Unaffordable housing and political kickbacks rocked the American economy.

• Author: Issa, Darrell

The economic earthquake that shook the world financial markets and bankrupted seemingly invulnerable multinational corporations exposed perilous fault lines of the federal government's own creation. Under mounting pressure, at a critical moment, the fault lines cracked and took down everything from auto manufacturers to insurance providers.

Now that the Obama Administration's comprehensive regulatory reform proposals are making their way through Congress, the time has come to identify the root causes of the most recent economic downturn. Many leading economists agree: The economic crisis we are experiencing is directly tied to an over-inflated housing bubble wherein mortgage lenders made reckless, high-risk loans. These loans were given in record number to over-extended, under-qualified borrowers to satisfy an increasingly aggressive government drive for home ownership. Why the lenders adopted such counterintuitive and irresponsible business practices is the critical question. The answer reveals the disastrous folly of government intervention in the housing market spanning more than three quarters of a century.

To secure affordable housing, Congress created a new Government Sponsored Enterprise (GSE) known as the Federal National Mortgage Association (Fannie Mae) during the Great Depression to purchase and securitize home mortgages and promote greater liquidity in the mortgage market (1) At a time of unprecedented economic strain, the nation welcomed this fundamental component of President Franklin Delano Roosevelt's New Deal.

For thirty years, Fannie Mae had a near-monopoly on the secondary mortgage market and, with the backing of the federal budget, an ostensibly endless supply of capital. In 1965, President Lyndon Johnson established the Department of Housing and Urban Development (HUD) as a part of his Great Society plan to eradicate poverty and promote homeownership through a government-run housing program and government subsidized mortgage lending. Facing mounting debt, however, Johnson later contrived a scheme to privatize Fannie Mae, removing the corporation's liabilities from the federal balance sheets without limiting the potential for a taxpayer bailout. (2)

By 1970, Congress was pushing Fannie Mae to purchase conventional mortgages, though the effort was complicated by federal restrictions on numerous primary lenders that were unable to work with Fannie Mae. The solution? Congress created the Federal Home Loan Mortgage Corporation (Freddie Mac) as a wholly-owned government-run mortgage lender, (3) and then re-chartered it in 1989 as a publicly traded enterprise. (4)

As the market for secondary mortgages grew, Fannie Mae and Freddie Mac nearly achieved monopoly results thanks to numerous competitive advantages guaranteed through their unique relationship with the federal government. (5) Among these advantages were government-backed lines of credit equal to a whopping $2.25 billion and a corollary market reputation that led investors to believe the GSEs were too big to fail. (6) This inflated investor confidence and exclusive government protection resulted in an unnatural expansion of Fannie Mae and Freddie Mac's market dominance, and by the time the 1990s rolled around, the corporations together held more than three quarters of the secondary market for prime mortgages. (7)

The GSEs were aided immensely by the federal government because Congress charged Fannie Mae and Freddie Mac with keeping the secondary mortgage market liquid and increasing the availability of affordable housing. No other private companies could borrow money at such an affordable rate. Private debt markets were willing to lend the GSEs money at an interest rate not much higher than the relatively risk-free rate they charged the U.S. government itself. (8)

As a matter of regular business, Fannie Mae and Freddie Mac sold their bonds in the debt markets at relatively low price points and used the borrowed money to purchase mortgages from primary lenders like Countrywide Financial that dealt directly with customers seeking home loans. They then bundled many of these mortgages into securities and sold them to investors who paid Fannie Mae and Freddie Mac a fee to guarantee payment in the event of a mortgage default. (9) The GSEs could also hold the securities in their own portfolios, (10) making profits from the difference between their low cost of debt and the higher rates borrowers paid on their mortgages.

Along the way, Congress continued to impose requirements on Fannie Mae and Freddie Mac to guarantee affordable housing opportunities to more and more Americans, including those whose credit ratings and annual income could not sustain a traditional mortgage. Under increased pressure to lower underwriting standards and to meet congressional mandates for loans to low-income families, the GSEs fell victim to successive administrations' campaign promises to increase home ownership regardless of the individual or systemic risk. (11)

Meanwhile, Congress exempted Fannie Mae and Freddie Mac from key regulations and responsible market oversight. For example, their congressional charters exempted them from Securities and Exchange Commission (SEC) oversight, making the GSEs the only exempt publicly traded corporations. It was not until scandals in 2003 and 2004 revealed the use of unapproved accounting practices to manipulate earnings that Fannie Mae and Freddie Mac agreed to "voluntary" SEC filings. (12) The GSEs were also protected from market oversight regarding the quality of their mortgage-backed security issuances, resulting in the packaging of $5 trillion in mortgages into mortgage-backed securities. (13) These securities were then sold to investors who received the interest and principal payments. Bit by bit the bubble began to expand.

The politicization of mortgage lending reached its zenith during the Clinton Administration through major alterations of the Community Reinvestment Act of 1977, (14) a piece of legislation originally passed to prevent banks from discriminating against otherwise credit-worthy borrowers in lower-income neighborhoods. The Clinton-era policies emphasized, on the other hand, performance-based standards of evaluation that tied bank ratings to the volume rather than the fairness of the banks' mortgage lending. (15) As subprime lending increased to...