Steamboat Springs — The recent "bailouts" of Fannie Mae, Freddie Mac, and AIG, as well as the failures, sales and restructuring of virtually all the country's major investment banking houses have caused a lot of concern and misunderstanding.

First, if you look around you, you will notice that the fundamentals of the economy are good. Unemployment and inflation are low, worker productivity is high, the gross national product is high, and the standard of living (particularly of the lowest 25 percent of income earners) has increased dramatically in the past several years. So, it is hard to maintain that recent market problems are attributable to general economic weakness.

Second, although greed and stupidity are always with us, they do not explain a disruption of this magnitude.

The immediate cause has been the lack of liquidity for mortgages and mortgage backed securities. Generally, these instruments have traded like cash, but there is essentially no market for them. Companies holding large volumes of these instruments are unable to convert them to cash on reasonable terms and further (under Sarbanes Oxley - an overreaction to the Enron fraud) they must be immediately marked down to "market value" on accounting statements, even though there is no meaningful market. Thus, capital vanishes.

This is the 21st century version of a run on the bank, but how did we get here?

- Ultimately, much of the cause for this has been the Federal Reserve setting interest rates at artificially low levels - often below the rate of inflation in recent years. This is intended to limit the downturn that is inherent in the natural business cycle, but it subsidizes borrowing and pumps money into the economy that needs to be invested.

- Mortgages, having been among the safest of investments for decades, attracted too many investors. To get the necessary volume invested, lending standards decreased.

- This effect is compounded by the requirement for lenders to make risky loans to subprime borrowers under the Community Reinvestment Act, which has been around since 1977, but was the subject of vigorous enforcement in the late '90s. It should have been obvious that any housing market downturn would cause subprime defaults to shoot up.

- With the rise of the secondary market for mortgage backed securities promoted by Fannie and Freddie (both quasi-government entities), the "lender" with whom a borrower deals has no economic interest in whether the loan ultimately is paid. They get their commission anyway.

- This is enough of a prescription for disaster, but, compounding it, Fannie and Freddie carried a combined mortgage securities portfolio of more than $1 trillion, financing 97 percent of these holdings with debt and only 3 percent with equity. Clearly any significant market downturn would destroy entities so financed.

The cause of this debacle is essentially bad regulation. The way to affordable housing is not forcing lenders to make risky loans. The Federal Reserve cannot eliminate the business cycle - at best, it can cushion it somewhat. Governmental bodies, such as Fannie and Freddie, cannot be exempted from sound business practices - no matter how massive their political contributions. Ignoring these logical limitations to the abilities of government is bound to lead to problems.

Because the situation was allowed to go this far, we are probably in a situation where the government will need to invest in mortgages to provide liquidity to the market, much as it did in the Great Depression. However, there is no reason that this program cannot be profitable to the taxpayers, like the Depression program was. The devil will be in the details.

Additional regulation, however, is only likely to have the same effect as prior regulation and worsen the problem.