Diamond and Kashyap on the Recent Financial Upheavals

As an economist, I am supposed to have something intelligent to say about the current financial crisis. To be honest, however, I haven’t got the foggiest idea what this all means. So I did what I always do when something related to banking arises: I knocked on the doors of my colleagues Doug Diamond and Anil Kashyap, and asked them for the answers. What they told me was so interesting and insightful that I begged them to write their explanations down for a broader audience. They were kind enough to take the time to do so. In what follows, they discuss what has happened in the financial sector in the last few days, why it happened, and what it means for everyday people.

The F.A.Q.’s of Lehman and A.I.G.
By Douglas W. Diamond and Anil K. Kashyap
A Guest Post

For most of the last 20 years we have been studying banks, monetary policy, and financial crises. So for us the events of the last year have been especially fascinating.

The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. In talking with reporters and our noneconomist friends, we have been besieged with questions about several aspects of these events. Here are a few of the most frequently asked questions with our best answers.

1) What has happened that is so remarkable?

This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.

The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)

On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

2) Why did these things happen?

The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.

Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.’s. Were A.I.G. to default on C.D.S.’s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.

In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world: nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely.

In addition, other large financial firms — including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world — had guaranteed A.I.G.’s bonds by writing C.D.S. contracts.

Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.

3) Why did the Treasury and Fed let Lehman fail but rescue Bear Stearns, Fannie Mae, Freddie Mac, and A.I.G.?

We have already explained why Fannie, Freddie, and A.I.G. were supported. In March, Bear Stearns lost its access to credit in almost the same fashion as Lehman; yet Bear was rescued and Lehman was not.

Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear’s regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.

The second problem was that Bear’s counterparties in many transactions were not prepared for the sudden demise of Bear. A Bear bankruptcy might have triggered a wave of forced selling of collateral that Bear would have given its counterparties. Given the potential chaos that would have resulted from Bear Stearns filing for bankruptcy, the Fed had little choice but to engineer a rescue. In doing so, the Fed argued that the rescue was a rare, perhaps once-in-a-generation, event.

When Bear was rescued, the Fed created a new lending facility to help provide bridge financing to other investment banks. The new lending arrangement was proposed precisely because there were concerns that Lehman and other banks were at risk for a Bear-like run. Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.

Once the Fed had made these changes and determined that it and the others in the market had an understanding of the indirect or “collateral damage” effects of a bankruptcy, it could rely on the protections of the bankruptcy code to stop the run on Lehman, and to sell its operating assets separately from its toxic mortgage-backed assets.

Against this backdrop, if the government had rescued Lehman, it would have repudiated the claim that the Bear rescue was extraordinary; it would have also conceded that in the six months since Bear failed, neither the new facility that it set up nor the other steps to make markets more robust were reliable. Essentially, the Fed and the Treasury would have been admitting that they had lied or were incompetent in stabilizing the financial system — or both.

It was not surprising that they drew the line at helping Lehman. Based on all the publicly available information, this was clearly the right thing to do.

4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?

The concern for the man on Main Street is not the bankruptcy of Lehman, per se. Rather, it is the collective inability of major financial institutions to find funding.

As their own funding dries up, the remaining financial firms will be much more cautious in extending credit to normal firms and individuals. So even for people whose own circumstances have not much changed, the cost of the credit is going to rise. For an individual or business that falls behind on payments or needs an increase in short-term credit because of the slowing economy, credit will be much harder to obtain than in recent years.

This is going to slow growth. We have not seen this much stress in the financial system since the Great Depression, so we do not have any recent history to rely upon in quantifying the magnitude of the slowdown. A recent educated guess by Jan Hatzius of Goldman Sachs suggests that G.D.P. growth will be just about 2 percentage points lower in 2008 and 2009. But as he explains, extrapolations of this sort are highly uncertain.

5) What does it mean for the Fed and Treasury going ahead?

A reasonable reading of the recent bailouts suggests a simple rule: if a firm is on the verge of collapse and its ties to the financial system will lead to a cascade of chaos, the firm will be saved. A bankruptcy will be permitted only if the failure can be contained.

Assuming the level of chaos is sufficiently high, this dichotomy is probably consistent with the mandate of the Federal Reserve. The rescue of A.I.G., however, raises some major challenges.

One is where to draw the line. A.I.G. was an insurance company, not a bank or a broker dealer, so the Fed had no special relationship with A.I.G. Presumably, if a very large airline or automaker had been involved in the C.D.S. market, the same reasoning that led to the rescue would apply.

A second challenge comes with defining the acceptable level of chaos. We will never be able to find out what would have happened if A.I.G. had been allowed to fail. Furthermore, there are some reasons to believe that even if A.I.G. continues to operate, the fundamental stress in the financial system will remain. If the rescue does not mark a turning point, the bailout may be viewed quite differently down the road.

Should the government intervene if it merely postpones an inevitable adjustment? Creditor runs can make adjustment too fast; blanket bailouts can make adjustment too slow. Has the Fed found the speed that is just right?

Third, now that A.I.G. has been lent to, how will regulation have to be adjusted? Surely the Fed cannot be called upon to provide backstop financing whenever a large member of the financial system runs into trouble. How does it prevent a replay of this scenario, and can it be done without stifling innovation?

6) What does this mean for the markets going ahead?

Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome.

If the remaining investment banks, Goldman Sachs and Morgan Stanley, do not get more secure funding in place, they may be acquired or subject to a run too. In the current environment, relying almost exclusively on short-term debt is hazardous, even if a firm or bank has nothing wrong with it.

7) When will the turmoil end?

The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.

One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.

The fear of being the next Lehman ought to convince many of the large institutions that, despite however much they already raised, more is needed. It may be expensive to attract more equity financing, but the choice may be bankruptcy or sale. The decision by the Federal Reserve to not cut interest rates suggests the Fed also recognizes that the short-term interest rate is a very inefficient way to address this problem.

Leave A Comment

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COMMENTS: 466


  1. Charles says:

    Excellent post, and story.

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  2. optionman says:

    Thanks for the great explanation.

    Of course, the executives that were way overpaid will get to keep their millions, as us small investors get to eat cake.

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  3. Paul says:

    If the ultimate source of funding (that is, savings) is households doesn’t this all mean merely that the existing channels through savings flowed to borrowers (including mortgage borrowers)had defects and will be replaced soon enough by other channels?

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  4. leanne says:

    thank you for the well-organized explanation! I’ve been trying to put the events together in a story that makes “sense” to me, and, reading this really helped my understanding.

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  5. MaxiCms says:

    The decision by the federal government to restrain themselves from saving the Lehman Brothers reveals to the other struggling banks that a safety net will not be guaranteed. This encourages current banks to make wise investments and not simply take large risks when lending money to individuals who may not necessarily be capable of returning the loan. Saving the investment company A.I.G will turn out to be a kind of test run, and if they are not able to succeed with the available bail-out then perhaps other companies will be denied a loan, that seems inefficient.

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  6. griff says:

    Thanks – could you perhaps extend the explanations to cover why one of the UK’s biggest banks (HBOS) has just had to be taken over by LLoyds TSB ? (Despite apparently being ‘perfectly sound’).

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  7. RC says:

    It’s a shame that we won’t see the parties that perpetrated this Ponzi scheme (Fuld, O’Neal et al) and have the bonuses they “earned” taken away and used to pay for all of the damage they’ve done to the economy. Every I know realized that this house of cards they created was going to fall sometime. The people that had the ability to stop this (Greenspan et al) left quite a legacy for us all.

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  8. Paul from Reston says:

    Absolutely brilliant. And terrifying. But also very “black swan”-ish, in that this lucid exposition very coolly explains the unanticipated complex catastrophe with all the elegantly reductive clarity hindsight can muster. This is the special brilliance of supremely literate economists in all their post facto splendour.

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  9. David says:

    Thanks, that cleared up a lot of questions I had about what is going on.

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  10. Chris says:

    If you have the time, this article does a pretty good job of explaining these really complicated problems in a way that is easy to approach

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  11. Robert Rieve says:

    At what point are we going to realize that fractional banking and the absence of a gold standard in this country will wreak havoc upon on society? More fiat money is not the answer. Legal tender laws are not the answer. According to the 10th amendment, (?) we’re not even supposed to HAVE paper money…AAAHHH!

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  12. chip says:

    When in doubt, Go to Chicago for the answer – where cool heads usually prevail.

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  13. Annole says:

    From Realty Check with Diana Olick on 1/25/08

    re: FNMA’s mission statement:

    ….”The focus has clearly shifted from families:

    In 2005: “Our public mission, and our defining goal, is to help more families achieve the American Dream of homeownership. We do that by providing financial products and services that make it possible for low-, moderate-, and middle-income families to buy homes of their own.”

    to lenders:

    In 2008: “We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market. Fannie Mae has a federal charter and operates in America’s secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates. Our job is to help those who house America.”

    I’m not criticizing the shift, just noting it. I did call Fannie, and as soon as I get a response, I’ll post it.”

    On the same day FNMA responded as follows:

    “FNMA quickly sent this response to my query about the change in the site. They also want to make clear that the page didn’t change this week but changed sometime around the beginning of 2007:

    “Fannie Mae’s mission always has been and continues to be increasing the availability of mortgage funds for low-, moderate- and middle-income borrowers. We achieve this by raising global capital and bringing it to local communities. The change in language on our website over the years reflects our role as a secondary market institution to provide liquidity, stability, and affordability to America’s housing market through our partners,” said Amy Bonitatibus, Fannie Mae spokeswoman.”

    As the current crisis unfolded, my thoughts went back to this exchange.

    My questions are as follows:

    1. Who authorized the change in FNMA’s mission statement.

    2. What effect, if any, did this have in bringing down FNMA.

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  14. Anthony says:

    Congrats, you did what 10,000 journalists and reporters haven’t been able to do for a week. Clearly explain whats going on. Thanks.

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  15. Forone says:

    One of the more troubling aspects of all this is it continues the unhealthy trend of unilateral executive / administrative improvising on national emergencies, sidelining a weak and irresolute Congress that should be very much involved but doesn’t even seem to want to be – the unhealthy trend began with and brought us the bungled “War on Terror.”

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  16. Boris says:

    Why not just borrow from the Pentagon? All of the needs of Bear, Lehman, AIG, Fannie, and Freddie could be covered with just a couple of weeks’ worth of Iraq War spending.

