WASHINGTON -- 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.
The bill barring most regulation of derivative trading was inserted into an 11,000-page budget measure that became law as the nation was focused on the disputed 2000 presidential election. It was sponsored by Republican Sens. Phil Gramm of Texas and Richard Lugar of Indiana — with support from Democrats, the Clinton administration and then-Federal Reserve chairman Alan Greenspan. Few opposed it.
Sen. Tom Harkin, an Iowa Democrat who help negotiate the bill for Democrats, says he put aside his qualms because Wall Street and Greenspan were adamant that less regulation would help the stock market.
"All of the Wall Street crowd, all of the investment firms, the Morgan Stanleys, the Goldman Sachs … that steamroller just rolled over anything," he says. Wall Street promised to police itself "and Congress bought it."
Better regulation could have provided greater transparency and ensured that enough collateral was in place for derivatives to meet their obligations, says economist Susan Wachter of the University of Pennsylvania's Wharton School. "It's totally obvious in retrospect that this was not good public policy," she says.
But a decade ago, many saw derivatives as a way to smooth the gears of free-market capitalism. That's why the financial industry was alarmed in March 1998, when a little-known agency called the Commodity Futures Trading Commission sought to regulate derivatives.
Financiers erupted. They feared the plan would invalidate existing contracts, and they argued derivatives often were uniquely tailored hedges against risk that could not abide one-size-fits-all rules. Greenspan, then-Securities and Exchange Commission chairman Arthur Levitt and then-Treasury secretary Robert Rubin said in a statement they had "grave concerns" about regulating such agreements.
A report by President Clinton's economic team recommended against regulation. At congressional hearings, Greenspan argued that sophisticated market players would check one another, and if derivatives were regulated here such investments would go overseas.
A bill barring derivatives from being regulated as futures contracts passed the House in October 2000, by a vote of 377-4.
But Gramm, chairman of the banking committee, was not satisfied. Gramm told USA TODAY at the time he wanted language making clear that banking products could not be regulated by the commodities agency. After the fall election, leaders of both parties cut a deal and in December 2000 inserted it in the budget bill.
"The work of this Congress will be seen as a watershed, where we turned away from the outmoded, Depression-era approach to financial regulation," Gramm said then.
The wall against regulation was a watershed in another way. Financial services employees and political action committees made $308.6 million in political donations in 2000, up from $175 million in the previous presidential election year, says the Center for Responsive Politics. Wall Street and the banking, insurance and real estate industries spent $3.2 billion on lobbying in the past decade, the center reports. AIG spent $73 million.
More than a quarter of the $3.9 million in campaign money Gramm raised from 1997 through 2002 came from the financial services sector, and nine of his top 10 donors, grouped by economic interest, were employees of financial companies that use or trade in derivatives, according to election records compiled by the center.
Gramm, who left office in 2003 and went to work for UBS, was a top economic adviser to GOP presidential nominee John McCain until he stepped down in July after saying the USA had become "a nation of whiners" about the economy.
Noting that he has always favored deregulation, Gramm scoffs at the idea he was influenced by campaign money. The derivatives provision didn't cause the credit collapse, he adds.
"The crisis was caused by government," Gramm says. He cites the Community Reinvestment Act, which he says "forced banks to make subprime (mortgage) loans" to people who couldn't afford them.
Democrats, including Harkin, and many economic analysts dispute that. As for what he learned, Harkin says, "Don't pay attention to Wall Street when it comes to issues like this."
2. Protecting Fannie, Freddie
In 2005, Congress rejected a Republican-sponsored bill aimed at curbing risky investments by mortgage giants Fannie Mae and Freddie Mac, thanks to resistance from mostly Democrats. It was the latest in a string of unsuccessful attempts to rein in the two agencies. In this case, Congress ignored Greenspan's warning about the financial risks Fannie and Freddie were taking on.
The agencies were designed to expand homeownership by injecting money into the home mortgage market and encouraging banks to lend more. They buy loans from banks and guarantee them, holding some in their portfolios and selling others as mortgage-backed securities.
With implicit government backing, Fannie and Freddie have been able to borrow money at below-market rates. In recent years, the companies borrowed to buy billions' worth of complex mortgage-backed securities. The investments earned big returns. Fannie and Freddie's stock soared. Their executives were paid tens of millions of dollars.
Republicans sought to reduce the size of the companies' portfolios, arguing they were too risky.
Then the housing bubble burst. Fannie and Freddie didn't cause the financial meltdown, but they fueled it by becoming one of the biggest purchasers of toxic mortgage products, says Harvard economist Kenneth Rogoff.
"There was tremendous coddling of Fannie and Freddie in the face of a lot of evidence that they really weren't helping homeowners all that much," Rogoff says. "I think it was very, very clear what was coming, and that they were a huge, huge risk to the American financial system. … It really was criminal neglect."
Fannie and Freddie spent $175 million on lobbying in the last decade, according to the Center for Responsive Politics. The companies' employees and PACs gave nearly $5 million in contributions since 1989, by the center's count.
Until they were taken over, Fannie had 13 lobbying firms on its payroll this year; Freddie had 33. Both packed their boards with politically connected people such as Democrat Rahm Emanuel, a former Clinton aide who joined Freddie's board in 2000 before he became a congressman. Both hired well-connected lobbyists such as Rick Davis, now McCain's campaign manager.
In seeking to crack down on Fannie and Freddie, Republicans were encouraged by banks that didn't want government-subsidized competition. But there also was a chorus of warnings that the highly leveraged corporations could pose a risk to the economy.
In 2003 and 2004, both companies were wracked by accounting scandals that led to the ouster of top managers.
In 2005, Sen. Chuck Hagel, R-Neb., sponsored legislation to shrink the agencies' portfolios. McCain later added his name as a co-sponsor. The bill passed the Senate Banking Committee, but every panel Democrat voted against it. That signaled that the bill wouldn't get the 60 votes needed to pass in the Senate. Obama was not on the banking panel; there is no record of him doing anything on the bill.
Sen. Chris Dodd, D-Conn., a senior member of the banking committee, is the largest recipient of political contributions from Fannie and Freddie employees and PACs, having received $165,400 since 1989, according to the center.
Dodd said he backed Fannie and Freddie because they encouraged homeownership. "I've never ever in my life been affected by a campaign contribution," he said in an interview. He noted that when he became banking committee chairman, he helped pass a bill restricting mortgage agencies' investment practices in 2007. By then, it was too late to stop the financial disaster.
In the House, Republicans and Democrats agreed on a different bill that passed easily. But the Bush administration opposed it, calling it weak. The effort failed.
The next year, Freddie Mac paid the largest election fine ever, $3.8 million, after regulators found it used corporate funds illegally to pay for fundraisers. From 2000 to 2003, Freddie Mac held 85 events that raised $1.7 million, mostly for Republicans on the House Financial Services Committee, regulators found.
Rep. Barney Frank, then the ranking Democrat on financial services and now the chairman, says he and his colleagues were not soft on Fannie and Freddie. "Yes, they lobbied strongly, but I was one of the most successful ones in challenging them."
Frank had no apologies. Rep. Artur Davis, D-Ala., by contrast, offered a rare Washington mea culpa: "Like a lot of my Democratic colleagues, I was too slow to appreciate the recklessness of Fannie and Freddie," he said in a statement. "Frankly, I wish my Democratic colleagues would admit, when it comes to Fannie and Freddie, we were wrong."