Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged.

The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs. As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created — and ultimately provided most of the money for — new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

The biggest offender? Not Bear Sterns or Lehman Brothers, but Merrill Lynch, now part of Bank of America.

Just before the financial crisis and credit crunch, it originated 31 collateralized debt obligation deals and ended up purchasing parts of 13 of them, for instance.

Without those extraordinary measures, they say, the United States’ GDP would be 6.5 percent lower, the unemployment rate would be 3 percentage points higher, there would be 8.5 million fewer jobs and the economy would be experiencing deflation. Blinder is a professor at Princeton and a former Fed official. Zandi is the chief economist at Moody’s Analytics and a former adviser to Sen. John McCain’s (R-Ariz.) presidential campaign.

The economists also note that the stimulus — the $787 billion American Reinvestment and Recovery Act — had less impact and proved less important than the government’s monetary policy and financial-market stabilization measures, like the Fed buy-up of mortgage-backed securities.

Zandi and Blinder write:

It is understandable that the still-fragile economy and the massive budget deficits have fueled criticism of the government’s response. No one can know for sure what the world would look like today if policymakers had not acted as they did — our estimates are just that, estimates. It is also not difficult to find fault with isolated aspects of the policy response. [...]

While all of these questions deserve careful consideration, it is clear that laissez faire was not an option; policymakers had to act. Not responding would have left both the economy and the government’s fiscal situation in far graver condition. We conclude that [Federal Reserve Chairman] Ben Bernanke was probably right when he said that “We came very close in October [2008] to Depression 2.0.”

Bullard says that the Fed might start selling off mortgage-backed securities — it owns around $1.2 trillion of them, most purchased from Fannie Mae and Freddie Mac — later this year, using a “reverse taper.” The Fed would start selling nominal amounts, and gradually increase the volume to figure out what the market can bear.

Mr. Bullard acknowledged that longer-term rates could rise “a little bit” but said the outcome would depend on how much is sold and over what period. He suggested starting with $100 billion in sales to assess the market impact. “It would still be very accommodative,” he said, but would allow the Fed to start normalizing its balance sheet.

“I would start slow and then move based on the economy,” Mr. Bullard said. “I would want to ensure markets that you would do it slowly over a longer period of time.”

Indiviglio writes:

One big problem: the government-sponsored mortgage entities, which essentially everyone agrees paid a major role in the financial crisis. They have been the recipient of a still growing $200 billion bailout.

One [New York Times] source agrees: “Lawrence J. White, a finance professor at New York University, said it made no sense to overhaul financial regulation without addressing the future of federal housing policy. He said he was trying to find the strongest possible words to describe the omission of Fannie Mae and Freddie Mac from the legislation. ‘It’s outrageous,’ he finally said.”

This is also a Republican complaint. Fannie and Freddie played a huge role in helping to overheat the U.S. mortgage market. Until those agencies experience some fundamental change in policy and procedures, it’s hard to see how another housing disaster won’t occur again in the future. There’s no attempt at any reform for these companies in either of Congress’ financial regulation proposals.

But I’d push back hard on the notion that the bill “ignores” Fannie and Freddie, the government-sponsored enterprises now backing 90 percent of mortgages. The bill chooses not to handle them, for a number of reasons.

One, the financial regulatory reform bill focuses on re-regulating Wall Street, not changing Washington — on bolstering oversight and regulation of private businesses to ensure that they do not endanger the economy, rather than altering the government’s complicated relationship with housing finance.

A second and related point: The Fannie and Freddie bill might not be as big as financial regulatory reform. But it will be a big and complicated bill. Why roll all of the politicking over the trillion-dollar question of whether to shut Fannie and Freddie down — or whether the government should be in the business of subsidizing mortgages and backstopping the U.S. housing market at all — in with the question of, say, whether Goldman should keep more cash on hand? Why hold up the Dodd bill while Washington figures out how it wants to handle mortgage finance? Why let two potentially controversial bills hurt one another’s chances? Moreover, why group what might be an expensive housing bill in with the slightly deficit-reducing financial regulatory reform bill?

A third point: Washington was ready for the Dodd bill 18 months after the financial crisis. Consensus — whether good or not — had formed around the Dodd proposals. Washington is decidedly not ready for the housing bill — there are no proposals yet, and many on the Hill do not even know the parameters of what Congress might hope to accomplish. (Republicans should stop complaining about this. Their financial regulatory proposal hardly offered a disquisition on Fannie and Freddie. More like a sneeze.)

Finally, the Obama administration has buoyed the housing market this year, engaging in policies to keep fewer people underwater and to soften housing losses for banks. The Fannie and Freddie bill will likely change the housing market, for better or worse — the administration would not want to tackle how to do that now.

But this is the first private issuance of mortgage-backed securities in more than two years — and it has sparked a market frenzy. Redwood Trust’s Brett Nicholas proclaimed, “This transaction has broken the ice in the private mortgage securitization market, which has been essentially frozen since 2008.” Investor demand was high enough that Redwood Trust cut its yield. And citing a turnaround in the private mortgage securities market, Wells Fargo said it is rebuilding its housing finance team.

Gearing up for the market reawakening, Redwood hired Moody’s to rate the securities — expecting a AAA rating, meaning no more of a likelihood of default than the U.S. government. Moody’s delivered. But then, its chief rival in the credit ratings business, Standard & Poors, without having been hired to assess the Redwood mortgage-backed deal, decided it had something to say. On Wednesday, it released a note saying that it did not believe the Redwood residential mortgage-backed securities met its AAA standards. These “jumbo” loans were riskier, it said. Some of the loans have periods where the mortgage-holder only pays the interest rate, and some become adjustable-rate after five years. “If mortgage rates rise, property values remain flat, and the extension of credit is limited, we believe borrowers may face difficulties refinancing,” S&P said.

