Once upon a time, in the land that FDR built, there was the rule of "regulation" and all was right on Wall and Main Streets. Wise 27-year-old bank examiners looked down upon the banks and saw that they were sound. America's Hobbits lived happily in homes financed by 30-year-mortgages that never left their local banker's balance sheet, and nary a crisis did we have.

Then, lo, came the evil Reagan marching from Mordor with his horde of Orcs, short for "market fundamentalists." Reagan's apprentice, Gramm of Texas and later of McCain, unleashed the scourge of "deregulation," and thus were "greed," short-selling, securitization, McMansions, liar loans and other horrors loosed upon the world of men.

Now, however, comes Obama of Illinois, Schumer of New York and others in the fellowship of the Beltway to slay the Orcs and restore the rule of the regulator. So once more will the Hobbits be able to sleep peacefully in the shire.


From left: Christopher Cox, Henry Paulson, Harry Reid, Richard Shelby, Nancy Pelosi, Chris Dodd and Ben Bernanke. AP

With apologies to Tolkien, or at least Peter Jackson, something like this tale is now being sold to the American people to explain the financial panic of the past year. It is truly a fable from start to finish. Yet we are likely to hear some version of it often in the coming months as the barons of Congress try to absolve themselves of any responsibility for the housing and mortgage meltdowns.

Yes, greed is ever with us, at least until Washington transforms human nature. The wizards of Wall Street and London became ever more inventive in finding ways to sell mortgages and finance housing. Some of those peddling subprime loans were crooks, as were some of the borrowers who lied about their incomes. This is what happens in a credit bubble that becomes a societal mania.

A Look Back at the Crisis Unfolding

  • Stopping the Panic 09/20/08 &ndash; Now the task is to protect taxpayers and restore markets.
  • Be It Resolved 09/19/08 &ndash; Paulson and Bernanke ask Congress for a resolution agency.
  • The Fed and AIG 09/18/08 &ndash; Nationalizations aren't stopping the financial panic.
  • McCain and the Markets 09/17/08 &ndash; Denouncing 'greed' and Wall Street isn't a growth agenda.
  • The Fed's Epic Day 09/17/08 &ndash; It's only fair to praise the central bank when it does the right thing.
  • Surviving the Panic 09/16/08 &ndash; A resolution agency, steady monetary policy, and a big tax cut.
  • Wall Street Reckoning 09/15/08 &ndash; Treasury Secretary Hank Paulson's refusal to blink won't get any second guessing from us.

But Washington is as deeply implicated in this meltdown as anyone on Wall Street or at Countrywide Financial. Going back decades, but especially in the past 15 or so years, our politicians have promoted housing and easy credit with a variety of subsidies and policies that helped to create and feed the mania. Let us take the roll of political cause and financial effect:

- The Federal Reserve. The original sin of this crisis was easy money. For too long this decade, especially from 2003 to 2005, the Fed held interest rates below the level of expected inflation, thus creating a vast subsidy for debt that both households and financial firms exploited. The housing bubble was a result, along with its financial counterparts, the subprime loan and the mortgage SIV.

Fed Chairmen Alan Greenspan and Ben Bernanke prefer to blame "a global savings glut" that began when the Cold War ended. But Communism was dead for more than a decade before the housing mania took off. The savings glut was in large part a creation of the Fed, which flooded the world with too many dollars that often found their way back into housing markets in the U.S., the U.K. and elsewhere.

- Fannie Mae and Freddie Mac. Created by government, and able to borrow at rates lower than fully private corporations because of the implied backing from taxpayers, these firms turbocharged the credit mania. They channeled far more liquidity into the market than would have been the case otherwise, especially from the Chinese, who thought (rightly) that they were investing in mortgage securities that were as safe as Treasurys but with a higher yield.




When debt instruments are downgraded, banks must then recognize a paper loss on these assets. In a bitter irony, the losses cause the same credit raters whose judgments allowed the banks to hold these dodgy assets to then lower their ratings on the banks, requiring the banks to raise more money, and pay more to raise it. The major government-anointed credit raters -- S&P, Moody's and Fitch -- were as asleep on mortgages as they were on Enron. Senator Richard Shelby (R., Ala.) tried to weaken this government-created oligopoly, but his reforms didn't begin to take effect until 2007, too late to stop the mania.


The New York Sun reports that an SEC rule change that allowed more leverage was made in 2004 under then Chairman William Donaldson, one of the most aggressive regulators in SEC history. Of course the SEC's task was only to protect the investor assets at the broker-dealers, not the holding companies themselves, which everyone thought were not too big to fail. Now we know differently (see Bear Stearns below).


- The Bear Stearns rescue. In retrospect, the Fed-Treasury intervention only delayed a necessary day of reckoning for Wall Street. While Bear was punished for its sins, the Fed opened its discount window to the other big investment banks and thus sent a signal that they would provide a creditor safety net for bad debt.

Morgan Stanley, Lehman and Goldman Sachs all concluded that they could ride out the panic without changing their business models or reducing their leverage. John Thain at Merrill Lynch was the only CEO willing to sell his bad mortgage paper -- at 22 cents on the dollar. Treasury and the Fed should have followed the Bear trauma with more than additional liquidity. Once they were on the taxpayer dime, the banks needed a thorough scrubbing that might have avoided last week's stampede.




We could cite other Washington policies, including the political agitation for "mark-to-market" accounting that has forced firms to record losses after ratings downgrades even if the assets haven't been sold. But these are some of the main lowlights.

Our point here isn't to absolve Wall Street or pretend there weren't private excesses. But the investment mistakes would surely have been less extreme, and ultimately their damage more containable, if not for the enormous political support and subsidy for mortgage credit. Beware politicians who peddle fables that cast themselves as the heroes.

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