The Bubble

Although the business of structured finance grew during the 1990s, Internet companies drew the sexiest action on the Street. When that bubble popped, average Americans who had invested in the high-flying stocks saw their savings evaporate. Consumer and business spending began to dry up.

Then came the 2001 terrorist attacks, which brought down the twin towers, shut down the stock market for four days and plunged the economy into recession.

The government's efforts to counter the pain of that bust soon pumped air into the next bubble: housing. The Bush administration pushed two big tax cuts, and the Federal Reserve, led by Alan Greenspan, slashed interest rates to spur lending and spending.

Low rates kicked the housing market into high gear. Construction of new homes jumped 6 percent in 2002, and prices climbed. By that November, Greenspan noted the trend, telling a private meeting of Fed officials that "our extraordinary housing boom . . . financed by very large increases in mortgage debt, cannot continue indefinitely into the future," according to a transcript.

The Fed nonetheless kept to its goal of encouraging lending and in June 2003 slashed its key rate to its lowest level ever -- 1 percent -- and let it sit there for a year. "Lower interest rates will stimulate demand for anything you want to borrow -- housing included," said Fed scholar John Taylor, an economics professor at Stanford University.

The average rate on a 30-year-fixed mortgage fell to 5.8 percent in 2003, the lowest since at least the 1960s. Greenspan boasted to Congress that "the Federal Reserve's commitment to foster sustainable growth" was helping to fuel the economy, and he noted that homeownership was growing.

There was something very new about this particular housing boom. Much of it was driven by loans made to a new category of borrowers -- those with little savings, modest income or checkered credit histories. Such people did not qualify for the best interest rates; the riskiest of these borrowers were known as "subprime." With interest rates falling nationwide, most subprime loans gave borrowers a low "teaser" rate for the first two or three years, with the monthly payments ballooning after that.

Because subprime borrowers were assumed to be higher credit risks, lenders charged them higher interest rates. That meant that investors who bought securities based on pools of subprime mortgages would enjoy higher returns.

Credit-rating companies, which investors relied on to gauge the risk of default, gave many of the securities high grades. So Wall Street had no shortage of customers for subprime products, including pension funds and investors in places such as Asia and the Middle East, where wealth had blossomed over the past decade. Government-chartered mortgage companies Fannie Mae and Freddie Mac, encouraged by the Bush administration to expand homeownership, also bought more pools of subprime loans.

One member of the Fed watched the developments with increasing trepidation: Edward Gramlich, a former University of Michigan economist who had been nominated to the central bank by President Bill Clinton. Gramlich would later call subprime lending "a great national experiment" in expanding homeownership.

In 2003, Gramlich invited a Chicago housing advocate for a private lunch in his Washington office. Bruce Gottschall, a 30-year industry veteran, took the opportunity to pull out a map of Chicago, showing the Fed governor which communities had been exposed to large numbers of subprime loans. Homes were going into foreclosure. Gottschall said the Fed governor already "seemed to know some of the underlying problems."

Chapter III