By mid-2008 Fannie and Freddie (the "GSEs") had a combined $5.4 trillion in securities outstanding, all of which were backed by the GSEs' full faith and credit. These securities financed 45% of all the residential mortgage debt in the U.S. GSE securities were viewed as having the implicit guaranty of the U.S government and were aggressively marketed to investors worldwide.

Investors in GSE securities were led to believe that the vast majority of the loans backing these securities were low risk. Thanks to the SEC's investigation, the GSEs have, for the first time, acknowledged the magnitude of their efforts to mislead investors with regard the true nature of their exposure to subprime and Alt-A loans. Instead of $600 billion in subprime and Alt-A loans, the GSEs' credit guaranty portfolios contained $1.6 trillion. Thus approximately $1 trillion in subprime and Alt-A loans were misclassified. Given the GSEs' high leverage--each dollar of capital supported about $80 in debt--their insolvency was inevitable.

"Government housing policies and the toxic mortgages they spawned were the sine qua non of the financial crisis."--Edward Pinto

A default would have created panic. With the collateral backing the GSEs' securities being of unknown value and their corporate guarantees worthless, uncertainty as to the magnitude of losses would have contaminated the entire $5.4 trillion in outstanding GSE securities. Market values would likely have plummeted by 20% or more - creating losses of $1 trillion or more. Policy makers had encouraged investment in GSE securities by way of low capital requirements. As a result further insolvencies would have occurred as many investors in GSE securities were themselves highly leveraged. The impact on the FDIC alone would have been catastrophic since depository institutions held about $1 trillion in GSE securities.

The game was up. The federal government would now be forced to acknowledge full responsibility for the GSEs' liabilities. While the government had in effect established the GSEs as off-balance sheet Structured Investment Vehicles (SIVs) - investors had long assumed that he taxpayers were ultimately responsible. This was a classic case of moral hazard and it had infected the $11 trillion residential debt market.

The GSEs' contributions to the financial crisis were pervasive.

In 1991 community groups told Congress that Fannie and Freddie's conservative underwriting standards (such as a down payment) were standing in the way of liberalized underwriting by lenders. Fannie's CEO Jim Johnson saw this as an opportunity to solidify political support for Fannie and fight perennial efforts to limit or eliminate its charter benefits. It joined with the community groups in successfully supporting legislation in 1992 that imposed affordable housing goals on the GSEs.

In 1994 Johnson vowed to "transform the housing finance system" and "provide $1 trillion in targeted [affordable housing] financing." This was followed in 1995 by the Clinton administration's National Homeownership Strategy with a goal of greatly expanded home ownership. President Bill Clinton, when announcing the strategy said it would "not cost the taxpayers one extra cent." At the same time, the Community Reinvestment Act (CRA) was expanded and HUD announced its "Best Practices Initiative" with Countrywide as its leading acolyte. The central tenets of all these policies were the elimination of down payments, the use of "flexible and innovative underwriting" and "administer(ing) a review process for loan applications to ensure that all applicants have every opportunity to qualify for a mortgage" - all undertaken in an effort to greatly expand home ownership.

Over the next 12 years trillions of dollars in additional affordable housing and CRA commitments would be announced and fulfilled by Fannie, Freddie, Countrywide, and many of the nation's largest banks.

In a private interview with the chairman of the Financial Crisis Inquiry Commission, Treasury Secretary Timothy Geithner noted:

"Moral hazard was everywhere and endemic. The biggest source was in the GSEs [Fannie and Freddie]. The GSEs were entirely moral hazard."

Government housing policies and the toxic mortgages they spawned were the sine qua non of the financial crisis.