But the point of this post is not to question whether the Redwood deal is good or not, or whether the unfreezing of the private mortgage-backed securities market is good or not, or whether anyone should care about this deal or not. It is to point out the inanity of the credit ratings business. These Redwood securities have received more scrutiny than any other mortgage deal in recent memory. Investors and the press have poured over them with a fine-tooth comb. They have ginned up hundreds of inches of newspaper space, and hundreds of blog posts and a number of research reports. Presumably, the financial sophisticates buying up the Redwood securities pool have done extensive homework on everything from the risks of these precise Californian jumbo mortgages to the possibility of housing finance bills changing the marketplace down the line.

Nobody really needed the credit ratings agencies to analyze this deal, per se. But the credit ratings agencies did analyze it and… came up with different conclusions. It is as good an argument as any for ignoring the ratings and doing one’s own due diligence. And I wonder, since the financial regulatory reform bill does little to reform the way credit ratings work, whether that might become more common — for sophisticated investors to not care about (and therefore not demand) ratings on smaller and highly transparent financial instruments.

Fed staff in the coming week will present models to forecast how different approaches to reducing the portfolio might play in markets. But some officials worry that they have little experience selling assets and can’t rely exclusively on models to predict how markets will react. That — and a worry about disturbing the vulnerable housing market — has top officials inclined to proceed gradually and cautiously, at a predictable pace. …

In April, Narayana Kocherlakota, president of the Minneapolis Federal Reserve Bank, called for monthly sales of $15 billion to $25 billion to eliminate the Fed’s mortgage holdings within five years…. Some Fed policy makers — among them Charles Plosser of Philadelphia, Jeffrey Lacker of Richmond and Kevin Warsh at the Fed board — are sympathetic.

The Fed — which started buying up Fannie Mae and Freddie Mac securities to perform “quantitative easing,” a way to pump money into the economy when the interest rate is near zero, and stopped on March 30 — now owns a quarter of U.S. mortgage debt. Right now, that debt is actually making the Fed money, generating interest payments worth $20.4 billion last year. But the Fed unloading such massive amounts of these securities will necessarily push their prices down (meaning the Fed could lose money on them) and mortgage rates up (slowing any housing recovery).

But such is the position the Fed is in, unraveling its extraordinary crisis programs even as the recovery is fragile. The Treasury faces a similar problem with its 1.5 billion shares of Citigroup, more than a quarter of the company’s stock.

The company expects the mortgages to be rated AAA. But, BusinessWeek notes, “$67.3 million of the loans were to self-employed borrowers and $66.3 million didn’t require borrowers to document two years of their incomes and assets.”

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

To simplify how the gambit worked: The hedge fund Paulson & Co. (no relation to former Treasury Secretary Henry Paulson) handpicked mortgage-backed securities that were doomed to stop performing, being backed with subprime mortgages, and Goldman packaged them into a kind of bond. Paulson bet against the bond, with Goldman acting as the broker; at the same time, Goldman sold the bond to other clients without disclosing that Paulson had engineered the bond to fail.

The SEC filing notes that those other clients lost $1 billion. Goldman had no direct stake in the success or failure of the CDO. It made money either way. Felix Salmon explains:

The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told Abacus that Paulson had a long position in the deal when in fact he was entirely short.

Goldman Sachs has lost more than $10 billion in market capitalization today, in the wake of these revelations. Good. It can go long markets and it can go short markets. But it can’t lie to its clients. That’s well beyond the pale.

One of the reasons the markets must be so spooked about Goldman? This sort of deal seems to have been ubiquitous during the run-up to the housing crash. This is just one SEC filing. My guess is that more will be forthcoming.

Tomorrow, the subcommittee will release more than 500 documents on Washington Mutual, the $300 billion bank that helped fuel the subprime bubble and then collapsed in the biggest bank failure in U.S. history. It will also hold a hearing with WaMu executives, including Kerry Killinger, the former chairman and chief executive officer. Then, on Friday, the subcommittee — headed by Sen. Carl Levin (D-Mich.) — will release an investigative report, the fruit of 18 months of labor, into how the Main Street bank took on and eventually died due to Wall Street practices.

Details about the report started to emerge today. The company decided in 2003 to move aggressively into subprime lending to bolster earnings, ultimately producing $77 billion in mortgage-backed securities. The company changed pay practices to prize quantity over quality. And it “built a conveyor belt to dump toxic mortgage assets into the financial system like a polluter dumping toxic substances into the river,” Levin told reporters. Expect ugly revelations all week.

The Washington Post’s Dana Milbank today points out some of the more remarkable parts of Greenspan’s testimony:

“I warned of the consequences of this situation in testimony before the Senate banking committee in 2004,” he informed the commissioners Wednesday. “In 2002 I expressed concern . . . that our extraordinary housing boom, financed by very large increases in mortgage debt, cannot continue indefinitely.”

Milbank then contrasts that with Greenspan’s remarks before the Joint Economic Committee in 2005:

“A bubble in home prices for the nation as a whole does not appear likely.”

“Home price declines . . . were they to occur, likely would not have substantial macroeconomic implications.”

“Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired.”

Perhaps we shouldn’t be surprised that the 84-year-old Greenspan — who was Fed chairman when Wall Street ramped up its interest in subprime loans, mortgage-backed securities, and a few of the other financial instruments that led to the collapse of the global economy — doesn’t want to be remembered as the guy who snoozed while the bubbles inflated. But neither should we let him rewrite history.