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  17. Candace says:

    A good understanding of this article still requires one to have some facility with financial industry terminology and structures, but it is the most direct, consise, “laymen’s speak” article I have read about what’s happening in this crisis. Thanks again to Mr. Levitt for having the foresight to ask the questions we all want answers to, and for helping to make it plain so we could “get it”.

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  18. Edwin Kellogg says:

    Where does all this money that the U.S. government is lending/giving to Wall Street firms come from?

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  19. trace says:

    Thanks for the effort, but it is still gobbledygook for me – all I see is that my stocks value has HALvED since yesterday.. What I want explained is how this will affect social services, or services in general that are funded by the federal gov. Will it affect funding for national parks? local police? schools? roads? the NEA? This is the question I want answered. Have the republican succeeded in making government so poor that it can now be drowned in a bucket?

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  20. Max says:

    This all really started when Bernanke started raising interest rates a couple of years ago which destroyed the subprime lending market.
    The entire sole purpose of having a Federal Reserve system is to stabilize the economy and keep us from experiencing another depression. Now we see that it is pure folly. The world economy is too vast to have a couple of guys in a room deciding every quarter what they feel the price of money should be.
    Unfortunately, the notion of free markets is taking a real hit when, the fact is, we never had a real free market to begin with.
    Abolish the Fed System! Rather than create stability, it adds a level of uncertainty and a false feeling of security.

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  21. Tony says:

    This is an excellent summary of the past 10 days, and another factor in the crisis is the inter-relatedness of these parties and counterparties in derivatives trading.

    This has been observed as a problem for several years (read Warren Buffet’s annual shareholder report in 2002: ” Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.”)

    The question then becomes how to deal with this going forward. Federal government regulation of all insurance and all derivatives operations? How?

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  22. TD says:

    rocky days ahead

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  23. ouchifell says:

    thank you. very illuminating

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  24. Duane E, CPA says:

    What are the implications for all of our market based retirement vehicles, 401-K, IRA, etc.?

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  25. Steven says:

    This is all fine and well but only discusses the most proximate causes of the crisis at these firms. Completely missing is any discussion of the deregulation that took place in 1999. The Gramm-Leach-Bliley act made all of this possible by allowing consolidation of lending, insurance, and securities firms and allowed insurance companies to get into the mortgage lending business. The ridiculously low interest rates a few years back made everyone and their brother get into the mortgage lending business. Included in this was the drive to push as many loans as possible and ease standard qualifying restrictions. Firms were willing to do this because they were turning around and selling those mortgages to investors. Result housing bubble propped up on interest only, adjustable rate, and subprime loans.

    This also allowed these firms to bundle their risky subprime mortgages with less risky conventional mortgages and sell them as securities to investors. However, investors where usually unaware of this thinking they were buying conventional loans. When interest rates went up and the housing bubble burst investors found themselves holding billions of dollars in securities backed by bad supprime mortgages.

    All of this was brought to you by the republican congress in 1999 (aided and abetted by Bill Clinton). The architect of his deregulation was Phil Gramm. Yes the same Phil Gramm who is McCain’s chief economic advisor (and likely treasury secretary). The same Phil Gramm who now thinks we are all just a nation of whiners. McCain voted in favor of this deregulation. Joe Biden and every other democratic senator voted against it. How convenient is it that now that the proverbial dung is hitting the fan McCain now wants to talk about new regulations of this industry.

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  26. Becky says:

    One question going into the future is whether or not the type of bail-outs that have been undergone will in fact curb risky, high margin behavior – what’s being done to make sure companies don’t now have an incentive to tangle themselves as deeply as possible into other systems, if they have lots of leverage and are facing an inevitable bankruptcy?

    And what will the short term effects of these skyrocketing federal debts mean for the dollar’s strength, esp with federal bonds now plummeting?

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  27. AG says:

    Makes sense, great article. Bottom line we’re talking hubris here, sheer greed. What infuriates me is I currently live in an apartment. My financial advisor said in 2001, “Oh, you can afford a condo, anyone with a pulse can get a mortgage.”

    Someone I trusted implicity was also playing the game. Fortunately I own no morgage stocks, or stocks in any of these companies. I am not insured by AIG. But my financial advisor — a man of great integrity — almost steered me into a huge mess.

    He is with Merrill Lynch. Where do you run … where do you hide? Whom do you trust anymore?

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  28. Claudio says:

    Interesting analysis. It will be interesting to see whether the Government’s intervention will now create a precedent for future crisis. Where do you draw the line?

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  29. Randolph says:

    Excellent explanation, as far as it goes. When do we engage the conversation about the underlying greed that drove these increasingly risky business decisions? There’s plenty of blame to go around: the greed of the bankers for their obscene and unjustified pay, as well as the greed of ordinary investors who expect double digit returns without thinking about the double digit risk for which those returns are paid.

    One question about AIG. Hank Greenberg has said that the company’s problems are primarily a liquidity crisis. If they are able to work out of this in a more or less orderly fashion over the next two years, are the government’s warrants rescinded? If it really is just a short-term cash problem that is resolved, why should shareholders be nearly wiped out?

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  30. Diane says:

    “Bear Stearns was bailed out for two reasons. One was that the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear’s regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.”

    ———————–

    We invaded Iraq on imperfect information too.

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  31. Stuart says:

    This is a very well written and cogent explanation. The only area it does not address is, “What the hell were the regulators doing while all this was going on?”

    Chris Cox, SEC, was absent on his own watch. Why did he not consider reinforcing the Glass-Stegal Act which separates banks and brokerage? Why did he not correct his obvious error when he eliminated the “up tick” rule for short selling? Why did he allow financial institutions to be leveraged 30-40:1 when the maximum leverage for banks is 20:1?

    Paulson, Treasury, was asleep for years and now he is only concerned with putting out the fire, while he did nothing for fire prevention in all the prior years.

    The government has become a large block of fat-assed bureaucrats who draw a pay-check and do nothing.

    And now both candidates for president are pussy-footing around the real issues of regulatory failure. Maybe one of them should call Hillary about borrowing her huevos.

    But we can be comforted by knowing that President Bush has said that he feels our pain. You’re doing a heck of a job, Bushy.

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  32. jblog says:

    We can rail all we want to a Wall Street, the banks the government, etc.

    But ultimately, none of this would have happened if it were for people who knowingly and willingly borrowed way over their heads on the assumption that the variable rates on their mortgages would stay low and housing prices would rise infinitely.

    There are reports of some people borrowing nine times their annual salaries for home mortages — that’s insane.

    Greed, yes. Foolishness, for sure. Shortsightedness, absolutely. And plenty of it all the way around.

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  33. sara says:

    This account reminds me of describing the progress of a cancer, but not addressing the toxic exposure that caused the cells to grow out of control.In medicine we distinguish between pathogenesis (how things go wrong) and etiology (what causes disease).
    I wish this forum addressed etiology- from Greenspan & supply-side economics to Robert Rubin to Phil Gramm.

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  34. Juan Dubra says:

    I adhere: very illustrative and comprehensive. Two thumbs up.

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  35. Brian says:

    Excellent and clear post but it covers only the period since the Bear Stearns rescue. It would be helpful to have a similar review of how the crisis developed, among which are: (1) A housing market bubble fueled by imprudent financing (with some fraud), (2) A cloudy derivatives market, (2) Overlapping and/or absent regulatory responsibilities, (3) The prevention or limitation of moral risk vs. the overriding need to protect the economy and avoid punishing society as a whole, (4) The need to (re)establish clear game rules (and the accompanying regulatory structure) to reduce the level of uncertainty in the markets.

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  36. Gerd says:

    Since the new century began, the US has had several severe financial crises. In management terms, this shows a lack of leadership in anticipating the potential problem and taking some steps beforehand to ameliorate (or at least prepare for) the issue. As the world loses confidence in the stability of the US and the dollar, it would seem that the next crisis might be a run on the dollar. Will the US go the way of the earlier financial crisis in Argentina?

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  37. Paul from Reston says:

    Bravo, Trace! (Post # 19). I would truly enjoy a posting to this thread by Mr. Grover Norquist, who should welcome the forum. That said, I hope this will open up to a discussion of governing philosophies rather than simply a rousing endorsement of the piece and the bitter ironies of all this.

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  38. Michael says:

    In my university economics courses almost 40 years ago, we read Galbraith and had Marxist professors rant about capitalism. My conclusion out of all of this is do not confuse your economic system with your political system. This administration created or at least perfected the fusion of the two: crony capitalism. Putting George W. Bush in charge of this country was like putting a highly trained pig, sorry Sarah, as a pilot , in the cockpit of a Boeing 747. We learned about the efficiency of free markets. Galbraith noted that these markets were never free and that as capital became more concentrated market forces stopped working. Oh have they stopped working.
    Econometrics rose and a Nobel prize was created for economics. Now the Nobel Prize group should create a prize for economic sophistry for this truly characterizes what we have been subjected to in the past 30 years. The prize would go to the economist who writes something that the fewest people understand. In the end, the mathematical gibberish that filled the journals created the opportunity for these republican con artists to loot this nation. We can only be thankful that a valiant group of Democrats in 2006 were able to resist the efforts of the fool in the White House to expend his “political capital” as he said to privatize social security. Had he been successful, probably two or three trillion dollars more would have gone into this financial conflagration and gone up in smoke while the cronies put several hundred billion dollars of that into their pockets. We must strengthen our democratic institutions and always remember the difference between republicans and Democrats is that republicans want one dollar to have one vote and the Democrats want one person to have one vote. We must not confuse our political system with our economic system and we must insure that our democracy works to represent and protect the people and not these monsters who have created the economic version of genocide.

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  39. Robert Baldwin says:

    Gentlemen:

    Was there also an option of allowing AIG to go bankrupt, but having the Fed unwind its businesses in a orderly way, separating and selling the profitable subsidiaries and guaranteeing counterparty risk if truly neccesary in the diseased sectons?

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  40. Ian Randal Strock says:

    Good explanation, but I must respectfully disagree with your answer #6:

    Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon.

    My take on it is that the bankruptcy of Lehman coupled with the rescue of AIG sends the signal that companies need to enmesh themselves deeply in many different parts of the market around the world, but once they’re big enough, the government will be there to step in because they’re “too big to fail”. So the new business paradigm isn’t “do it better”, it’s “protect yourself by getting into a position where the government will bail you out.”

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  41. DJH says:

    I don’t normally post just “thank you” comments, but in this case, I find I must — this is an enormously useful description of the problem and how it’s been dealt with to date. So … Thank you!

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  42. Dhaval says:

    Thank you for the post, all year long we have been facing credit crunch and challenges to secure financing to grow businesses. The reasoning about makes sense but still does not.

