How Congress set the stage for a fiscal meltdown

During last week's presidential debate, John McCain and Barack Obama sparred over what caused the financial crisis.

"The match that lit this fire," McCain said, came from the government-sponsored mortgage companies Fannie Mae and Freddie Mac, which backed risky home loans "with the encouragement of Sen. Obama and his cronies … in Washington."

Obama shot back: "The biggest problem was the deregulation of the financial system. … Sen. McCain, as recently as March, bragged about the fact that he is a deregulator."

It was a classic example of Washington finger-pointing. McCain and the GOP blame Fannie and Freddie — which were taken over by the government last month — because the troubled mortgage agencies' biggest backers were Democrats who said they wanted to increase access to homeownership.

Meanwhile, Obama and other Democrats highlight Republicans' longtime focus on limiting regulations for the financial industry.

No single government decision sparked the crisis, but collectively the candidates had a point: Both parties in Congress played important roles in setting the stage for the ongoing financial meltdown.

They did so in moves that reflected not just their ideological priorities, but also the wishes of special interests that have spent millions aggressively lobbying Washington and contributing to lawmakers' campaigns.

By not reining in increasingly risky investments made by Fannie and Freddie — and by keeping complex financial instruments known as derivatives free from most government oversight — Congress chose not to impose barriers that economists widely agree could have helped stave off the crisis that continues, even after lawmakers approved a $700 billion emergency bailout package for Wall Street.

Here is a look at how Congress' actions on two key fronts became significant factors in the financial crisis:

1. Not checking derivatives

In 2000, a united financial services industry persuaded Congress to allow a vast, unregulated market in derivatives, which are contracts in which investors essentially bet on the future price of a stock, commodity, mortgage-backed security or other thing of value.

Derivatives — so named because their value derives from something else — also are known as hedges, swaps and futures. They are designed to lower risks for buyers and sellers, but in some cases, economists now say, they gave investors a false sense of security.

Today, derivatives are compounding the risks to a shaky economy because they are tied to complex mortgage securities that have plummeted in value. Instruments called credit default swaps, for example, were supposed to insure investors against default of mortgage-backed securities. With a mass collapse of those bonds, it's not clear how the swaps can pay off.

The ultimate fear, as Fortune magazine put it, is that swaps can cause "a financial Ebola virus radiating out from a failed institution and infecting dozens or hundreds of other companies."

Derivatives are traded privately, and their estimated notional value is huge: $531 trillion. Losses from derivatives helped bring down Wall Street powerhouse Lehman Bros., and led the government to spend nearly $123 billion so far bailing out the giant insurer AIG.

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