Maybe the problem is not capitalism, or a failure of the "free market" economy, but the failure of political interference in a free market economy. Congress passed legislation, signed by Carter, like the Community Reinvestment Act, which gave community activists and organizers the right to stop a banks growth if the bank didn't make loans available to unqualified borrowers. This legislation forced banks to lend to uncreditworthy borrowers, mostly in minority areas. Banks were forced to give loans to people with bad histories of creit because of policies like this, which specifically stipulated that "a banks activities must help meet the credit needs of the local communities in which the banks are chartered," otherwise those banks wouldn't be able to expand lending, add new branches, or merge with other companies. Congress did this to increase homeownership and make credit more available to minorities and the poor. They thought the loans would be paid off when rising home values led borrowers to access their equity through refinancing, while others sold and moved up. However, this didn't happen.
Banks knew that the majority of these loans would fail, but it was the price they had to pay in order for their bank to expand and grow. By doing this, banks did overleverage and take risks they shouldn't have, but you could say it wasn't all from greed or untrustworthy lenders, instead it was also brought about through political pressure. Basically, banks didn't necessarily want to give loans to people who couldn't afford them, but politicans told them to to give the loans to minorities. The number of mortgages extended to Hispanic applicants jumped by 87.2 % from 1993 to 1998, according to Harvard University's Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 % and the number of Asian Americans by 46.3 %.
The banks who didn't give out more loans to minorities were seen as racist, as evident in the CRA ratings, which measured how diverse a bank's portfolio is. In July 1999, the Department of Housing and Urban Development proposed that by the year 2001, 50 % of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. In 1998 alone, 44 % of the loans Fannie Mae purchased were from these groups. So loans was given under political pressure and millions of these loans, as predicted, failed. Now we are in the situation we are in today.
It should also be noted that in 1992 President Clinton pushed for more rules requiring lenders to give loans to unqualified borrowers. In 1993, President Clinton's comptroller of the currency, Eugene Ludwig, told the Senate Banking Committee that "We have to use every means at our disposal to end discrimination and to end it as quickly as possible," in response to the administration's suport for this practice. So in the name of diversity, banks made a huge amount of loans that would otherwise not been made. Because of Congress's support, loans increased from $35 billion in loans in 1994, to $1 trillion by 2008.
In 2003 President Bush recomended a significant reglatory overhaul in the housing finance industry, but the democrat controlled Congress stopped him. One democrat, Rep. Baney Frank, with strong ties to Fannie Mae and Freddie Mac went so far as to say "Fannie Mae and Freddie Mac are not facing any kind of financial crisis" and that"the more people exaggerate these problems, the more pressure there is on the companies, and therefore the less we will see in affordable housing." During this time, Fannie and Freddie grew heavily involved in "community development," giving money to local housing rights groups and trying to avoid groups, such as ACORN, for whom Obama once worked for in Chicago, who went after banks to make these loans.
Since 1989, Fannie Mae and and Freddie Mac have spent an estimated $140 million on lobbying in Washington. They contributed millions to politicians, mostly Democrats, including Senator Chris Dodd (No. 1 recipient) and Barack Obama (No. 3 recipient). This is why warnings, such as the 2005 warning by John McCain, and even attempted legislature by Bush have failed in Congress. In 2005, McCain said "If Congress does not act American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system and the economy as a whole." Too bad no one listened to him.