Once upon a time, generous-minded social engineering resulted in the Community Reinvestment Act, which forced banks to lend to disadvantaged borrowers who otherwise couldn’t get mortgages to buy homes.

But because these potential borrowers were financially disadvantaged, they also represented a bigger credit risk. Banks didn’t like being told to make mortgages to high-risk borrowers because they wouldn’t be able sell these loans off to anyone else.

Fannie Mae (FNM) and Freddie Mac (FRE) were mandated to insure these higher-risk loans so that with a de facto government guarantee these “subprime” mortgages could be repackaged and sold, removing them from the inventory of the originating bank.

Thus the seeds of the subprime mortgage debacle were planted.

A series of devastating events – the bursting of the tech stock bubble in 2000, the 2001 terrorist attacks on U.S. soil, and the war on Iraq and the spike in oil prices, to name the key ones – posed serious recessionary threats.

The U .S. Federal Reserve aggressively lowered interest rates to stimulate the economy. A long period of low rates reduced returns for investors, but simultaneously afforded borrowers cheap financing. Wall Street went to work manufacturing all manner of products to squeeze extra yield out of this ultra-low-interest-rate environment.

Subprime collateralized mortgage-backed loans, similarly structured and packaged commercial mortgage-backed loans, leveraged corporate loans, and derivatives (especially credit default swaps), were manufactured in massive quantities.

Many of the products were rated investment grade by the major ratings agencies, which were incongruously but handsomely paid by the manufacturing banks to rate their products. Higher ratings meant easier sales and greater profits.

Buyers of the products, including the banks themselves, used cheap financing to leverage returns by borrowing from each other to create and buy more and more products.

Low interest rates were driving homebuyers to banks and mortgage finance companies, most of which were offering cheap “teaser” rates and no-document “liar loans” – all in a mad rush to capitalize on what was actually a rapidly inflating housing bubble.

Consumers were flush with credit and used it, as Wall Street took credit card receivables, packaged them into pools, sold them, and gave the proceeds back to credit card issuers, who then offered the public even more credit in a competitive horn of plenty. Then the housing bubble burst, and the music stopped. Banks were afraid to lend because they had lent too much to too many suspect borrowers, including each other, meaning their collateral was depreciating faster than any econometric model had ever calculated.

As banks’ capital evaporated, lending stopped everywhere. The securities markets imploded, leaving us in a state of suspended animation in which there’s no longer any way to borrow, produce and spend.

Source: How Subprime Borrowing Fueled the Credit Crisis