1. The U.S. government, armed with the Community Reinvestment Act, forces banks to make home loans to people who cannot afford to repay the loans. At the same time …

2. Fannie Mae and Freddie Mac—government-sponsored enterprises (GSEs)—create a credit-scoring formula with a very low qualifying score. They give this formula to banks and say, “If you make a home loan to anyone who meets this low score, we will buy the loan from you at a profit to you.” The banks play along and make more of these bad loans. The GSEs play along too and buy the bad loans from the banks. The GSE’s create a portfolio of about $6 trillion (half the home-loan market) in this manner.

3. At this point, the mortgage crisis is unavoidable, because this mortgage portfolio that is nominally worth $6 trillion is really worth much less, because the people who took out the mortgages will not be able to pay them back. And the money is gone, into the hands of those who sold the homes and then bought things that they never before thought they could afford and that they did not really need.

At this point in our process, the GSEs are holding the bag. But they get bailed out by unwitting investment firms and insurance companies, through the following scheme that has been going on concurrently with Steps 1 and 2 above.

4. For years, government officials have hinted, suggested, implied, and never denied that the government stands behind these dicey mortgages. Private investment firms, foolishly, are inclined to believe this. After all, these loans serve the government’s social goal of affordable housing (i.e., robbing from the rich to give to the poor); surely the government would not let such a “noble” program fail.

5. So, the GSEs package these loans into large bundles, and private investment firms buy the bundles. Now these private investment firms are holding the bag. And these firms create even larger bundles of mortgages, classified by degree of risk, and sell them to other private firms. Now those private firms are holding the bag.

6. The private firms still trust that the government will stand behind these loans if too many of the loans go bad, but—just to be safe—they want some insurance. And so they make a deal with firms such as AIG. AIG sells insurance (called “credit-default swaps”) that promises to reimburse the private firms in case the mortgages go bad. AIG is not worried because, after all, the underlying assets—the mortgages—were created by the government to carry out noble social policy; if anything goes wrong, surely the government will stand behind these securities and “bail us out.” Now AIG is holding the bag.

7. Eventually, everyone realizes that many of the mortgages are virtually worthless, and AIG has to pay up on the insurance it wrote. Barney Frank, Chris Dodd and the rest of the government say to AIG and investment firms: “You incompetent fools [for buying and insuring what we were selling]! Okay, we will bail you out, but it will cost you. From now on, we own you. And we’ll decide your salaries.”

Memo to owners of US Treasury instruments: You could be next.

(See also The Tyrant’s Lies Against Capitalism)