*****

Once upon a time, the U.S. government created the secondary mortgage market. (During FDR's New Deal, if you're dying to know). With help from the agency known as Fannie Mae, this government creation grew tall and strong. What's more, the government held a virtual monopoly over its creation for several decades -- and after all, the market was its creation.

And this was a prosperous market indeed! Fannie perfected the practice of "securitization," whereby it bundled mortgage loans into tradeable securities. Everybody was happy. The getting was so good that, with a wink & a nod, the government made a partner for Fannie, and called him Freddie Mac -- eventually, the time came when they were even allowed to call themselves Private Corporations! The handsome couple was a model of stability.

Now, going private meant Fan and Fred lost their monopoly over the secondary mortgage market, and securitization was loosed upon the world. Yet the couple was more than clever enough to meet this challenge. Big Brother government's wink & nod meant Fan and Fred could get away with a slightly naughty ploy -- namely, paying just a wee bit less in yields than the competition. This discount was the value that investors placed upon Big Brother's wink & nod.

Alas, a suitably potent mix of time, monetary policy, and mania psychology can turn even the happiest couple ... well, into something it didn't used to be. The 1980s arrived and Fan & Fred stopped behaving like "government sponsored entities" and started acting like hedge funds. They created ever-more elaborate ways to transfer large interest rate risks. Derivatives and interest-rate options found their way into the mix. But Fan and Fred's competitors were no less creative. More time passed, and fewer and fewer mortgage lenders held on to the debt. Securitization became the norm.

The secondary mortgage market was a financial party, and Fan and Fred got a little crazy. They held more than a trillion in mortgages, and saw fit to pay millions to dozens of their executives. They got into some trouble with Big Brother in 2003, but their "time out" in the corner didn't last long. Interest rates had fallen to 50-year lows, and an even bigger mortgage market party -- the "Subprime Bash" -- was about to begin. They intended to be the stars of the show.

Tune in for Part Two tomorrow.