THE ECONOMY

The ultimate bill for taxpayers could run more than $1.3 trillion as the government tries to clean up the mess made by one of the worst financial crises since the Great Depression.

The 14-month-old turmoil began when homebuyers with less than stellar credit began to default on their mortgages. Foreclosures soared.

The problems spread to more creditworthy borrowers. Hedge funds, banks and other investors in mortgage-backed securities took a huge financial hit.

Over the past six months, some of the biggest names on Wall Street went out of business, merged or revamped their structure.

Looking back on how the mess was made, critics say regulators’ absence wasn’t the sole cause of the credit bubble, but Washington’s decisions set the stage for the crisis and exacerbated it once it began.

The most important decision may have been the Federal Reserve’s move to keep interest rates near all-time lows for three years, which acted as a clearance sale for borrowers.

The Fed cut its target short-term interest rate for overnight loans to banks, the federal funds rate, from 6.5 percent in 2000 to 1 percent in 2003. Loans for cars, homes and houses were on sale, almost 85 percent off.

Cheap credit spurred the rise in housing prices. The Fed viewed that rise as fuel for the economy after the burst tech bubble and the Sept. 11 attacks.

“Fixed mortgage rates remain at historically low levels and thus should continue to fuel reasonably strong housing demand and, through equity extraction, to support consumer spending as well,” former Fed Chairman Alan Greenspan told Congress in July 2002.

At the same time, international changes in bank regulation in 1988 and 2001 lowered banks’ reserves.

The reserves, kept in banks’ vaults and with their regional Fed banks, are their cash cushion; when borrowers don’t pay back loans, banks can cover the shortfall with their reserves. That meant they had to hold on to less money when they made loans, effectively freeing more money to lend, but giving them a much thinner cushion if loans soured.

Associated Press