agency to oversee them, but this agency also had to reapply to Congress for its budget each year (no other financial regulator must do so), assuring that it would tell Congress exactly what it wanted to hear: "things are fine." **In 1995, Fannie and Freddie were given permission to enter the subprime market and regulators began to crack down on banks who were not lending enough to distressed areas. Several attempts were made to rein in Fannie and Freddie, but Congress didn't have the votes to do so, especially with both organizations making significant campaign contributions to members of both parties**. Even the New York Times as far back as 1999 [2] saw exactly what might happen thanks to this very unfree market, warning of a need to bailout Fannie and Freddie if the housing market dropped.
Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977. **The CRA requires banks to to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership**. What all of these did together was to create an **enormous profit and political incentives** for banks and Fannie and Freddie **to lend more to riskier low-income borrowers**. However well-intentioned the attempts were to extend homeownership to more Americans, forcing banks to do so and artificially lowering the costs of doing so are a huge part of the problem we now find ourselves in.
“An Open Letter to my Friends on the Left [3]” (emphasis added)
I want to quote the whole thing as this explains my thoughts behind the recent financial markets, but really, why should I quote the entire thing when I can just point to it and say “read the entire thing”?
So … read the entire thing already!
[1] http://www.ibdeditorials.com/IBDArticles.aspx?id=307241242284619
[2] http://query.nytimes.com/gst/fullpage.html?res=9C0DE7DB153EF933A0575A