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  43. Johnny E says:

    Perhaps a little trust-busting is in order so that we don’t have any financial institutions that are “too big to be allowed to fail”. A little competition might help the situation.

    The trouble really is that the world’s investors don’t trust the numbers coming out of Wall Street anymore. A little more transparency and enforcement of existing regulations would help in that regard. You can’t have a free-market without it being a well-regulated market. Throwing a few white-collar crooks in jail might do a lot to put the others in line so that small conservative investors don’t get wiped out through no fault of their own. I don’t hear much about the role of fraud in this debacle.

    Investing nowadays is like betting on the Superbowl while the referees are on strike.

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  44. Mike says:

    Very good article. But why no mention of the Quants who started this mess with their ” Perfect Risk Control Models ” a repeat of LTCM.

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  45. Charles says:

    This was a great post worthy of praise. But everyone should remember this is an after the fact explanation with facts intertwined. It’s a guess, as smart as it sounds, and is most assuredly missing some key, important, unexpected, root cause akin to Lorenz’s rounding errors in his weather models. So it’s a story. A Coherent, clean, rational, tight, story.

    My main concern is the specific forward looking thoughts based on the backward looking rationalizations.

    “Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon. Both of these developments are welcome.”

    You’ll find stuff like this throughout history, yet, as I think twain said, history continues to rhyme. And will continue to, going forward in time. This isn’t to say we can’t learn and that’s why this is still an excellent post – we just need to maintain a measure of respect for what lies beneath.

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  46. G says:

    finally, some good answers

    journalists have been confused too and their articles show it. this post finally gives something solid

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  47. frtiz says:

    Incredibly, the systematic deregulation of Wall Street for the past eight years is not even touched
    on in this article.

    This is not a (technical) financial failure of “access to capital”, nor is it simply (emotional) human greed. It’s quite simply a (political) failure to regulate risk.

    If the rule of law does not return to financial services, history will look back on the turn of the this century as America’s sudden and unexpected slip into nationalization, and even fascism.

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  48. Galymzhan Kirbassov says:

    The explanation of the crisis is very clear. But I would want to have some explanations on the implications of this crisis for the world financial markets.

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  49. norman zelvin says:

    Good summary in a large nutshell. Its’ result is in describing scenerios where determined scoundrels can subvert our financial system for nefarious purposes . In effect it is an expost facto idictment of several prominent individuals who have taken their ill gotten gains seemingly legally and are now resting easily While the rest of us have sleepless nights!.

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  50. Chris Meserve says:

    Does the weaker dollar make the usual sources of cash, namely, Asian central banks and Middle Eastern states and individuals, less interested in investing 15 billion dollars, and hence the Treasury needs to step in? I mean, has our borrowing depressed our dollar to the point where people no longer want it? Or are the usual sources of cash more intertwined globally and hence do no represent such geographic/nation state boundaries?

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  51. Jim says:

    It appears to me that the public is being sold more than subprime mortgages in these bailouts. Having looked at the Census Bureau index of housing stock in the United states, the total housing stock numbers around 126M houses. Of these, over the last two years about 3M have been involved in some foreclosure action. The median cost of housing in the US is about $212.4K.
    Therefore 3M houses * 212.4K/house = $637B, meaning the government could buy every house foreclosed on over the last two years for $637B. This is less than half of what various public agencies have pumped into this so called subprime mortgage crisis, which is stated at about $1.4T.
    My guess is that there are a host of other business loses that these financial and mortgage lenders are bundling with these bad loans. The public should be leveled with about what we are being forced to invest in and it is not just bad mortgage loans.

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  52. JimB says:

    Excellent explanation. It brings everything together quite nicely and I think it’s spot on.

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  53. Bob says:

    Thank you so much for putting this together. It was very hard for me to find a cogent summary of the entire process written by someone who knows what he is talking about, yet, can write about it for laymen.

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  54. Kenny says:

    One question that is relevant to the current presidential race is whether this economic crisis could have been prevented. Is this an answerable question? Would more regulatory oversight have prevented the crisis?

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  55. VG says:

    Thank you for the great insight.
    But there are still some basic questions I can’t wrap my head around.
    1) Why should the cost of borrowing go up for some one on the Main st. when the risk characteristics haven’t changed – is it a matter of demand and supply of money in the system?
    2) It’s understandable that unsophisticated investors give-in to the herd psychology and get into the vicious cycle of deleveraging. But I’d imagine that banks like Lehman must have developed models that told them how much leverage they can sustain, given the risk characteristics of their assets. They can’t be leveraged to a level, just assuming the most optimistic conditions; they know about fat tails, right?
    Also, it was clear in July of 2007 that risk of the mortgage backed assets has increased significantly. Why didn’t they delever since then? Were they assuming it was a short blip?

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  56. Jonas Grumby says:

    The structure surrounding Fanny Mae and Freddie Mac all but guaranteed that the profit would be “private” but any losses would be “social”. Nice job!!

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  57. PaulK says:

    One thing this reminds us is that not all government regulation is bad, and if you have regulation, it has to be enforced. As much as free markets make sense in the small, in the very large, few know what is going on and house of cards have a way of falling down completely (so, the market corrects, but the costs are too high). Each company was gambling with too many ways to fail (counting on too many things going right) and the intersections of those (loans, roll overs, insurance, guarantees, collateralized on another loan, capital juggling, etc) created the havoc.
    The Fannie/Freddie thing is a perfect example of the current administration’s love of deregulation – it does not consider that if you use taxpayer money to back their loans, you better understand what those loans are used for. More importantly, the very purpose of backing Fannie/Freddie was forgotten as they were increasingly moving off their core purpose. It is almost like attacking Iraq in the name of going after the terrorists.

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  58. Madhav says:

    When financial institutions throw caution to the winds, this type crisis arises. In the earlier too
    many similar collapses have happened. Some years ago
    while reading Readers Digest, I came across quotation, the history repeats because, we dont listen to the earlier one.

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  59. Matt in Dallas says:

    Thank you for explaining things in a way I could understand and with enough detail to make it meaningful.

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  60. AJ says:

    The subprime mortgages are the central thread in this money crisis. The Democrats gave HOUSES for VOTES – forget dollars for votes. And somehow they knew this would devastate the market and the Republicans would look like it’s their fault.

    By the way, the Democratic controlled Congress that allowed subprime mortgages to bankrupt the US economy is thinking of recessing because they don’t know what to do about the financial crisis that ended exactly the way they knew it would. Actually, there is nothing else to be done – fait accompli.

    If the Dems win in 2008 – a pox on their houses.

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  61. priceofcivilization says:

    This article only tells us what happened after the fact. It would be considerabley more impressive if it had been written as a warning beforehand. Prediction is a sign of science, but this is merely descriptive. Hence it has little value to predict what happens next.

    Chicago economics is highly overrated. As a graduate of the U, I can see how ideological much of their scholarship has been.

    I would say the causes of this meltdown in the short-term are banking deregulation by Greenspan, Gramm, and friends. The long-term causes are Friedman’s economics, which became Republican dogma starting with Reagan.

    If you want a better future, you need to admit that unrestrained capitalism is about as good as unrestrained communism. What is needed for success are checks and balences, bottom-up and top-down, motivations of profit and protections of the social good (commons).

    As a professor, my political recommendation: stop electing people with a C average in college, and start voting for some star students. Good students not only make fewer mistakes, they also are able to learn from their mistakes rather than just joke about them.

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  62. Susan says:

    Just exactly how stable is the government funding backing these institutions? Who is financing the government? This cannot all be taxpayer dollars – certainly some, if not quite a bit, is borrowed money. Why is government agreeing to take on risky collateral – junk bonds, subprime mortgages – and why is the government allowing commercial and investment banks to co-mingle (Bank of America & Merrill and a possible merger of Wachovia & Morgan Stanley)? These transactions look less like solutions and more like acts of desperation that could end very badly. Once again, it looks like a roll of the dice.

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  63. slarrow says:

    A good explanation, but I also wanted to second jblog’s observation. We can certainly place much blame on regulators, bank executives, and politicians, but the core of the problem is this: lots and lots of people borrowed money they shouldn’t have and didn’t pay their debts when they were supposed to. All of this hullabaloo is geared toward blaming people who didn’t keep people from making bad decisions. Let’s not forget the multitudes of people who made bad decisions in the first place. They bear responsibility too, and let’s be cautious about inviting more scrutiny and control into the lives of those of us who are make good judgements in order to fix those who make bad ones. People get uptight when this kind of intervention happens on moral issues; they don’t seem to recognize it as well when it involves economic ones.

    Our political and economic systems are remarkably democratic: we the people typically deserve the situations that we get. The guy down the street may be able to tell the sob story of how he’s lost everything without stressing his own bad judgement; he may rightfully point out that he’s only one case. It does recall the old saying, “No individual raindrop ever considers itself responsible for the flood.” This is just another good reason to remind myself and those I can influence not to get in over our heads.

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  64. slarrow says:

    As a followup to my comments, I also warn against the boogeyman syndrome. Big Oil, Big Money, Big Whatever–they’re easy to blame and point fingers at. The truth is usually more difficult and sophisticated, of course.

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  65. Tony Gillotte says:

    Swell explanation of the unknowable leading the blind to drink and swill at the fountain of greed. This is obviously not the end of the story. There are probably another dozen shoes to drop before we reach what economists call the drop zone: a time when money becomes irrelevant and economies start to buckle under the pressure. Hope you have your food and water put away cause this is going to be one helluva ride.

    Tony Gillotte
    Vacaville, CA

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  66. Peter M says:

    When will the american people realize that the Federal Reserve is a part of the cause?

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  67. Debbie says:

    Enjoyed reading this article. Wondering…did the money from household investors evaporate into fine wine and caviar (investment brokers salaries) or get frozen into a housing glut no one wants any more? Bad mortgage used as collateral for mortgage insurance! Why o why o why o why? Why o why o why? Because because because because goodbye … …

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  68. JPT says:

    Excellent post!! This explains the turmoil in a manner that can be understood by us “regular” folks.

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  69. Adam Ross says:

    To Boris (#16),

    The Iraq War is costing approximately $9 billion a month.

    In terms of magnitude, this financial crisis outstrips that by jillions.

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  70. Bob B says:

    This was great and helped me understand a lot, but something still is not sitting right with this AIG bailout. It sounds like what has happened is that my tax money is being used to save insurance on mortgage debt that was backed by more mortgage debt.

    Any chance I could get the Fed and Treasury to come to Vegas with me?????? I love to double down but hate losing my money too.

