The descriptions have ranged from "meltdown" to the oft-used "crisis", but whatever one calls it, the US financial sector is a mess.  The government has responded by facilitating the breakup of a former Wall Street titan (Bear Stearns) allowing another to fail (Lehman Brothers), a bailout of an insurance giant (AIG), and a takeover of two "government sponsored entities" (Fannie Mae and Freddie Mac).  Much of this is an extension of what started as the so-called "subprime contagion" — the defaulting of mortgage loans made to higher credit risks, coupled with an overall bursting of the housing price bubble.  The activist government response is predictable, as is the political rhetoric:  the situation is most commonly blamed on a lack of government regulation and overzealous capitalists on Wall Street. 

The common storyline is that those greedy capitalists need to be more effectively reigned in, lest they hungrily feed on the economically powerless like vampires at a blood drive.  The conventional wisdom, especially with the campaign rhetoric, is that mortgage companies were using "predatory lending practices" to prey on unsuspecting consumers, herding them into loans they couldn't afford — all in the name of profit.

But is the conventional storyline correct?  To paraphrase a famous Reagan quotation, is the government part of the solution or part of the problem?  Is our current problem the result of too little regulation of the market, or of too much?  Was this current mess a surprise, or was it preventable?

One explanation of the mortgage-market crash proposed by free market-oriented commentators is that banks were given "encouragement" from the government to make more loans to low-income, high-risk home buyers — those sub-prime mortgages.  They were also encouraged to loan money with looser rules on down payments, dropping the amount required to secure the loan.  A story in the New York Times from 1999 provides some potential explanation:

the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The action ... will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.

...Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people...

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer.

...By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

...In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

Even within that same article was the following warning that seems 9 years ahead of its time (emphasis added):

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''

Others repeated that warning later.  As detailed by Cafe Hayek, a George Mason economist had this to say in 2001 about Fannie and Freddie (emphasis added):

These privileges do more than just give the GSEs a funding cost advantage, they also reinforce the perception of a federal guarantee on GSE debt obligations.  In order to avoid a federal bailout like the one we saw with the savings and loan industry, policymakers may want to consider a variety of alternatives, including privatization of one or more of the GSEs.

Further warning was detailed in this article from Business Week in 2002 (emphases added):

And mortgage lenders are willing to oblige, even in the case of buyers who might not have qualified before. The average downpayment has dropped to only 5% to 10% over the past decade rather than the 10% to 20% it was in the past, according to Doug Perry, a first vice-president at mortgage lender Countrywide Home Loans Inc. Under the right conditions, Countrywide is even willing to lend homebuyers 103% of the value of their new home to cover their closing costs, too.

In part, the aggressive tactics of mortgage lenders have been made possible by the automated underwriting systems developed in recent years by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These two government-created companies buy 70% of new mortgages in the U.S. and repackage them as mortgage-backed securities, which they then sell to investors.

The new underwriting systems being used by Fannie Mae and Freddie Mac, which are analogous to the credit-scoring systems used by banks, allow for higher loan-to-income ratios than in the past to encourage home buying. That's good for borrowers, but the relaxed ratios could pose serious problems in the future. For one, there is already evidence that defaults are rising, particularly at the low end of the market...

...Moreover, investors in mortgage-backed securities have always assumed that the two mortgage companies are backed by an implicit government guarantee that investors would be bailed out in the event of big mortgage defaults.

Ultimately, the Clinton Administration pursued a policy to increase home ownership among low-income families by increasing the incentives for banks to make high-risk loans, putting the taxpayers on the line.  This policy fit in well with President Bush's "ownership society" philosophy, so the problem is a bipartisan one.  And, of course businesses saw the opportunity to reap profits with minimal risk — the government would give them the incentive to make loans they might not otherwise have made with lower down payments, with the implicit guarantee that if things came tumbling down the government would bail them out.

That's not free market capitalism.  It might go against the conventional "wisdom" and greed was certainly involved, but greed is not the same as rational self interest; government intrusion in the marketplace fuels the former, while the latter is the basis of a free market — a free market distorted by the government.