The looming financial market meltdown/apocalypse/end of civilization as we know it is extraordinarily complicated and it was designed to be that way. I'm going to try to use this diary to explain, to the best of my abilities, what happened and why. I can't claim full understanding, but I'm hoping to impart the little bit of knowledge I do have to those who want a more complete answer than "it's Wall Street's greed that got us into this mess!"
Full disclosure: I'm a litigator, not a corporate lawyer. I don't create or hawk securities or synthetic instruments, but I do get a headache and a lot of work when they go bad.
The main point, and one you may well know already, is that bankers and fund managers went to great extremes to create complex instruments of questionable value and then convince everyone that they couldn't go wrong. They built a house of cards that they couldn't understand and relied on everyone else not understanding them either in order to profit. So long as the underlying assets kept increasing in value at unsustainable and astonishing rates, nothing would go wrong. Credit rating companies, either oblivious to the ridiculous risk here, or unable to quantify it, went along with the bizarre claim that very risky loans suddenly became gold standard debt obligations, so long as you sliced, diced and repackaged them in a way that no one understood. So they gave these instruments their seal of approval (Triple A Credit Ratings) and investors bought them up like candy. The scheme couldn't fail. Until it did.
The whole sordid mess gets worse because of the effect of the 1999 repeal of the Glass Steagall Act. Glass Steagall, a piece of New Deal legislation, created the FDIC and reduced speculation by forcing banks to be adequately capitalized (keep enough cash in reserves to cover their operating expenses and higher than normal calls on the bank's obligations). Glass Steagall also kept insurance, consumer, and investment banking functions separated. The result was seventy years of a largely well functioning banking system. But because Republicans have never seen a well functioning regulation they didn't dislike, they pushed hard for the repeal of Glass Steagall. Phil Gramm, McCain's economic dynamo, and a gang of his buddies introduced the Gramm-Leach-Bliley bill, which dissolved the walls between insurance firms, investment banks, and retail/commercial banks.
Banks began gobbling each other up and insurance firms like AIG started acting like banks, but without capitalization requirements. Without capitalization requirements, credit became too easy to get, which leads to speculation and asset bubbles. Basically, if the interest rate is too low, that means the cost of money is cheap. When money is cheap, you go looking for things to invest in, because you don't need a very high return to turn a profit. For instance, a 5% return on an investment isn't very good if the loan you need to take out in order to invest in it is 4.5%. It's a loser, if the loan you need to take out costs you 8%. But if the loan costs you 1.5%, a 5% return looks like a pretty good deal. You know what else looks like a good deal when money is cheap? A really risky loan with a high upside (say 15%).
The bankers started telling themselves that a lot of risky investments were okay, because enough of them would pay off in order to make a profit. But just to be safe, they bought assets on the other side of the balance sheet called credit default swaps (CDSs). CDSs can be used as a hedge against the loss in value of an asset. The banks found a counter-party and entered into a transaction where they made regular payments to the counter-party in exchange for a promise of a much bigger payment in the event that a particular asset lost all or part of its value. The thing with CDSs, though, is they can be used for speculation as well as for hedging risk. There was no law that required you to own the security you took a CDS on. In other words, if you thought an asset was going to lose value, you could enter into a CDS and basically bet on it losing value.
One of the risky assets banks started gobbling up during the credit glut were collateralized debt obligations (CDOs). A particularly popular form of CDOs are mortgage backed securities. Before Glass Steagall was repealed, investment banks couldn't offer mortgage backed securities (Fannie Mae and Freddie Mac could). If your loan wasn't a Fannie Mae or Freddie Mac loan, you'd go to the First Bank of Yourtown and get a loan. The First Bank of Yourtown would lend you money based on your ability to pay and would charge you an interest rate based on the risk of default that you presented. In recent years, mortgage lenders popped onto the scene. These lenders lend money, but they don't hold onto the loan. They bundle a bunch of loans together and then sell them. They earn a commission based on the number of loans they make, instead of earning the percentage on the mortgage. This practice creates a moral hazard. The mortgage lenders don't actually care if you can pay back the loan. They care about being able to sell the loan to someone else.
The lenders made all sorts of risky, irresponsible, and flat out stupid loans. For our part, the American people signed on to a lot of risky, irresponsible, and flat out stupid loans. Lenders started providing what were known as NINJA loans (No Income, No Job, No Assets). Loan applications became the size of post cards. Lenders convinced everyone they didn't need a $200,000 house, they needed a $400,000 house. Borrowers didn't bother to figure out what an ARM was, or what it meant to their monthly payments. Because everyone was buying a house (and more house than they could afford), housing prices went up. In the immortal words of Paul Krugman, we somehow came to believe you could build a sound economy on a bunch of people selling each other houses. Alan Greenspan added to the idiocy by constantly claiming their was no housing bubble because there was no national housing market. It is true that there is no uniform, national housing market, but there was a national lending market that was driving up the rates of borrowing, especially for mortgages.
