The banks weren't taking losses on loans that were performing, i.e. people were actually making their payments. The losses the financial industry is suffering now is on defaulted property. Government is also exacerbating the situation even further due to their drastic over-response to the Enron situation. Sarbanes-Oxley, an extremely poorly written law with byzantine and unnecessary requirements, was only one part of the government overreaction. The FASB (Financial Accounting Standards Board) controls how accounting operates within the country. When Enron happened, FASB changed the rules of accounting so that property had to be discounted to its lowest value, in many cases zero, when payments for loans were not being made, essentially a worst-case scenario.
Since we all know that real estate cannot be worth zero, the new accounting rules, meant to offset Enron's over-inflation of asset values, went too far in the other direction. In the cases of Lehman, Merrill Lynch, AIG, etc., these companies even warned that the write downs on their real estate were not real losses as many of those properties were written down to zero as FASB required. Yet because of the new rules, their balance sheets of those companies became total disasters, destroying their credit and hence putting them into the boat they're in.
Now how do banks make money with loans? They take deposits which people place into their bank accounts (known as demand deposits) and they make loans on them to other people. Deposits are considered liabilities on a bank's balance sheet while loans are considered assets. As long as the loans are worth more than the deposits in terms of cash flow, then the bank makes money. Note that most checking accounts actually pay zero interest while even savings accounts offer negligible interest rates, clearly giving banks access to money that is depreciating. In a nutshell, banks make money using other people's money, not their own.
You underestimate what people will do to get a loan to buy a house. People have a tendency to push negative news to a later time and will sign onto the many creative financing methods in order to afford what they really can't afford. So while the current loans were affordable, the slightest rise in interest rates would cause many of them to default. Not everyone is versed in economics. People have a tendency to believe that current circumstances can last forever. So the possibility of rising interest rates wasn't enough to deter them. The lure of home ownership, pushed so hard by the Clinton Administration, caused many of these people to sign up for loans they shouldn't have been carrying. If they could afford it, they would not have defaulted and the financial industry would not be in the shape it's in right now.
Owning a house is considered part of the American dream along with the 2.1 kids, two cars and the white picket fence. People will go through quite a bit to obtain that dream, including stretching themselves thin.
I should also bring up that many of these banks did not actually originate the mortgages in question. For instance, AIG carried $600 million in bad Fannie Mae mortgages. Banks buy mortgages through swaps in order to offset the short-term nature of demand deposits and the long-term nature of mortgages. The reasons for swaps are because short-term deposits and long-term mortgages have different risk levels, so banks attempt to balance risks. It's a fairly complex topic that I'll admit I don't fully understand despite having learned a bit about them when I had a securities license with the NASD. Believe it or not, I started my career as a securities broker before becoming a software engineer years later.
As for banks fearing the federal government, just saying the word, "audit," will bring panicked expressions on people's faces. The government has a lot of power, too much power, to impose its will on the markets. The threat of fines if they turned down a low-income or minority borrower is a powerful incentive for them to make those loans. They take the risk, knowing that it could come back to haunt them, but it's better than facing the certainty of fines.
I also disagree with your assumption that money was transferred to the wealthy through tax cuts. Tax cuts, by percentage, went to the lower income brackets so that the burden on the wealthiest actually rose with the tax cuts, becoming even MORE progressive. I'd think you'd be all for that. When I have the time, I may look up the statistics, but you'd be staggered to see what the tax burden is on the wealthy. One figure I remember is that the lower 50% of all wage earners pay 3.6% of the total federal income tax while owning roughly 25% of the income. As with the examples I used in the earlier post, using raw dollar figures doesn't paint an accurate picture since it's really percentages that matter when you determine who benefitted most from tax cuts.
It's also impossible to transfer money from one group to another through tax cuts, only through transfer payments, i.e. welfare. When everyone gets a tax cut, everyone's taxes go down so there can be no transfer involved.
I do have to say Obama supports using the tax code to propagate welfare since he advocates giving tax cuts to people who don't pay taxes. His proposed middle tax cuts are a myth. In reality they are transfer payments disguised as tax cuts.
