Just as the Sarbanes-Oxley law sidestepped the securities fraud perpetrated by Enron and WorldCom, and instead focused on corporate governance, Dodd-Frank also deliberately misses the point. Washington’s grab-bag habits stem from the fact that few members of Congress have the time, let alone the inclination, to study finance, much less the intricacies of a bill such as Dodd-Frank. When it comes to designing legislation, members and their staffs ultimately are led around by the nose by big-bank lobbyists who finance reelection campaigns—or not. But the most telling point about Dodd-Frank is that even with thousands of provisions it does not address the root of the crisis—namely, the government’s intimate involvement in housing finance.

THAT INVOLVEMENT goes back to the Great Depression and, before that, to progressive-era concepts that came to the fore in American politics during World War I and the presidency of Woodrow Wilson. In terms of the origins of the subprime crisis that led to the passage of the Dodd-Frank law, obviously housing is the main foundation. Government subsidy and promotion of home ownership by all Americans from the 1930s onward is the historic precursor of the collapse of the U.S. financial markets in the last decade. The failure of markets for private mortgage securities would start the avalanche that became known as the subprime crisis, but the entire U.S. mortgage market was built upon a financial and legal template that assumed a leading role for Uncle Sam.

Since the turn of the last century, American progressives have pushed for legal remedies to contain the worst tendencies of big business and the malefactors of wealth. A main goal of the progressive movement was purification of government by exposing corruption and undercutting political machines and bosses. The other notable tendency in Washington from World War I through the Great Depression was the creation of “parastatal” entities in Washington, modeled after 1920s European countries experimenting with fascism and Communism, especially Italy, Germany and the Soviet Union. The use of GSEs during World War I and the New Deal reinforced this model of a direct and continuing role for the federal government in the U.S. economy, a model that was effectively combined with the progressive urge to use the state as an agency for social good. GSEs such as the Reconstruction Finance Corporation (chartered by President Herbert Hoover, a Republican with progressive leanings) were explicitly modeled after European organizations.

This tendency to rely upon the state rather than private individuals for economic solutions very much underlies the U.S. approach to housing in the post–World War II era and reflects a broader philosophical conflict in the American body politic. It is worth noting that when Franklin Roosevelt commanded that Congress pass the Glass-Steagall laws, it was, of course, good politics to attack the big banks and Wall Street speculators, just as it is today. In 1936, the Journal of Social Psychology sought to survey latent authoritarian tendencies of the American populace. While the vast majority of respondents described themselves as antifascist, they also expressed support for fascist views so long as they were not identified as such, as renowned cultural historian Wolfgang Schivelbusch recounted in his 2006 book Three New Deals. Even Walter Lippmann had declared during the early stages of the Great Depression that perhaps the time had arrived to roll up the Constitution and put it into abeyance. The grim economic realities of the Great Depression made Americans amenable to authoritarian views that would never have won majority support prior to World War I or during the Roaring Twenties.

After losing the 1932 election, Hoover identified housing as one of the more attractive areas for generating employment. Though he was highly critical of FDR’s New Deal public-works programs and mildly critical of government providing cheap credit for private business, he supported the use of housing to create jobs. “The American people are always underhoused both in quantity and quality,” Hoover declared in pressing his case for government support. Hoover, who had served as commerce secretary in both the Harding and Coolidge administrations (and as Wilson’s Food Administration chief during World War I), was no ideologue when it came to the economy. Unfortunately, FDR and the Democrats in Congress ignored Hoover’s proposal in 1933 to use the newly created Federal Home Loan Banks to discount mortgage loans, a proposal that “would have done more good than billions in tax money,” Hoover wrote in his three-volume memoirs.

The New Dealers were not about to let a good crisis go to waste if they could leverage it to gain a firm grip on political and economic power, which is what they did. And it’s fair to note that the Great Depression was so deep because of the flimsy condition of the mortgage-finance industry a century ago. Mortgage finance in the early 1930s was primitive and definitely not consumer friendly, providing a ready laboratory for progressive reform under FDR and the New Dealers. Banks did not typically provide mortgage loans, which instead were short-term instruments financed by title and insurance companies.