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  71. -JR says:

    “Should the government intervene if it merely postpones an inevitable adjustment? …Has the Fed found the speed that is just right?”

    Unfortunately Mr. Diamond and Mr. Kashyap miss the fundamental point of recent Fed activity, which is that the transparent gain of control of over $6T worth of assets is NOT ‘government’ activity at all, since the Federal Reserve is very much a PRIVATE corporation.

    I highly recommend G. Edward Griffin’s book “The Creature From Jekyll Island”, which predicted this type of activity (and more).

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  72. english44 says:

    How much debt can our government handle before something breaks or foreign investors turn away from us? And then what happens if our debt is not funded by China, the Saudis, etc.? Why should we think that the government is able to run these companies? Will they simply re-hire the folks who ran them into the ground?

    Have we turned into the folks from “1948″ who have no memory and buy into the idea that “loyalty is unconsciousness”, that ThoughtCrime will be impossible because no one thinks anymore?

    So, when is a “bailout” only a bailout in form but not in substance? How long have we heard the government say that it is acting to ‘stabilize’ the markets and the markets still gyrate out of control?

    However, I do feel re-assured by our President telling us that everything will be O.K. Whew, I was beginning to worry for a minute. And, you know, when Bush speaks, everyone listens.

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  73. Johnny E says:

    This crash of the economy sounds like some Tom Clancy novel. I’m not usually a fan of conspiracy theories but it’s not hard to conceive of foreign rivals engineering some of the problems bringing our economy down. “Free Market” ideology could be a very naive strategy in a hostile world economy. Everybody else is looking out for themselves and they aren’t burdened by our free market theorists.

    I’m old enough to still remember Krushcev’s threat to bury our economy (we think he lost back then) but Russia is resurging. Bin Laden boasted he would hurt us by driving the price of oil above $100/barrel. We’ve already lost our sovereignty to multi-national corporations if you think about it. The Saudi’s manipulate the price of oil however it suits them. Foreign governments can manipulate our economy by investing in it with sovereign wealth funds. Usually it’s in their self-interest to keep our economy stable and strong but we’re in debt to potential adversaries.

    That United Airlines bankruptcy rumor shows how vulnerable we are if somebody tried to mess with things. I suppose intelligence agencies and the SEC are trying to protect us from threats like that one, but they can’t protect us from the follies of our economic policies.

    We’re fighting costly land wars overseas now but the real battlefield could be Wall Street. The US might still have the biggest economy and military, but the balance of power in the world is unbalanced now. History shows that alliances change to counteract soembody who is getting too powerful. Pollsters asking if you think the war or the economy is the most important issue facing our country miss the whole point. They’re one and the same problem.

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  74. Brian says:

    Agree with Fritz (#47) — no mention of the degregulation of Wall Street. However, I expected as much as the writers are with the University of Chicago Gradudate School of Business and/or Department of Economics. As a graduate of these programs, I find their explanation and lack of mention of regulation perfectly consistent and predictable. It is rare and would be surprising if a UofChicago professor would blame deregulation. I am also a strident Obama supporter but would remind people that one of his key economic advisers is a UofChicago economist. We can expect some conflict within the Obama administration over economic policy if he retains his UofChicago advisers.

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  75. still-confused says:

    Thank you for a great explanation, That was much better than what I heard or read so far. But I’m still confused as to how this sits with a free market economy. Can we really look at this and still say that we have a free market economy?

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  76. dehud says:

    I had a feeling at the time that repeal of the Glass-Steagal Act was a really bad idea. What actually is the distinction between an investment bank and a commercial bank functionally? There is a conflict of interest in allowing one bank to be both, is there not?

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  77. Wolfgang Stockhausen says:

    Thank you all very much for this very hard work- surely more than 24 hours without sleep. Wolfgang.

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  78. Roberto says:

    I am a small business owner. I make a decent living with a lot of hard work. I am forced to “save” by investing in IRAs and pension plans that folks like these investment banks.

    At the same time, whenever I need more money for my business, I am forced to get a loan from these same folks.

    Do you ever foresee a situation where it will be really free market (i.e., I am allowed to make my own decisions about what to do with my money), without giving it to someone else to manage for “tax benefits”?

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  79. upstate bob says:

    previous poster, “Max” states that our problems were created when the Fed increased the fed funds rate.
    -sorry Max, the problem started when the Fed eased
    back and pumped excess liquidity after the 2000 tech
    bust. We would have survived that without today’s consequences if failure had been allowed to progress
    normally.

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  80. EA says:

    We need more articles about short selling and it’s role in all of this, I am just learning that the SEC has been traitorously negligent in regulating this activity, thanks to Jim Cramer for going postal over it!

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  81. reader says:

    Very informative, thank you.

    Like many others commenting, I would have appreciated some explanation of the role of deregulation as well as a commentary on how similar events can be avoided in the future, given that we are seeing a wave of consolidation and the big firms are only growing. Also, any prognostications on how this is likely to impact the growing push for private retirement accounts?

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  82. pacr says:

    Good article, but I agree with ‘priceofcivilization’ on this one. What is missing from the analysis is the most important question of all: what is wrong with economic theory that we didn’t see this coming? Market intervention is an anathema to these Chicago economists yet here they are glibly talking about why it was necessary. The theory they teach tells us this shouldn’t happen, and that intervention only makes things worse. I also understand that the pricing models the financial gurus use are all based upon that same theory. So much for that. Perhaps we don’t just need a ‘market correction’. We need a theory correction and a little less hubris over there at Chicago U.

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  83. Daniel says:

    Does this mean we can stop debating about whether or not we’re in a recession?

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  84. Laura says:

    Thank you! This is very clear– I really prefer reading from the experts themselves, rather than reports on what the experts say. I would love to see this sort of piece more often, in politics, as well.

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  85. Nikki says:

    “Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets.”

    I did not understand the above. Say Lehman invested in a real estate project, the project is not bringing in the income expected, does “rolling over” mean Lehman must invest more in the project so it does not go bankrupt? If Lehman’s investments in stocks goes down, why would they need to put more money into stocks.

    Don’t really understand what investment banks do.

    thanks

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  86. Tom S says:

    Great explanations. I kind of understand this…for a little while. I think I’ll put my money in FDIC-insured CDs–that’s simple enough so I at least think I understand.

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  87. Paul from Reston says:

    jblog and slarrow: I suppose blaming the victims is one response: they brought this down on themselves. That said, how many misunderstanding people who simply wanted to own a home were knowingly bamboozled into borrowing on variable rates? How many investors purchased unfathomably complex instruments that, they were assured and reassured, sliced, diced, and spread the risk around so ingeniously as to be virtually “risk-free.” I know: nothing is “risk free” in this particular world, but I’m guessing, from the standpoint of a simple newspaper-reading interloper, that the phrase “risk-free” came up early and often, surely in some hedged form (as in “virtually risk-free”) in the sales pitch. And if so – as it most assuredly is so – shame, shame, shame.

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  88. John Johnson says:

    Great Article. Compelling theories. Posters stop whining.

    Didn’t you receive a prospectus when you invested? Didn’t you understand there was risk involved with your investments? Seriously, people lose money when they invest, the housing market occasionally goes down, companies and their executives make mistakes.

    The fact is no one reads the fine print, and when your investment advisor says “this is a good deal”, most actually believed it. Who could have predicted this two years ago and not be called crazy?

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  89. Amit says:

    Kashyap is an aptonym for a guy who lectures on economics.

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  90. bytejockey says:

    Too bad no one listened to Ron Paul five years ago when he introduced legislation to remove the government subsidies from Fannie Mae and Freddie Mac.

    House Financial Services Committee, September 10, 2003.

    http://www.lewrockwell.com/paul/paul128.html

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  91. Suresh Manian says:

    Can someone please explain how a company that has 1 trilliooooooooooooon dollars in assets, with just 100,000 employees go broke? what do these assets mean in real terms then?

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  92. Trust no one says:

    Great article! Beware that in times of crisis there are always victors. The victors in this case are the rich. Socialism for the rich and free market capitalism for the poor. Beware the banks who come out on top of this. The banks that came out on top of the depression where the ones who pushed for central banks. Look at what central banks have done for the working man. Nothing! This will become or is a way that they will be able to exact better control on the working man.

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  93. Sukh says:

    Great column. Is gold a safe haven for the forseeable future? Curious to hear feedback.

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  94. Richard Schatz says:

    Reaganomics died this week and the killer was a Republican administration that has long touted the merits of unregulated free market capitalism. Government assistance to Americas poor was regularaly opposed by this administration on the grounds that it discouraged the work ethic. But when the rich fell on hard times, the US Treasury and the Fed were quick to to write huge checks with no mention of the moral message this sends both to the rich (“We’ll save you if you make mistakes.”) and the poor (“You’re not big enough or important enough to save”)

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  95. Joe Konn says:

    Well, where did the capital go? Why is there not enough capital? One major reason is the spend and borrow war, brought to you by the spend and borrow administration. Doesn’t take a Ph.D. to figure out that if piles of capital are sucked out of the system, we will be short of capital. Also, perhaps, the limits of available capital help practical folks moderate the risks they are willing to take, not a bad thing. Moreover, more capital would not make the bad loans good, it would just cover the behinds of the fast and loose players. More capital may save general motors, but it will not correct nearly 30 years of poor management at GM.

    Also, very interesting, two Chicago economists do not mention the role of de-regulation. Milton Friedman via Alan Greenspan refused congress’ invitation to increase regulation of these “non’banks’, he claimed he was not as smart as the market. He was correct the market smarts. Friedman-Greenspan are just two more idealogues willing to substitute a dogma for reality. Reality is the folks who are the big players are just human, they need rules, without rules some humans will take irrational risks with other folks money. After all, they take big risks, maybe they get a big bonus, if the risk fails they get a big salary anyway.

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  96. Dan says:

    The underlying cause of all this mess was that there were too many loans made to deadbeats and liars.

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  97. Gunning says:

    You do not have to be a University of Chicago Economics professor to figure this out. The REASON is that for the last 10-20 years the entire US enconomy has been based on “Buying stuff we don’t need, with money we don’t have.” This is what everyone has been doing and of course at some point it falls apart. It fell apart.

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  98. Cameron Berry says:

    Last question “WHENWILL IT END?”
    No answer
    Grade D_

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  99. Louise says:

    I thought this was a very thorough and helpful explanation of what is going on right now in the markets.

    Love you

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  100. George Klepper says:

    Kind of sounds like an elaborate Ponzi scheme.

