Sheila Bair logged onto her e-mail account recently and got a pop-up ad offering a $175,000 home loan with monthly payments of only $400.
"I thought, 'Oh no, it's coming back already,' " said Mrs. Bair, the Federal Deposit Insurance Corp. chairman who had spotted problems with abusive and risky mortgages long before the mortgage crisis broke out last year.
The pop-up on the screen took her back several years to the time she first saw trouble brewing. The ads had been the warning flags: pop-ups, spam e-mails and junk-mail fliers offering loans at extraordinarily easy terms and low rates without explaining that the payments would eventually shoot up to unaffordable levels — a practice that will be banned in the future.
Today, federal regulators are on the firing line trying to explain why they were seemingly asleep at the switch and failed to crack down on the abusive loans that led to the worst housing bust and financial collapse in modern times.
If regulators failed to act quickly or aggressively enough, they can share the blame with most of their interrogators in Congress. Elected officials did little to deter risky lending and instead mostly sat on the sidelines between 2000 and 2006, cheering on the housing boom and the easy mortgage financing that made it possible.
Three years ago, those early signs prompted a fruitless effort by the FDIC, the Federal Reserve and other regulators to warn banks against the risky lending practices that were proliferating, including loans with teaser rates as low as 1 percent whose monthly payments could more than double once the loans adjusted to market interest rates.
While that light-handed regulatory guidance may have been heeded by a few banks it had no effect on the legions of mortgage brokers operating outside the banking system. They took their marching orders from Wall Street investors ready to throw billions of dollars into the lucrative mortgage securities derived from pools of subprime and exotic loans.
Brokers joked that anyone who could fog a mirror could get a loan, borrowers exaggerated their incomes with impunity, and the race to the bottom in lending standards went largely unchecked until the market for such loans collapsed in the middle of last year. The crisis brought on by accelerating defaults on subprime loans quickly spread to nearly every corner of the credit market.
It seemed like a win-win situation when the boom was raging. Many first-time buyers attained the American dream of homeownership while the 70 percent of Americans who already owned homes watched their household wealth soar along with house prices.
Federal and state tax coffers were filled with revenue generated by booming home sales and prices, and political leaders reaped millions of dollars in campaign contributions from the profitable real estate and mortgage businesses and Wall Street firms, all of which benefited from keeping the party going.
"Everybody was happy," said Mrs. Bair. No one in Washington wanted to break up the financing orgy and end the housing bonanza. "So long as prices were going up, not many people were complaining. ... Consumers were getting these mortgages, but they could refinance out of them" when the payments shot up, as long as the market remained strong.
As a top Treasury official in 2001 and 2002, Mrs. Bair worked with consumer groups and other regulators to try to establish voluntary "best practices" aimed at marginalizing predatory lenders, but the effort went nowhere. Legislative efforts on Capitol Hill spearheaded by leaders of the House Financial Services Committee — Reps. Barney Frank, Massachusetts Democrat, and Spencer Bachus, Alabama Republican — fared no better.
"Back then, we mainly looked at it as a consumer issue. I don't think anybody thought it had economic implications," Mrs. Bair said. Few people at the time had "a full appreciation of the costs of these mortgages, or [realized that] if the market stopped going up [borrowers] would lose their ability to pay."
The result is a record level of foreclosures and a major credit crisis that likely has thrown the economy into recession. Many analysts compare it to the savings and loan crisis two decades ago, when lax federal policies allowed a proliferation of fraud and abuse in bank lending that ended in a big real estate bust and recession.
"The smart people really screwed this one up," said Mr. Frank, now chairman of the House committee. He has spent much of the last year threatening to impose a heavy-handed legislative hammer on the financial industry if voluntary and regulatory efforts by the administration fail to make headway toward resolving the crisis and cleaning up lending standards.
Mr. Frank and many financial analysts say Alan Greenspan, the former Federal Reserve chairman, made a "grave mistake" by refusing to impose tougher standards on the industry. The Fed is the only regulator with the broad authority to curb lending abuses both by banks and the army of mortgage brokers operating outside the banking system.
Many economists also blame the extraordinarily low interest rates Mr. Greenspan engineered in 2003 for getting the housing bubble going and enabling lenders to offer unbelievably low teaser rates that eventually adjusted to higher rates that borrowers couldn't afford.
Under prodding from the House and Senate banking committees, Mr. Greenspan's successor, Ben S. Bernanke, used the Fed's powers in December to propose a nationwide ban on the most abusive practices.
Those included lending to borrowers with poor credit with no income documentation, advertising loans with low teaser rates without informing borrowers about future increases, and coercing appraisers to ratify inflated house values. The rules are expected to be finalized soon.
Mr. Greenspan declined to answer questions for this article. An ardent advocate of free markets and deregulation, Mr. Greenspan generally disliked government intervention in financial markets and once boasted that President Reagan signed off on every proposal to deregulate markets that he presented him as chairman of the White House Council of Economic Advisers before he joined the Fed.
Mr. Greenspan also frequently discouraged Congress from regulating the huge and complex market of credit derivatives — estimated at $62 trillion — which became a key source of financial instability in March, threatening the bankruptcy of Wall Street titan Bear Stearns and forcing the Fed to intervene with a bailout.
But even the free-market enthusiasts at the Bush White House, who also sat on the sidelines while the lending debacle developed, say they have learned a lesson about allowing easy-money loans to proliferate.
Keith Hennessey, chairman of the White House National Economic Council, said if the administration could do anything differently to have prevented today's housing crisis, it would have encouraged the Fed to crack down on lending abuses much earlier.
