Andrew Leonard: Did Fannie and Freddie cause the meltdown?

.... Fannie and Freddie did not cause the subprime mortgage crisis. The private sector, acting on its own initiative, serenely confident in its own financial manipulations, spawned the greatest Wall Street conniption since the Great Depression. Fannie and Freddie got into the game late, after watching in dismay as their market share in the lucrative business of originating and selling off pools of mortgage-backed securities began to shrink.

There are many bit players in this drama who bear blame, from home-buyers to government regulators, but the two biggest culprits live on Wall Street.

First: The innovative financial products that allowed bankers to pool together risky loans into packages that could earn high enough credit ratings so as to be sold to investors who would normally deem risky loans made to people with bad credit, well, risky.

Second: The proliferation of credit derivatives that allowed financial players, banks, hedge funds, insurance companies, mortgage lenders, etc., to buy protection against the risk that those pools of mortgage-backed securities (and any other kind of bond) would default.

These two innovations dovetailed nicely, allowing Wall Street to gorge itself on risky bets, while comforting itself that all bases were covered.

There were people, like the former investment banker Frank Partnoy, who saw this as it was happening and warned of potential disaster. From my review of his 2003 book,"Infectious Greed":

What does it all add up to? In a worst-case scenario: quite a bit of trouble. In the long run,"risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for. As government for the most part looks the other way, the stability of the financial markets is increasingly an illusion. In the last decade alone, the markets have come closer than most people realize to collapsing. Unless serious steps are taken to change the status quo, disaster could be imminent. We haven't seen the last of the bubbles, by any stretch of the imagination. We seem, in fact, to be addicted to them.

Wall Street's best, brightest and filthy richest scoffed at the critics. We were shouted down by those who told us that we just didn't understand how modern finance worked -- how these new products really made the whole global financial system safer, how risk was more widely distributed than ever before, making the chances of any one disastrous economic event bringing down the system, less than ever before.

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