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  101. Mr Marty says:

    A few other questions: Who profited while these institutions were gambling with our money? Who is profiting from this current chaos? What are we doing to prevent this type of legalized theft? How does self-regulation work when self-interest is dominant? Why do we allow all of these complicated “instruments and products” that in hindsight seem absurd and ridiculous? The con artists have run away with their profits and the rest of us rubes are left holding the bag. Aside from the usual “America is great” and condescending “folk talk” from our elected officials and presidential wannabes can we expect anything more specific or effective than these platitudes? Maybe we should let Hu Jintao and his merry men run the show? They’ll probably wind up buying us out sooner or later the way we’re going now.

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  102. Logan says:

    The only appropriate comment for anyone from the University of Chicago economics department to make at this point would be “sorry, we were wrong. I guess we really do need some regulation of markets to make things stable and effective.”

    That will never happen though, because they’re all a bunch of Friedmanite zealots who will swear 2+2=5 if admitting the truth would cast a shadow on their idiotic blind faith in the “free market.”

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  103. Steven says:

    Very good article. Perhaps Section 2) should read “The common denominator in all three cases was the inability of the firms to secure financing.”

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  104. Virginian says:

    I would also like to point out that in this day and age when most middle class tax payers have a 401k plan, a tax payer is also a stock holder. The same person, meaning you, gets hit twice: the devaluation of your stock portfolio, and the government using your tax dollars to bail out investment firms.

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  105. Jeff says:

    If only everything money was so logically explained…

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  106. rfk says:

    Good article, but, I would like to see a discussion of the long term effects of the bailouts as to how they impact the future strength of the dollar, and consequently the continued attractiveness of our treasury securities abroad, in particular with China. Are we risking a devaluation of the dollar and consequently treasury
    bonds (as to the foreign investors) that is going to drive interest rates to the levels of the 1970′s? Also, will OPEC and other states dependent on oil production need to raise prices even above the current levels in order to maintain the stablility of their governments when facing with the potential downward spiral of the dollar? I think we could be courting a real economic and potentially national security disaster, and the transfer of our manufacturing sector to China and elsewhere in the apparent blind faith in free trade will ultimately be recognized as incredibly foolish. Bottom line, and as the old saying goes, if war is too important to be left to the generals, then business is too important to be left to businessmen.

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  107. Michael Williams says:

    Three observations on this crisis:

    1) We clearly need better regulatory practices regarding banking and mortgages.
    2) Millions of Americans are phenomenally stupid/irresponsible and have hurt all of us by taking out mortgages they couldn’t afford.
    3) We should NOT privatize social security. This episode shows us, once again, that private investments are never a safe security blanket for retirees.

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  108. Earle Conklin says:

    What someone forgot to mention was the role Bank of America played in the failure of both Countrywide and Merrill. Countrywide was the loan originator, Merrill sold the bonds. They both used massive lines of credit from BofA to accomplish this. BofA did not “buy” these companies, they foreclosed on the debt. Meanwhile, BofA profited handsomely from the arrangement. Merrill and Counrywide could not have killed themselves without the generous assistance of BofA.

    Now look at who the bank partners of Lehmans and AIG are and you’ll see which bank is getting rescued.

    It’s the banks!! Look at the banks!

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  109. Jared says:

    I understand why the Fed rescued the above-mentioned companies. However, I still take issue with it. Part of valuing whether someone should take the plunge and invest in a company is determining the risk. That is why stocks traditionally return more than bonds and why risky companies must pay more to investors than safe bets. The Fed has stepped in and falsely removed risk that investors should be taking into account. This distorts the market. It honestly makes me sick that it’s happening and I’m being forced to pay for it.

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  110. Alex says:

    This is exactly the analysis I needed.

    1.) Is the US economy really on the brink of a collapse similar to the Great Depression?

    2.) What events would need to transpire for another Great Depression to occur?

    By Great Depression, I mean a significant contraction of growth and significant unemployment.

    3.) What recourse does the US Goverment have in procescuting the corrupt CEOs of companies mentioned above?

    If there is a possibility of criminal charges, what would be the maximum penalty they would face?

    Were these CEOs even breaking the law? With all the deregulation in the past 30 years, perhaps these CEOs were acting completely lawful.

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  111. Left Back says:

    Until we reorganize our ecomony from one that is based on people spending money they don’t have, on stuff they don’t need that was made overseas – things won’t really change. The government is guilty too, borrowing to send us rebates to stimulate the economy. I fear we’ve passed a point where we no longer are creating enough wealth (manufacturing creates wealth, most other economic activity just moves it around) to support our global position and financial obligations. Give us simple incentives to save, allow manufacturing and farming to use incentives to grow and rewrite the tax code to no longer favor the rich … then the economy will begin to restore its fundamental strength.

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  112. Edna says:

    Thanks for the explanation. What I want to know is when is somebody going to go to jail?

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  113. nancy says:

    Am I correct in understanding that “liquidity”,
    or money changing hands,
    is critical to the functioning of government
    because the government collects taxes
    only when money changes hands?

    And therefore the government is more motivated
    to see that money changes hands
    in significant amounts,
    rather than to see that money changes hands
    in such a way that it can keep moving?

    As I see the growing gap between people who do and do not have enough money to realize the American dream in their own lives, common sense tells me this is NOT GOOD!

    But the experts I would like to confide in
    (the “free” press, and “our” elected government officials) keep telling me everything is fundamentally sound.

    Wishful thinking on a collision course with common sense equals a train wreck.

    However, as David Brooks recently wrote,
    “We change our behavior, not because we see the light, but because we feel the heat.”

    Have we felt enough heat to know that we need a change?

    . . . hoping so, in Fort Lauderdale

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  114. Pilgrim says:

    While this autopsy may be useful as a basis for further explanation, I don’t think it really gets at the core issues. Yes, these firms (broadly speaking) took these actions, but why?

    While it’s convenient for a first order analysis, the constant and widespread treatment of the companies themselves as the actors (AIG did this, Lehman did that) obscures what’s going on: the management and compensation systems that drove the actions done on behalf of the firms.

    The managers and bankers were doing what they were incented to do: drive short term profits, without real regard to the risks involved. (Nobody on Wall Street is paid the big money to stop deals, or to consider risk, really. The gatekeepers inevitably get ignored.) As long as the music kept playing, the game went on.

    So the banks don’t know their risks, and they certainly don’t disclose what they do know. What about the ratings agencies, then? It’s interesting that despite the (once again) tragic incompetence of the ratings agency, they are still regarded as having anything meaningful or relevant to say about the financial health of firms.

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  115. Bill says:

    Excellent article.
    I would like to see some discussion of how these forms of federal assistance may actually be protecting foreign debtors, and ways that domestic debtors can be protected first.
    Specifically, if an investment bank has an interest in a failed Spanish real estate development, and federal money is used to assist in a workout via a RTC type entity, are we not providing assistance to foreign firms simply because they obtained credit from US firms. To put it another way, shouldn’t we be working with US homeowners as a way for having them pay off or restructure their debt, rather than backstopping whatever debt an investment bank takes on. It would seem to me to make more sense to deal with domestic debtors and apply the assistance there.

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  116. Sam says:

    Great post! You have accomplished what many reporting on this have not – providing a consise, articulate explanation of recent events….but wait….oh, but of course, according to Palin and co., “real people,”, these are “academic elitists” who have provided the commentary, so we “can’t trust them…”

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  117. Stephanie says:

    So- selling everything and putting my cash under my mattress for a while isn’t such a bad idea after all, huh?

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  118. Michael T says:

    Re: Your point 6) What does this mean for the markets going ahead?
    Don’t the Government’s actions strongly incentivise further mergers (e.g. take overs of Goldman Sachs and Morgan Stanley) to create financial intermediaries that are “too big to fail?” At this point, haven’t we effectively privatized profit (the up-side), and socialized losses (risk/downside)? What will this do to market choices and our economy going forward?

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  119. TLWAYNE says:

    Mortgage lending practices of the last six years are the root of this financial upheaval.

    Agreeing to lend money to individuals with a recent history of credit defaults and failing to verify the ability to repay by accepting stated income (subprime) was the recipe for this disaster.

    While you can argue that the borrowers should have acted more responsibly the poor credit history indicates a lack of good judgment. The lenders are the supposed experts and yet in this system have no legal or financial liability as the mortgages are securitized and sold to investors.

    These guidelines while embraced by mortgage lenders were facilitated by Wall Street issuers of mortgage backed securities who established the parameters (bad credit, no income verification) for the loans backing the securities.

    The free and unregulated Wall Street market established a demand for this type of financial instrument and the lenders were happy to accommodate.

    As is the case with almost all demand a marginal increase or decrease (subprime was approximately 17% of the home buyers) in the available borrowers had a dramatic increase in housing prices which has led to this melt down.

    Regulation of credit practices and financial instruments seem prudent given that unrestricted free market forces have resulted in damage to world wide markets and households.

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  120. Adrian says:

    I thought AIG would be staffed full of actuaries.

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  121. Mark Robinson says:

    Republican presidential candidate, Ron Paul, preached incessantly for the last twenty years about the hazards of “printing money out of thin air”, the necessary collapse of an empire because of the “destruction of it’s currency”, and the power of the Federal Reserve (a Delaware Corporation) to bleed the American working people to death.

    Oddly, the young men and women of “You-tube” and a few “crazies” like me (I’m 51) listened. It has been like knowing an airliner was going to crash and then watching the news and being able to do nothing about it. I wish it felt good to be right, it doesn’t. My young daughters will not have the same qualities of life for near the same price. Shame.

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  122. Independent says:

    great article. feels great to read something non-partisan for a change. what america needs is the unadulterated truth. enough with the spin. puh-leez.

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  123. Johnny E says:

    I suppose it all boils down to is the scramble to see who gets stuck holding the bag after it sorts itself out.

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  124. Rafael says:

    What I haven?t heard yet is: WHERE IS ALL THIS MONEY GOING?? The Billions for Bear Stern, Freddie MAc and Fannie Mae…the 85B to AIG, and now 180B loan to foreign Central Banks…

    From what I?ve understood, the crisis comes from the need for more collateral to support the derivatives and CDS?s on all these guys books.

    So are you telling us that ALL this money, which could basically end hunger on a worldwide scale, is being spent so that the guys (individual and corporate) who bet that consumers were not going to pay their mortgages, can get paid!!!???

    Please tell me I?m wrong…pleeeasse

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  125. D. Johnson says:

    Fantastic post. It would have been better only if you could have gotten Randy Kroszner’s take as well.

