In 1977 the U. S. government tried to make things fairer. They outlawed "redlining" in the Community Reinvestment Act. That is, in the poor parts of town, few people can get loans and risks are greater, so lenders "drew a red line" around bad neighborhoods. The CRA made it more difficult for lenders to refuse to make loans to borrowers who were not credit worthy, creating sub-prime mortgages.
In 1995 the CRA was amended to allow sub-prime mortgages to be bundled into big packages and sold to Fannie Mae and Freddie Mac (big, government created firms that buy bundles of mortgages and sell securities that allow investors to get a big piece of the mortgage action). This greatly increased the number of sub-prime loans.
Enter, low interest rates (easy money) by Greenspan and Bernanke in this new millenium and we have the explosion of real estate investment I described here.
I have come to understand another piece of the puzzle. After the S&L crisis of the late 1980's, we realized that some financial institutions hold loans or debt that they know are bad, but because accounting standards valued them at their original value (the book value*), the institutions could get into big trouble by pretending that the accounting numbers were correct. The archetypical example from the time is this. A S&L in Texas has made a loan to an oil producer who is struggling and cannot be counted on to pay. The loan is valued at its original value until the borrower defaults. So the S&L can hide its weakness for a while.
The new accounting rules are called "mark to market." These rules value a promise to pay (a debt or a security) at that promise's current market value. Mortgage backed securities are hard to value at the moment. Many of them will pay well because plenty of the mortgages that back them are fine. But the increased uncertainty means that not many buyers and sellers can agree on a sales price. Markets with few transactions are called "thin."
Suppose 10,000 of a certain security are held by Lehman Brothers and have been used as collateral for a loan that Lehman has taken out. Then a bank sells a few of that kind of security very cheaply. "Mark to market" rules say that Lehman now owns something that is not very valuable--and the creditor that made the loan tells Lehman, "You don't have sufficient collateral anymore." So Lehman goes looking for another loan--backed by what?
In the end, Lehman has to default and declare defeat. The rough thing is that Lehman's securities may truly have enough value to back its obligations, but in a thin market, "mark to market" rules force instant devaluations that may be huge. The market value of those securities may be much higher in a week or a month.
This post makes plain how the Community Reinvestment Act (and the 1995 addendum) and "mark to market" rules helped precipitate the current crisis. Being an advocate of freedom, I am opposed to forcing companies to make risky loans if they do not want to. Further, being skeptical of government efficiency, Fannie Mae and Freddie Mac have always scared me. And, yes, the Fed cannot seem to stay focused on its true mission--to maintain a strong and stable currency.
I am an athiest on "mark to market" rules. They seem more realistic than using "book value," as was previously done, but also seem to have big problems in thin markets.
My overall theme remains the same, though. Fannie/Freddie, the Fed, and the CRA are government impediments to freedom and have thoroughly trashed the financial markets.
Oh! One more thing. Politicians have found an innocent scapegoat--"deregulation." In particular they blame the Gramm-Leach-Bliley Act (G-L-B) of 1999 (passed the senate 90-8), which allowed banks, insurance companies, financial service companies, etc., to co-mingle ownership. In 1933 the Glass-Steagall act had made it illegal for banks to mingle with other financial companies, so G-L-B repealed Glass-Steagall.
Glass-Steagall was wrong-headed at the time. Diversification helps companies maintain themselves in crisis. In fact, the "rescues" and buyouts of financial companies this year would not have been possible without allowing banks and other financial companies to co-mingle. G-L-B is mitigating damage, not causing damage.
To me, the scapegoaters reveal their dishonesty by blaming G-L-B, but without being able to say in what way G-L-B actually hurt anything.
*Book value is just a little more complicated than this--not much.