Lenders took all their risky loans and packaged them into what were essentially bonds. The mortgage payments made by the borrowers would go to paying the interest on the bonds. The value of the bonds was discounted to account for the fact that some people would default on their mortgages, but this discount rate was extremely optimistic and didn't account for how many more people would default on an adjustable rate mortgage if the rate shot up significantly. Credit rating entities didn't really know what to make of these mortgage backed securities, so they listened to bankers' and fund managers' assurances that they were perfectly safe and that the risks of default had been adequately addressed in their price. The credit entities happily slapped a AAA rating on the mortgage backed securities and everyone went along buying up tons of CDOs and Wall Street types made a fortune.
On paper.
This whole ponzi scheme rested on credit remaining cheap. It didn't. Housing prices proved that they weren't the anti-gravity particles of comic book science. In 2005, housing prices started to drop. It became harder for people to get home equity loans when their houses started to drop in value. People who bought for speculative purposes found themselves unable to sell or selling at a loss. The percentages of houses on the market increased and prices continued to fall. People began defaulting on their mortgages. This triggered an increase in the interest rates. Banks don't want to lend to people likely to default and to cover existing risks, they start charging everyone more for credit. People with ARMs started seeing their monthly payments increase dramatically. They started to default on their mortgages. The Federal government tried lowering the interest rate it charges to its banking members, hoping that if banks saw money as being cheap, they'd be more willing to lend it. They weren't.
With all the subprime mortgages going bad, the mortgage backed securities that they had been bundled into started to lose their value, too. Firms like Bear Stearns, which had tons of these things, found their balance sheets getting wobbly. Unlike a regular bank, Bear Stearns didn't have to keep 10% of its assets in cash reserves. It was fully leveraged and only had about 2-3% of its assets as cash capital. Bear's trading partners got nervous that it couldn't meet its other obligations because so many of the assets on its balance sheet were suddenly worthless.
To make matters worse, the collateralized debt instruments weren't the only exotic assets on Bear's books. Major players in the market lost all appetite for risky and exotic securities. This resulted in Bear Stearns having a lot of assets on its books that it would have a tough time selling on the open market. It doesn't mean the assets had no value, or even that they were particularly risky. It just meant that there wasn't a market they could be traded on. Accounting laws in the United States require that you mark your assets to market, meaning, you list them on your balance sheet at the price you would get for them on the open market. If your assets are highly illiquid (you can't sell them), they don't have much value. This meant that Bear Stearns wrote down billions in paper losses. If Bear hadn't been so poorly capitalized, it probably could have ridden out the storm and waited until market appetite for those assets increased again. Instead, investors and counter-parties lost faith in Bear. The company was sold this spring to J.P. Morgan for no more than the value of its corporate headquarters ($1.1 billion) in Manhattan. In other words, Morgan bought Bear's entire book of assets, good and bad, for zero dollars. In the days leading up to Bear's death, speculators started buying up credit default swaps against its assets. In effect, they were betting that Bear's book of business would lose its value. Everyone betting on Bear's death was basically a self fullfilling prophesy. No one had confidence in Bear Stearns and the storied investment bank that survived the Great Depression without laying off a single employee collapsed. Suddenly the parties who, years ago, had promised to pay on the credit default swaps in the event the assets lost value now found themselves sitting on huge liabilities they couldn't afford to pay. Not one of them had predicted Bear Stearns would go belly up and they'd have to pay out on every one of those CDSs. The speculators proved Warren Buffet right - the CDSs were financial weapons of mass destruction that helped bring Bear down.
Some in the financial sector thought the death of Bear Stearns was the end of the credit crunch. But rate cuts at the fed didn't help lower the cost of money. Banks still didn't want to lend. Housing prices continued to fall and major banks and investment firms kept writing down the value of their complicated financial instruments. The investment banks are still under-capitalized. If they had had better capital structures, many of them could have ridden out the crisis and waited for their assets to regain their value. In order to meet their obligations, the firms are trying to sell assets (trying to sell assets to increase your cash on hand is called deleveraging). This deleveraging, however, is only making matters worse. As these assets flood the market, they have a deflationary effect on similar assets. The more you try to sell, the more you drive the price down, the more losses you have to take. So instead of riding out a tough time, firms like Lehman Brothers and Merrill Lynch, titans of capitalism, are failing.
The more these entities flounder, the less commercial banks (the ones who lend to big businesses) want to lend. The high cost of borrowing money is crippling other businesses outside the financial industry. European Central Banks have injected huge amounts of cash into their banking systems, but to no avail, as of yet, interest rates haven't fallen.
The current plan in Washington is to bail out the financial system by buying up all the toxic paper assets that no one else wants (the mortgage backed securities and worthless credit default swaps, among other things). The hope is that if Washington buys up all this stuff and helps companies move it off their books without causing a panic, banks will get less fearful of doing business with the financial firms and the credit crunch will ease. It's not a bad theory, but in my opinion, this should not be a give away for Wall Street. The Fed should do what it did in the case of AIG - demand equity. If we bail a company out, we should own part of it. We should also bring any entity we bail out fully within the regulatory system and make sure that they are properly capitalized from here out. Furthermore, any company that, like AIG, can be save with a loan (and with a harsh rate of interest like AIG) should be saved with a loan, instead of a give away. If a company is largely healthy, but is just having a tough time getting cash, there is no reason why we should be buying up its bad assets. A punitive loan, like the one provided to AIG will help solve the problem without sticking it to the tax payers.
So, there's my primer on the credit crisis. I hope it was helpful.