    I know things are bad when I see Kashyap (a student of the Japanese banking debacle) quoted multiple times in major NYT and WSJ stories in a 2-day span.

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  126. X-POLYGAMIST WIFE says:

    Bring Hillary back!!!! We need a woman to clean up POLYGAMY in Arizona and Utah.

    BANKING ON HEAVEN . COM

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  127. Richard Friedman says:

    Cutting through all the nice jargon, at bottom the problem seems to be too many risky home loans. Yet the percentage of these loans that have actually defaulted is unknown, as is the amount that will ultimately be uncollectible. Although the crisis has some basis in economic reality, it was fed in large part by that oldest of human emotions: irrational fear of the unknown. So the next “reform” must boost the cognitive environment of investment and rest on the premise that a “security” that cannot be understood, should not be allowed to be marketed.

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  128. Jay Gouline says:

    As a graduate of the University of Chicago’s MBA program in 1976, Merton Miller and Eugene Fama stressed that the investment decision is independent of the financing decision. Clearly today’s “Master’s of the Universe” missed those lectures. Drs. Miller and Fama, thank you for keeping me out of harms way.

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  129. Lynn says:

    Thanks so much for this very informative explanation. I’m e-mailing it to friends and family.

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  130. Robert Lenard says:

    Let me get this straight. Congress, at the behest of the credit industry, removed the ability of people to revise their mortgage via bankruptcy. And the problem was caused by “sub prime” mortgages. The only conclusion is that the credit insustry killed themselves via their sycophants on the Hill. And I’m supposed to bail them out? All the bums need to be thrown out. Let’s start by repealing the 16th.

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  131. slarrow says:

    Paul from Reston: I “blame the victim” in order to point out the rest of the iceberg that’s under the water. Whether someone was conned or bamboozled, only adults can sign the papers, and infantilizing them in order to justify further top-heavy command and control is both worrisome and ultimately not as effective as some would hope. While many of the calls for further regulation, prosecution, and firings have much validity to them, I think it’s dangerous to think that these narrowed focuses will solve the problem.

    We may end up paying attention and directing instructions to a couple of thousand people, but it’s the actions of hundreds of millions of people that will actually determine what’s going to happen. Let’s not get sucked into the illusion of control that’s going to come out of the proposed changes; much of this is going to be uncontrollable by its nature. Perhaps the best advice still comes from Douglas Adams: “Don’t panic.”

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  132. Pierce Randall says:

    The last line in the article — that’s a big shift. The Fed regulating the economy mainly outside of the rate. I wonder if this will persist after the crisis. Did the Japanese economic crisis and banking troubles usher in this new era?

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  133. tiddle says:

    While most of the info presented are not new, the materials were discussed and presented in a very clear, concise and coherent fashion, allowing even laymen to have a grasp of the issues at hand.

    Albeit the chaos, I appreciate the controlled discipline in which Paulson and Bernanke have been approaching the situations; in particular, Bernanke in holding the rate steady, rather than resorting to cutting rate and getting out of the mess quick, like Greenspan did, which had in no small way contributed to the bubble in the housing market.

    The industries (banks, credit agencies, brokers, and what not) had played it fast and loose, in allowing the subprime mess to spread to the credit market at large. As food for thought, if we can have more discussions on suggestions for fixes, going forward, that would be truly awesome.

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  134. Adam Caper says:

    Excellent brief, gents — thanks to you and the freaky guys for getting it out so quickly.

    To address Maxi’s thoughts: the only way one might expect wisdom prospectively from the remaining players is if one defines it mathematically — as the average between unregulated greed and absolute panic. In my mind that’s a little like hoping that if you add bitter and sour you’ll get sweet. Probably not all that likely….

    In a more serious vein, the problem with the hope that a new regime of “wise investments” will save the remaining banks is that such opportunities are generally few and far between when the fundamental fabric of reality becomes tattered, as it does in a panic. It also assumes that those organizations have a sober, realistic view of the value of their current portfolio, which is fundamental to both the confidence of counterparts and the development of a strategy that will strengthen their balance sheets. There’s been very little evidence that they have much of a reservoir of either sobriety or realism close at hand, and even if they do their skills at utilizing such things are no doubt rusty, to put it kindly.

    The problem we’re facing is that our financial system was designed (or evolved) as a system of checks and balances, which themselves are dependent on a set of powerful regulating forces to ensure that today’s players don’t whittle away future stability in order to secure short-term benefits (which they will naturally do, as that’s the most “rational” way to book profits). Without regulating elements securely in place, markets tend towards bubbles. Bubbles are painful but not usually crippling, as they’re generally sufficiently sequestered from the rest of the economy not to turn into a cancer that eats away at the broader capital base. So the institutions that the economy needs to allow it to regroup and start rebuilding may be a little bruised, but not so damaged that they can’t do their job.

    Unlike previous bubbles however, which involved things like dot com shares, tulips and commodities, this bubble involved an element of the economy which had always been thought of as a safe (if illiquid) place to store wealth — homes. To think of it another way, by securitizing so many homes — and in particular homes (which represent income streams to repay the securities) being held by the least financially capable members of our society — we basically untethered the safe financial anchor of housing assets into just another commodity to bubble up and float away.

    To make matters worse, since most of the sources of repayment for those securities are the middle class, and since the middle class has been so eroded by 30+ years of so-called ‘trickle down economics’ (which has led to the historically huge income disparities that we hear so much about), the system just doesn’t have the strength to take the stress.

    So, here’s the ironic description: In order to win the election of 1980, Reagan & his crew persuaded people that government was the thing that stood between them and prosperity. Voters – entranced with his roguish good looks and insouciant charm – responded by electing a series of administrations which chipped away at the regulatory mechanism steadily over time. This allowed the financial system to start treating our society’s “rainy day money” (the equity in our homes) as just another commodity to be securitized. Financial actors, in the perfectly rationally pursuit of higher and higher returns, made it far too easy for people – both good credit risks and bad ones – to ride the bubble, which grew out of all proportion because there wasn’t anyone keeping it in check. Because of the bubble, many people stopped saving (why save, which is painful, when the increase in value of your home easily outstrips whatever you might, with great sacrifice, be able to put away?), which means that the most likely route out of the mess will be for the “evil” government to print money to throw at the capital markets to replace what we should have been saving in a little more sensible way (which is to say, borrow it from our children…who, of course, will have good reason to think of the government which has saddled them with all of that debt in a pretty unfavorable light.) Congrats, Ronnie & Co – you were right! Yaay!!

    The consequence of all of this will in all likelihood be a much higher inflation rate – which is another form of negative savings – but we’ll save that part of the story for another time.

    Fortunately, we’ve got Sarah Palin to save us. She’ll just stare unblinkingly (Charlie!) into the eyes of the crisis and shoot at it from an airplane. Or something like that….

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  135. samspike says:

    i am extremely angered by the transfer of risk and especially the transfer of massive LOSS to the taxpayer. very, very angry. why the f**k did i have to jump through hoops of fire to get a morgage or business loan, when the atmosphere at the top is handing out the keys to the national treasury to these precious fat companies, and defer the fundamental problem into the future? it will certainly return, and there will be more knocks on the treasury door, and they no doubt will be happily answered AGAIN and AGAIN. thanks for nothing you fools.

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  136. Jh says:

    Poster #71 – The Fed is not PRIVATE – it was created by Congress in 1913 and its Board of Governors is appointed by the President. Also, each of the 12 regional Federal Reserve Banks act as fiscal agents for the US Treasury.

    Yes, there are private components but it is very much influenced by our gov.

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  137. Dave Clemens says:

    Sorry if I demur from the round of congratulations to the authors of this piece of evasion. This is journalism at its most meretricious — a long, detailed explanation of what happened without a smidgen of an indication of why.
    Those posters who bring up deregulation and the lethal biases of the UChicago crowd are on the right track. We are witnessing the quintessence of capitalism, not some sort of momentary deviation from the wonderfulness of free markets.

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  138. Nondumiso says:

    Brilliant article- Thanks!

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  139. Anish Sinha says:

    Simply brilliant! (well it is simple as well as brilliantly explained)

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  140. Skeptic says:

    It’s a real laugh to hear these sentiments expressed by Chicago libertarians.

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  141. Rey Olsen says:

    The systemic problem is that if executives at
    Lehman and other firms took large risks they stood
    to gain large rewards. But they had no downside
    as they were not risking their own money.

    It was like playing roulette with other people’s money where you get a percent of winnings but no risk of losing your own capital.

    As with all professionals, the answer is licensing and malpractice insurance. If you are negligent or reckless you can lose your license and be susceptible personally for damages. Plus if your track record makes you uninsurable, no one will hire you.

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  142. mopar says:

    Great article. Two questions: What are the chances all the banks will fail? What are the chances the government will run out of money to lend and borrow and collapse, at least financially?

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  143. Erin Bowie says:

    Best summary I’ve seen so far. This is great!

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  144. Edward Butler says:

    Since the Fed is stepping-in to bail-out all of the banks because they bet wrongly, does this mean that the Fed will step-in and bail me out because I bet wrongly in Atlantic City and lost my shirt?

    Edward Butler

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  145. collegestudent says:

    Thanks so much for this insightful blog. I’ve been looking for a clear assessment of the crisis all week.

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  146. otti says:

    The Ponzi scheme debt capitalism is dead.
    You get no more credit.
    That’s the problem!

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  147. Satish Sharma says:

    One thing you could add to the reason for Lehman’s demise is that they never used the fed facility.

    As someone explained a while ago; if you live on upper east side; you know tee-shirts are cheaper in walmart, but you never shop there.

    That snootiness and incompetence caused their death as much as other market conditions.

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  148. justin says:

    savings and loans in the 80s
    LTCM in the early 90s
    Dot-Com in the early 00s
    and the subprime market in 08-09

    I’m not worried at all, we will weather this storm

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  149. atm says:

    I noted no mention of the bank multiplier effect (and its anticipated reduction now) in predicting any widespread future financial difficulties.
    The article was instructive, the fingerpointing of the responders was less so.

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  150. Charlie says:

    I just realized last night that I don’t understand why the stock market works the way it does. It seems to me that many investors plan to make money primarily by selling it to other investors at a higher price than they bought it, rather than by collecting dividends or selling their stock back to the company. Given that, why is the price of stock (at least in more normal times) so closely tied to the company’s performance? If I own Company A stock, and will make or lose money on it depending primarily on how much I can get for it from a third party buyer, why do I care about Company A’s earnings? Can anybody help?