From the New Deal onward, the market for home mortgages was dominated by federal housing agencies such as the Home Owners’ Loan Corporation (HOLC) and the Federal Housing Administration (FHA). The HOLC had the power to restructure existing home loans, while the FHA provided a guarantee for investors to encourage them to hold mortgages. From the mid-1930s, the government provided a guarantee to investors willing to invest in mortgage paper, thereby creating a marketplace that otherwise would not have existed. Their key innovation was to change the structure of the mortgage from what was essentially a short-term demand note into a long-term (typically twenty-year) fixed-rate, self-amortizing debt instrument.

Once the immediate emergency of the Depression was met, however, the federal apparatus created around housing continued to operate and perform a role that the private sector would not. The HOLC was dissolved and the FHA remained as guarantor. Fannie Mae was created to facilitate a secondary mortgage market. Owing to laws passed during the Depression and several earlier landmark Supreme Court decisions, the private sector was not yet prepared to underwrite twenty-year fixed-rate mortgages without a guarantee. The FHA provided surety for private investors, and Fannie Mae helped banks fund term loans. But the key point is that by embracing a government-intervention model similar to those of European nations such as Germany and Denmark, Roosevelt fundamentally altered both home financing and the country’s political economy. FDR effectively replaced traditional private lending with publicly supported risk-pooling, rendering home loans more affordable but also injecting a large public subsidy—as well as the same type of cronyism and political corruption one now sees in the European Union’s largely nationalized banking sector.

During and after World War II, the U.S. government provided subsidized loan guarantees to returning soldiers, creating a new entitlement for housing that would eventually grow into a more general federal subsidy for much of the middle class. In 1944, a Veterans Affairs loan program was added to the Veterans Bill of Rights. By 1948, Fannie Mae was buying VA loans and adding greatly to credit availability. In 1968, Fannie Mae was split in two, creating Ginnie Mae to continue underwriting government-guaranteed mortgages while Fannie Mae was “privatized.”

An August 1968 memo from Housing Secretary Joseph Califano to President Lyndon Johnson outlines the budget savings from the Fannie Mae privatization. Even as the Johnson White House planned the privatization, though, Fannie Mae was pursuing an ambitious effort to promote greater home ownership. “It will probably save some $200 million in the budget by having the private corporation, rather than the public Fannie Mae, sell bonds in September,” Califano told the president. Little did the secretary know that four decades later, a pseudoprivate Fannie Mae would nearly bring about a collapse of the U.S. financial markets.

Congress created Freddie Mac in 1970 to securitize mortgages originated by savings and loans. Only then did the private sector begin to think about getting into housing finance in a serious way, without a federal guarantee for the credit risk on the mortgage. Indeed, from the 1970s onward, a procession of federal subsidies and initiatives increased the federal support for the U.S. housing sector. In 1987, Congress passed tax rules for “Real Estate Mortgage Investment Conduits,” which gave Fannie and Freddie an effective monopoly over the market for residential mortgage-backed securities. The fact of this legal monopoly opened the door for the GSEs to underwrite and sell toxic loans to investors under the benign label of “short-term government securities.”

IN THE FORTY years since Freddie’s creation, the U.S. housing market has gone through dramatic boom-and-bust cycles. In 2006, the private sector was underwriting a significant portion of the overall mortgage market, but today private mortgage lending has almost disappeared. Virtually all of the $1.5 trillion in residential mortgages that will be underwritten in 2013 will carry a federal guarantee. Private mortgage-backed securities will probably total no more than $50 billion this year, down from hundreds of billions annually before the crisis. The last decade may mark a peak for private financing for mortgages—and for home ownership—that may not be reached again.

Image: Pullquote: The terrible irony of Dodd-Frank is that it seeks to address the misdeeds of Washington and Wall Street by reducing the availability of credit for American consumers at both ends of the credit spectrum.Essay Types: Essay