The Market is Innocent, Part I

"The free market failed."

"Greedy businessmen have ruined us all."

"The age of capitalism is over."

Such are the explanations that surround the collapse of the financial and real estate markets from 2007 to 2008, shortly followed by a nationwide recession. Big banks and speculators had made too many risky investments, we are told, and lost their fortunes, putting at risk the entire economy. At the surface this is indeed what took place to set up the crisis. The whole truth, however, requires far more than a surface-level understanding of the boom and bust of the 2000's. To gain an understanding of what happened during the economic bust, one must first understand what took place beforehand--the economic boom

This is the first of a three-part series detailing the complete failure of government intervention and the innocence of the free market in the buildup to the current economic crisis.

Boom and Bust

Normally, there are two parties principally involved in the process of purchasing a house: the buyer and a lending institution of some sort. The buyer, unless he is filthy rich, needs to get a loan with which to buy the house, and the lending institution is more than willing to provide him with that loan, with interest. The buyer takes the loan, buys a house, and spends several years slowly paying the mortgage.

The times from 1998 to 2006, however, were not "normal." Housing prices increased dramatically. Houses became the "best investment," because "they never lose value." Speculators and house-flippers bought low and sold high, riding the waves of the economy. Precious few suspected the boom was merely a bubble, prone to popping at one point or another. Yet, despite the doubts of the vast majority, the minority was proven correct. In 2006, home prices and stocks began to decline, then freefall. By 2009, multiple bailouts of failing industries, "stimulus packages" for the groaning economy, and increased regulation of the financial industry were deemed necessary to "save capitalism."

Fannie and Freddie

Most everyone assumed that the collapse was due to the wild swings of a normal, free-market economy. Yet, as I stated before, nothing was normal in the usual sense of the word during the housing bubble. Government intervention ran rampant during this time period, and two key pieces to the government puzzle are the corporations known as Fannie Mae and Freddie Mac. These corporations, known as "government sponsored enterprises", were technically private but were given governmental powers over the housing market.

Their primary function was to purchase mortgages from lending institutions. Lending institutions would then receive a large sum of money up front, while Fannie and Freddie would receive the steady income from the debtor and hold responsibility for that loan and the possibility of default. Once Fannie and Freddie had accumulated a large number of loans, they would repackage them as "mortgage-backed securities." These were essentially several loans bundled together and sold on the market to investors. Critical to these securities was the diversity of the loans packaged inside them; there had to be a wide variety of loans, some safe, others much riskier.

Absolute Power

Despite the fact that the risky loans were packaged together with the good loans, the security as a whole was considered to be safe, or "AAA", by investors and advisers. Why? Political pressure from various government branches pushed independent rating agencies to certify those risky investments in order to stimulate more homebuying; the more mortgage-backed securities sold on the market, the more money banks got from Fannie and Freddie, the more loans those banks could make to potential homeowners.

As will be detailed in Parts II-III of this series, this pressure placed on private rating agencies is just the beginning; political power in its various forms, from Fannie and Freddie to regulation to monetary policy, formed the bedrock of the boom and subsequent bust, and will likely shape the global economy for decades to come.