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  151. Leake Little says:

    What about the failure of off-balance sheet commitments to fully diversify risk in this instance? Are you saying that these instruments were simply not used properly by managements, or were still too concentrated to perform as expected? Why couldn’t these firms shrink their balance sheets to adjust their funding requirements or risk profiles? Was short-funding “inevitable” or was it really a management choice based on the assets accumulated in the last five years? A lot of market commentators are making points about the opacity of the assets being held by these institutions, and the lack of transparency or disclosure to investors and/or rating agencies. Was this deliberate or did the firms themselves have no active, holding company-level asset-liability management function?

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  152. ronin469 says:

    this explanation is incomplete, as it makes no mention of the long-standing circumstances that led into these credit issues – this did not start with bear sterns – this did not start 12 months ago.

    any explanation that begins with the problems of bear sterns is ignoring the genesis of the trouble – like saying your roof won’t stay up because the walls keep falling, but ignoring the circumstances that have eroded the foundation responsible for supporting the walls.

    what i want to know – how much will the fed lend to Mr. & Mrs. US Taxpayer when this rolls down to them??? good luck! soon, your mortgage company will have all the emergency bail out funds AND your house….

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  153. T.A. says:

    Is any of this (actions by the Fed and the Treasury) legal? Do we, as a taxpayer, who ultimately get burdened with the loss have a say in any of this? What happened to laissez-faire?

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  154. Tim Bal says:

    The article was an excellent description of the trees, but it said nothing about the forest.

    Missing was how Wall Street executives and hedge fund managers sucked billions out of the American economy, and the consequence of the federal bailouts is that the rest of us will have to live with higher taxes and higher inflation. The latter is really bad because average people do not realize how they are being robbed to pay the billionaire Peters.

    Wall street and the hedge funds used obscene leverage (equivalent to a down payment of ten thousand dollars on a million dollar house) for years while they paid themselves big bucks from the borrowed money. Now the little guy has to pick up the tab.

    This is political. The Republican Party advocated deregulation of Wall Street, low taxes (so the government now owes 9.6 trillion dollars), and big spending for things like unnecessary wars. The deregulation allowed Wall Street and the hedge funds to go crazy.

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  155. norbert hirschhorn says:

    Is the Fed just printing money to pay for all this?

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  156. Sprizouse says:

    @ #150(Charlie)

    The value of the asset underlying your trades is very important. It’s exactly the problem that caused this mess. You can buy and sell a company’s stock and profit from it that way, but if the company goes in the toilet you’ll be left holding worthless stock.

    To understand the current fiasco, just replace the words “company stock” with “mortgage-backed securities” and replace “you” with “investment banks” and there you have it.

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  157. eduardo says:

    Great article.

    But, at the end of the day, our real problem is the corporate culture in New York. Financial and other industry executives seem to have degenerated into a self-selected society of free-market-anarchist super-sociopaths. They are willing to take advantage of anything, willing to do anything, to make themselves rich.

    They do not care one cent for anyone but themselves. And, they do not even care about the shareholders of the corporations they are running. This seems worse, given that the logic behind most of their behavior is that they have “to answer to their shareholders.”

    They spend billions of dollars lobbying our representatives for less regulation and freer, more open markets, promising that they will regulate themselves. Well, let these events teach us. They will absolutely not regulate themselves.

    And now, the regulatory noose will tighten even further around their delicate pencil necks. I hope they don’t choke….

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  158. Carl says:

    I understand “man on Main Street” is a figure of speech, but it’s a bit jarring to read in a discussion like this today.

    Women and their money, of course, are just as affected. The “average American” would have been a more suitable phrase to use, and just as euphonic as the one it replaced.

    That said, very interesting insights. Thank you!

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  159. Joe Bob says:

    TLWAYNE, I think you have one of the most cogent comments in this thread.

    Prior to the “financial innovation” pioneered by Wall Street, mortgage lenders made most of their money the old-fashioned way: They made loans to people who had the financial means to pay them back, plus interest. During the throes of the housing bubble, mortgages were still the product but the main customer changed. The customers were Wall Street investment banks who needed a plentiful supply of mortgages they could securitize into CDOs, SIVs, and JUNK. What’s beyond me is why the investment banks kept buying the mortgages as their quality went down.

    Ergo, the path to riches for the mortgage lenders was to originate as many mortgages as possible, no matter what. Mortgage lending turned into a boiler room operation and underwriting standards went out the window. Make no mistake, the overwhelming cause of the current debacle is widespread and institutionalized fraud and deceptive business practices on the part of lenders, not borrowers.

    Why do I think it’s the lenders who are primarily at fault? Look at the new rules the Fed approved this past summer: they all address abusive lending practices. Apparently, they didn’t think borrower fraud was that much of a problem. If one good thing comes out of this entire debacle it will be that home buyers take a much more jaundiced view of the entire real estate and mortgage business.

    The typical homebuyer doesn’t realize that the fiduciary duty to them of everyone from mortgage brokers, to loan agents, to realtors ranges from zero to marginal. Esteemed lenders like Citigroup were paying their agents ‘yield spread premiums’: that means their incentive was to get you to sign the most expensive loan they could sell, not the best one you qualified for. One change I would like to see: an enforcable fiduciary duty (not some mealy-mouthed Code of Conduct) imposed on mortgage lenders and brokers.

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  160. g says:

    I’m still confused, but at least now I feel better about my ignorance. I feed my chickens. I think about wind. I watch the river.

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  161. billkeep says:

    A big “THANK YOU” for this piece. A recent column in the NYT by David Brooks probed the rather delicate issues of elitism, education, experience, and populism. This particular piece bridges those gaps.

    I happen to be the only one in my family to go to college and I was fortunate enough to be able to successfully pursue a PhD. This article speaks not just to me but also to my siblings and friends.

    I particularly liked the hotlinks to academic pieces (though I am not sure all will).

    But more importantly, this pieces gives a thoughtful consideration of current events and suggests how we might think about the future.

    Thanks!

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  162. cory says:

    I am no economist yet, but it seems to me that the bailouts encourage more risky business in the future. Some argue that we need more intervention (regulations), but perhaps we would be better off if the government were less involved. After all, didn’t our government have a lot to do with creating the monster that became Fannie and Freddie. Had they not tried to get everyone everywhere home loans (regardless of financial condition) they would not have offered backing to Fannie and Freddie which led to them being an unusually large giant in their industry. In the short run the failure of AIG would hurt, perhaps hurt very badly, but I believe that we would have a healthier economy in the long run.

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  163. Bill S. says:

    I can’t be so grateful to this post. There is an underlying assumption that things are great most of the time and in certain cases, well, the government simply has to intervene. No it doesn’t. People see “growth” as the normal thing, and if banks and finance don’t rule the world, if their temple is shaking, then the government has to do something. No one looks around and questions the foundations, no one speaks for those who are daily exploited in such a great “system.” About the impoverishment of everyone when the whole society becomes trained on and obsessed by stock prices, consumption and debt. The rich arrogantly demand public welfare as if it were in the “national interest” while denying it to the starving, and scorning public intervention during the “good times.” Even more discouraging than this “crisis” is the obfuscating, white-washing, and yes, ideological response of those who claim to speak both in the name of everyone and from the high chair of academic “expertise.” Terms like “Main Street” are euphemisms meant to represent the “common man” or “you and me,” when the real threat is mostly to the moneyed or investor classes in all locations. Why not take this as an opportunity for radical transformation, or less drastically, re-assessment of societal goals and values? Because few people are ready for it, or even consider it possible… This should cause us to trust the government even less, but if we don’t pay our taxes to support this outrageous behavior (Fannie, Freddie, AIG, Bear) they will throw us in jail. Let’s see public dividends from these trillion dollar companies to all citizens when they are making their profits. How’s that for “economic stimulus”?

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  164. PapaOscar says:

    The authors, like most economists discussing the financial system, want any future regulation to “be done without stifling innovation.”
    Well, there’s innovation and then there’s dreaming up new ways for really smart people to get really rich before the bills come due — to be paid by the ordinary shareholders and taxpayers.
    Seems a little stifling might be in order…

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  165. Wes says:

    As Michael Greenberger put it on Fresh Air yesterday, what we’re witnessing now is the privatization of profits, but the socialization of loss. That means that those who made so much money selling these faulty mortgages and securities have walked away with little consequence (and no one would have dared suggest that we, the taxpayers, share in the benefits of their enormously expanding wealth), but now we will all pay for their bad decisions. As for the future: McCain is sticking to his deregulating stance, which shows that he knows little about the economy and even less about how to make strong leadership decisions.

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  166. Robert Solomon says:

    When Adam Smith wrote “The Wealth of Nations”, championing free enterprise and capitalism, he was singing the virtues of the English system, as opposed to the French and Spanish, where the government granted monopolies to new industries. It was the height of the Commercial Revolution, and the naissance of the Industrial Revolution. He was writing about markets where buyer and seller were small, each having no great effect on the market, each with perfect information about the market conditions, each buyer having as much power as each seller.

    So isn’t time we gave laissez faire a rest. It does not apply. People back then thought a human could not travel more than 30 miles per hour – we would be crushed by the pressure on our circulatory system. Well, many such old ideas are proven to be bunk.

    Our economy is global, it works are the basis of a few giants that dominate markets, that secrecy abounds. Regulation is necessary, important and vital for these kinds of activities to continue. Our economies do not work the way things did in the Enlightened Eighteenth Century. There has not been a “free market” for finance for more than a century. We voted to regulate all these activities because it wasn’t working before.

    When things collapsed, it was called a Panic. They happened repeatedly. Farms and businesses were wiped out. Andrew Jackson destroyed the Federal Bank, and crippled the economy for decades, and brought on the Civil War.

    Here we go again.

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  167. Che Migeløn says:

    Ahh, the humanity. Please allow me to point out that there is an universal reset button located on the back side of the debt box. It is labeled “forgiveness”. A.K.A Forgivonomics. We don’t have to wait for implosion, do we? Forgive all debts via UN accord, as we forgive the debts of all others.

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  168. Nunuvyer Bizniz says:

    Umm, what happens when the Fed runs out of money to lend? Do they just print some more?

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  169. JaxMax says:

    Cogent, comprehensive, concise.

