The mainstream media’s narrative for the financial meltdown of 2008 generally states that a bunch of overly greedy Wall Street insiders cooked up inscrutable instruments like CDOs and MBSs, and then parsed them into further inscrutable derivatives like default swaps until nobody knew how much risk was out there. These instruments, which ultimately relied on debt structures up to 98% of their assets, were destined to fail given any correction in the underlying real estate assets’ value. Occasionally, reporters throw in that Congress abetted the process by fueling excesses at Fannie Mae – Rep. Frank’s famous “roll the dice” quote says it all. Even rarer is a mention of how the Bush Administration repeatedly tried to put the brakes on the debt orgy.

Naturally, the whole mess stirs up the regulatory instinct in Washington. In the shadow of cap and trade and socialized medicine, Congress is rewriting government’s role in the capital engine. The premise, especially on the Democrat side, is that the free market gets risk wrong and is prone to excess swings. Government’s new role is to monitor aggregate risk, even regulating healthy firms. In effect the new laws will make Washington the gateway for all capital formation in the US.

But what, really, did the free market have to say about securitized mortgages and the rest of the debt bubble? The open market measures risk by comparing a risky security to a similar but risk free security (e.g. government bonds). Most often this is expressed by the difference in return between a security and a US Treasury Bond (i.e. the spread). Riskier investments carry higher spreads, thus compensating investors for the relative lack of certainty of being repaid in full. By March 2008, before the bubble burst, the spread on a Fannie Mae bond had reached 258 basis points, or an extra 2.58% return per year over a similar government bond. By Comparison, two years earlier the equivalent spread wasy only 39bp (0.39%). Remember that these Fannie Mae instruments were considered highly safe by government approved risk experts (e.g. S&P and Moody’s). These bonds were considered as safe as any private sector security, plus most people believed that Fannie Mae enjoyed the implicit guarantee of the government.

Why would a AAA rated bond with an assumed government guarantee require a 258bp premium to sell in the open market? The answer is that the market knew something was badly amiss. In the absence of a AAA rating and a government guarantee, the bond should have been priced as junk.

Why the AAA rating when the market knew better? The government actively contains the number of firms who issue such ratings, effectively creating a triumvirate that works in tandem. By allowing merely three agencies, there was little chance of a maverick questioning the status quo. Further, these agencies would hardly benefit from a reputation of being deal killers. Still further, since the government sponsored both Fannie Mae and the unofficial rating agency oligopoly, rocking the boat would be unwise. The ratings agencies rubber stamped MBSs, and their opinions were not valued by sophisticated bond investors.

The government’s medling with risk standards definitely caused the real estate bubble and collapse that engulfed the entire financial sector, but that is hardly stopping Washington from making things worse. Currently, the FDIC is hastening a commercial real estate collapse by arbitrarily requiring larger reserves for commercial loans than for residential loans. Even if a given commercial loan is performing well, the FDIC is requiring up to 30% more in reserves for that loan than for an even marginal residential loan. As a result, commercial lending is collapsing and dragging down both good and bad business properties.

A free market that assesses risk would not paint with such a broad brush, but because the government has no skills at its new task, it can only generalize risk policies. Naturally, favored special interests are exempt from government risk restrictions, further distorting the efficient flow of capital.

While Pres. Obama’s plans to socialize health care, expand union influence, and eliminate energy dependent industries will harm the US, his sweeping plan to regulate and distort the process by which businesses form and grow is just as threatening. Voters need to know that government manipulation of risk assessment largely caused the 2008 disaster and that further government distortions of the free market system are not the path to recovery.