WASHINGTON -- There is no more insidious myth than the notion that the subprime-mortgage debacle began on Wall Street and that predatory capitalism was responsible for the whole blooming mess.
Economist Milton Friedman used to say that just about every economic and social ill that confronts our country could be traced to misguided federal policies and their "unintended consequences." And that is certainly true of the subprime crisis seeds that were planted by two federally created, government-assisted lending agencies: Fannie Mae and Freddie Mac.
To be sure, there's lots of blame to go around, but these two mortgage giants were at the root of this scandal. "Fannie and Freddie did this by becoming a key enabler of the mortgage crisis," wrote economist Kevin Hassett in a revealing article for Bloomberg financial news. "They fueled Wall Street's efforts to securitize subprime loans by becoming the primary customer of all AAA-rated subprime-mortgage pools. In addition, they held an enormous portfolio themselves."
To a large degree, Fannie and Freddie became the mortgage market, as Democratic leaders in Congress pressured, pushed and ordered the agencies to make housing loans to lower-income borrowers who could not meet credit standards elsewhere in the mortgage industry.
As of last year, Fannie Mae alone owned or guaranteed more than $388 billion of these high-risk loans. "Their large presence created an environment within which even mortgage-backed securities assembled by others could find a ready home," the American Enterprise Institute economist says.
There were those who saw disaster early in the making, and that's what happened from 2004 to 2005 when both agencies were caught in the undertow of an accounting scandal that swept Fannie Mae CEO Franklin Raines from office in disgrace.
One of those who tried to rein in the two agencies was President Bush, who recommended in 2003 that an agency be created to regulate the housing-finance industry, including Fannie Mae and Freddie Mac. But Barney Frank, then the ranking Democrat on the Financial Services Committee and now its chairman and chief protector, stopped Bush's regulatory initiative cold.
"These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis," Frank said then. "The more people exaggerate these problems, the more pressure there is on these companies and the less we will see in terms of affordable housing."
Frank's Democratic ally, Rep. Melvin Watt, saw the Bush regulation as a sinister move to tighten control of the lending giants. "I don't see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing," Watt said at the time.
So the situation festered, despite repeated warnings that the two mortgage businesses were a catastrophe in the making.
In 2005, Federal Reserve Chairman Alan Greenspan told Congress that if Fannie and Freddie "continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest-rate aversion, they potentially create ever-growing potential systemic risk down the road.
"We are placing the total financial system of the future at substantial risk," Greenspan testified.
Around that time, a regulatory reform bill came out of the Senate Banking Committee that would have cracked down on the two agencies and forced them to jettison their riskiest investments. But that bill, opposed by Connecticut Sen. Chris Dodd and New York Sen. Hillary Clinton, among others, never became law, because Democrats rallied in lock step against it and prevented it from coming up for a floor vote.
In layman's terms, Hassett explains that, if Fannie and Freddie had been disbanded or at least had been forced to submit to needed oversight and regulation, "this whole mess could never have happened."
This is not to say that there weren't other factors involved in a subprime scandal.
"This is the result of a witches' brew of bad government policies and programs -- from the Community Reinvestment Act, which required banks to provide homeownership loans to people who couldn't afford to repay them, to Fannie Mae and Freddie Mac, which started the financial contagion by encouraging 'subprime' loans, to the Fed's easy monetary policies that helped produce the housing bubble," said Cesar Conda, former chief domestic policy adviser to Vice President Dick Cheney.
But Fannie and Freddie are at the core of this financial calamity. "There shouldn't have been a Fannie and Freddie. They are the perfect example that power corrupts," free-market economist Arthur B. Laffer told me last week.
They are also another reason why government should not be running commercial enterprises and why Treasury Secretary Hank Paulson should dismantle and sell both businesses as soon as it is feasible to do so.