"If you had a magic wand, would you have liked to put those regulations in place a few years ago? Sure," he said. "But it's not the government's job to necessarily step in and interfere in private market actions. Our job is to see if the market is creating distortions" and make corrections through regulation only if necessary, he said.
Treasury Secretary Henry M. Paulson Jr., similarly, has testified that today's housing morass was created by years of lax lending standards. "We had a dry forest out there," he told the Senate Banking Committee in mid-February.
One factor that appeared to prevent the Fed and the administration from moving earlier against abuses was their preoccupation early in the decade with trying to reduce the dominant role played by Fannie Mae and Freddie Mac in the market for mortgage securities.
Arguing that the government enterprises had grown too large, competed unnecessarily with private securities firms and Wall Street brokers, and posed a potential risk to taxpayers should they ever fail, the administration and regulators actively pushed for increased privatization of the mortgage securities market.
Their efforts to diminish the role of Fannie and Freddie were largely successful. Responding to pressure from the administration and Congress and public pressure created by accounting scandals in 2004, the agencies massively withdrew from the market.
Mortgage-backed securities issued by the agencies peaked at $1.9 trillion in 2003 but fell to less than $1 trillion in 2004 and stayed there until last year. After the subprime mortgage crisis began, issuance crept back up over $1 trillion, according to Inside Mortgage Finance.
As the gigantic housing agencies' presence in the markets shrank, private securitizations of unconventional, subprime and exotic mortgages took off. The amount of such "private-label" mortgage securities soared from $136 billion in 2000 to $864 billion in 2004 and peaked at $1.2 trillion in 2005 before plummeting last year to $707 billion with the collapse of the subprime market.
The administration's and Fed's obsession with curbing the empire of Fannie and Freddie likely accelerated the crisis, analysts say, as the mortgage agencies had been in effect the main "regulators" in the market throughout the housing boom, imposing minimum lending standards on independent mortgage brokers seeking to sell them loans.
Fannie's and Freddie's seemingly old-fashioned insistence on making loans to people with good credit, documented income and a stake in their property caused them to lose market share to private issuers who abandoned traditional standards.
Fannie and Freddie made limited forays into the nontraditional loan market, but their higher standards enabled them to survive the mortgage market rout last summer that wiped out the subprime industry and many firms specializing in exotic and jumbo loans. Since that time, the agencies have played a larger role than ever, providing three-quarters of the funding for new mortgages today.
The laissez-faire policies that led Mr. Greenspan and the administration to encourage privatization of the mortgage market and hold off regulating lenders reflected both their deep-held convictions as well as Republican orthodoxy about how to best manage the economy.
But they also catered to the interests of the administration's financiers. During the critical 2004 political campaign when subprime and exotic lending was taking off, Mr. Bush was by far the top recipient of funding from all the affected industries — including Wall Street investment firms, commercial banks, savings and loans, credit companies, and mortgage and real estate brokers.
The $23.8 million Mr. Bush raked in from financial and real estate businesses that year was more than two times the $10.6 million received by Sen. John Kerry of Massachusetts, the Democratic presidential candidate and the second top beneficiary of financial contributions, according to OpenSecrets.org.
Some key lawmakers also were among the top recipients of finance company cash. Sen. Charles E. Schumer, New York Democrat who became Joint Economic Committee chairman when Democrats gained control of Congress in 2007, pulled in $2.65 million from financial firms. Sen. Christopher J. Dodd, Connecticut Democrat who became the Senate banking chairman, attracted $2 million.
Both of those Democrats, even while out of power in 2004, received more contributions from the financial sector than Sen. Richard C. Shelby, Alabama Republican, who was then chairman of the Senate Committee on Banking, Housing and Urban Affairs.
Other Democrats who enjoyed the largesse of financial firms were Sen. Barack Obama, freshman Illinois Democrat, with $1.8 million in contributions; and Sen. Hillary Rodham Clinton, freshman New York Democrat, with $1 million.
The campaign contributions shed light on why Congress was sluggish in responding to the developing crisis. Mr. Dodd, while berating the Fed for not cracking down on abusive lending, spent much of last year campaigning for the Democratic presidential nomination and failed to push legislation through his committee addressing the housing crisis even as Mr. Frank shepherded a comprehensive bill through the House.
Mrs. Clinton has pushed for vigorous action to address the mortgage crisis, calling for a nationwide moratorium on foreclosures last fall, while Mr. Obama crafted his response to the housing crisis only this spring and took a less heavy-handed approach toward the industry.
While the politicians were blinded by the contributions to the risks created by the unbridled housing and lending bubbles, they were able to tell the public about the benefits of the housing boom and the easy loans that fed it.
Mr. Bush touted the "ownership" society as one with less crime and social ills and more jobs and opportunities, while Democratic lawmakers trumpeted that loans with low initial payments and easy terms enabled many disadvantaged Americans to stretch their incomes and become homeowners for the first time. Subprime loans, in particular, went disproportionately to black and Hispanic borrowers.
In addition, a community reinvestment law passed by Congress in the 1990s required banks to go to great lengths to make loans available to minorities. Many mortgage brokers who made loans to people who couldn't afford them rationalized that they were just doing what Congress and the federal authorities wanted.
"The political pressure to create a housing 'happy meal' was enormous," said George Cormeny, a former loan officer and vice president at Allfirst Bank who also worked as a legislative aide. The circular reasoning rationalizing the subprime lending boom became "unreal" to any longtime observer in the lending world, he said.
"A financial institution would be rewarded with a good score and heaps of praise for making increasing quantities of poor quality housing credit available to marginally credit worthy borrowers," he said. "The regulators had almost complete disregard for the consequences. ... The costs of this social experiment will be large and linger for a long time."