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  170. Bill says:

    If the government does do something like a Resolution Trust Facility, I can understand how this tax expenditure could assist asset holders.
    But, we tax asset holders and wage earners (who may not have assets) based on their earnings.
    Can you explain how this program benifits both groups–asset owners and non-asset owners–and how both groups are taxed. It would look to me like non-asset owners who only have income are not beneficiaries, other than indirectly. It would seem to me there is a different incidence of tax and benefit to both groups.
    Secondly, instead of giving a tax cut to the top 1%, why don’t we give them the face value of debt instruments that the government acquires instead. It would be a way to resell the instruments, and would cancel out the benefits to asset holders from this RTC facility. (A facetious proposal).

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  171. ZBicyclist says:

    Since many of the SIV’s involved in these debacles were headquartered abroad for tax purposes (notably in the Cayman Islands), I assume the Cayman Islands will be kicking in a few hundred billion dollars to help out.

    I’m sure their check will have pretty pictures of a beach on it.

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  172. Saad says:

    Very nicely explained. Thanks!

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  173. greg says:

    Where’ the FED getting the money. Everybody is asking this question but does anybody have an answer?

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  174. Sue says:

    I hope Mr. Obama has consulted with you about what he’s going to tell the nation. He will understand it and, I hope, be able to give an Econ 101 explanation that will prove once more that he is the candidate for the 21st century.

    Go U. of C.!

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  175. Coughlin Stoia Fan says:

    The Private Securities Litigation Reform Act, while not a major cause, is something I have not seen mentioned in any of these threads. The corporate political machine convinced everybody that securities fraud plaintiffs lawyers were fleecing investors and that legislature should raise the pleading standards for securities class actions – as a result, it became much harder to bring successfully leverage a bona fide class action complaint into a meritorious settlement. The number of filings and the average settlements went down. The government did just stop enforcing the securities laws; it decommissioned the private attorney generals out there who were doing a great job of making it very expensive to defraud the American people.

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  176. Penny Scott says:

    Thanks for the explanation. Placing blame was not the purpose of the article. Perhaps you might take that on. A Congress that lived off Fannie Mae contributions and deluded themselves into thinking it would fulfill the “American dream” of nice houses for people with no money; a sleeping SEC and Federal Reserve; political appointees like Raines;
    greedy and feckless CEOs who became fabulously wealthy while destroying their companies; all of these are guilty.

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  177. Jesse says:

    “The inability to secure short-term funding fundamentally comes from having insufficient capital. There are many indicators that the largest financial institutions are collectively short of capital.”

    Out of curiosity, where is the existing capital?

    Whether central banks or private entities, those with capital may have just gained a lot of power.

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  178. brent says:

    From Post # 25: “McCain voted in favor of this deregulation. Joe Biden and every other democratic senator voted against it.”

    1. Actually, McCain did not vote for Gramm-Leach-Bliley (GLB), he was on the campaign trail at the time of the vote, so we will never know his position.

    2. Joe Biden did vote for GLB, as did Harry Ried, who is also out claiming that GLB is the heart of the problem.

    3. Leach, the L in GLB, is an advisor to the Obama campaign.

    4. In any case GLB passed 90-8 in the Senate on 11/4/1999, the House passed it 362-57, and as Mr. # 25 poster noted, Bill Clinton signed it into law.

    If GLB has anything to do with today’s problems, and I know of no evidence to support the theory, it is a bipartisan creation.

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  179. Jeremy McMillan says:

    With the rampant flag-waving and warmongering (Terrorism, Iraq, Iran), large scale nationalization of the financial system (which indirectly controls almost all investment thus production capacity), all we need is a good-ol’ witch hunt (several calls to raid past executive compensation might be a good start) to bring back the Nazis! Then when we are all literally nauseous from the constant spin of high drama futility, we can welcome ‘ol Hadrian back to the throne.

    First we start the “War on Credit Fraud” and then we extend it from the scope of CEO class scapegoats to reach people who misstated their incomes on mortgage apps, and then we go after any kind of fraud, and then we go after any information that doesn’t meet some trumped-up standard of “truth.”

    Bye-bye Bill of Rights.

    Goodbye, sweet America, land of the free, home of the brave!

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  180. Harold says:

    I do not offer myself as a financial expert, no even close. However, one aspect of the AIG failure intrigues me. They were going to have their credit rating lowered by Moody’s…which meant that they had to come up with $40 billion more cash. They could not get it…hence “crash”. The part that amazes me is that no one said that they didn’t or couldn’t “pay their bills” or couldn’t make good on any insurance claims. So why were they in trouble? It seems that they did not match some probably arbitrary criteria for a stable business.
    So the usual Wall Street stampede started. It’s like fine art…the painting that you just bought at auction for 1-million is worth that amount only if other people think it is. Intrinsically, its worth the cost of canvass, paint and framing.

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  181. Margaret Fell says:

    Bless you for saying outright that the Fed NATIONALIZED Fannie & Freddy. Now here’s my dumb question: the Bush administration refused to create a vehicle for saving those dummy middle-class & poor folks with mortgages that they could no longer afford– or which were suddenly worth more than the houses. They were small enough to fail, singly…. but in aggregate, did/does the total amount of defaulted mortgages come to a economically significant total? And if so, would it have been both economically smart as well as plain decent to have bailed out these unimportant citizens?

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  182. GKM says:

    Remember that joke about how many Chicago-school economists it takes to change a light bulb? (None; if the light bulb needs to be changed, the market will take care of it.)

    The joke may not be that apt anymore, but after reading this I was still left wondering what these two economists think will happen now that the government has had to step in and change the light bulbs for the financial markets. The questions they pose are the same ones I was hoping someone would answer:

    “…now that A.I.G. has been lent to, how will regulation have to be adjusted? Surely the Fed cannot be called upon to provide backstop financing whenever a large member of the financial system runs into trouble. How does it prevent a replay of this scenario, and can it be done without stifling innovation?”

    Well, how about it? Does anyone have anything to propose?

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  183. Sprizouse says:

    GLB certainly hasn’t caused the problems we’re facing but it’s certainly going to cause them in the future.

    Prior to GLB all these failing i-banks would simply have withered and died (failed business models in a free market are supposed to wither and die). But now, Merrill can safely resume it’s prop trading operations within the friendly confines of BofA. What happens when Merrill’s traders make some colossally stupid bet ten years from now? Not only does an i-bank go down but now a consumer bank goes with it.

    These “saving” mergers — only possible since GLB — will create more long term problems.

    Fannie and Freddie and AIG and Bear and Long-Term were all “too big to fail”. Now we have JPMorgan-Bear, Bank of AMerrill and Wachovia-Stanley on that list.
    Sprizouse

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  184. Ming Yeow Ng says:

    Just published a dummies guide to the financial mess for people who know very little about finance. Take a look!

    http://v3.mingyeow.com/?p=98

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  185. alijeffty gonzales says:

    great posts! thank you

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  186. Nancy L. Donahue says:

    I’m curious……where does the government get all the people to step in and run these institutions that they have taken over? Is there a government pool of experienced, intelligent people just waiting in the wings for this kind of situation????

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  187. Mike says:

    Wow! Look at the rabid anti-capitalism in these posts. Go to your favorite financial website, find the chart of the DJIA, and hit “Max” for some perspective. I’m surprised no one has yet blamed global warming (cue Al Gore).

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  188. Jack says:

    In more basic societies, the guilty and their familes would be dragged into the streets to meet public executions. Let’s get back to basics.

    176.September 18th,
    2008
    4:45 pm Thanks for the explanation. Placing blame was not the purpose of the article. Perhaps you might take that on. A Congress that lived off Fannie Mae contributions and deluded themselves into thinking it would fulfill the “American dream” of nice houses for people with no money; a sleeping SEC and Federal Reserve; political appointees like Raines;
    greedy and feckless CEOs who became fabulously wealthy while destroying their companies; all of these are guilty.

    - Posted by Penny Scott

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  189. justthesame says:

    Others have motioned it, but the _final_ Gramm-Leach-Bliley (GLB) Act was voted nearly unanimously in the Senate: 90-8

    This is all business as usual.

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  190. Emery says:

    Of course the underlying truth underlying the sub-prime mortgage mess which undelies the financial crisis is that average Amercians are not earning enough to afford a decent house with a mortgage.

    Until the country figures out a way to more equitibly distribute income throughout all sectors of the population, we may never see the end of these types of crises.

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  191. Kate says:

    I’m a little taken aback at the suggestion that “large financial services firms now must understand that they need to manage their own risks more carefully.” how, exactly–are you familiar with Game Theory? They can’t–thre’s no real incentive to do it and all this pressure to take on lots of risk. The other concept that left me breathless was “an acceptable level of chaos.” This isn’t some sort of computer model–these event have had and will continue to have a terrible effect on people’s lives. And this type of free marketeering pretty much guarantees the further concentration of wealth into a very small coterie of individiuals. Oh, but I forgot. You folks are from the University of Chicago, home of Milton Freidman and the other “Chicago Boys” who advised very repressive, bloody, rapacious authoritarian regime for the past 30 years. Unregulated markets and the repeal of the Glass-Steagall Act are very directly responsible for this crisis. And yet, you neglect to mention those facts.

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  192. Jill says:

    Thank you for this explanation. Extremely helpful.

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  193. Mckenzie Richards says:

    Thank you for the effort. Could you please explain Sarbanes-Oxley and how that impacts, and why it was gutted and who has responsibility for voting for that deregulation? Thank you.
    MJ Richards

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  194. Alan says:

    The idea that it was possible to structure
    financial instruments in such a way as to make
    it almost computationally impossible to
    derive the tree of fragmented positions that
    constituted them is testimony to the
    recklessness of the quants and to the
    blindness and laxity of the regulators.

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  195. Gregory says:

    I believe less Government means “sit on your rump”, but if the Gov. truly cared, and had been doing the right things, we would not be sitting hear today talking about this…. The Gov. had no clue this was going to happen, sure, right, I beleive it! “Where did all the lost money go (To the Government!)anyway”!!!!!!!!! And many other program’s money like social security… Where are our experts hiding,were they fired? We all know what’s going on, but can’t do anything about it. The peoples voice cannot be heard anyway… I think the Government is playing silly games with its people. We have been hoodwinked, or the wool has been pulled over our eyes. Well have fun anyway, and good luck during the election! Take care these problems will all go away when more Americans votes will count… Thank you, Gregory

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  196. sophie says:

    “Good explanation, but I must respectfully disagree with your answer #6:

    Letting Lehman go means that the remaining large financial services firms now must understand that they need to manage their own risks more carefully. This includes both securing adequate funding and being prudent about which counterparties to rely upon.

    My take on it is that the bankruptcy of Lehman coupled with the rescue of AIG sends the signal that companies need to enmesh themselves deeply in many different parts of the market around the world, but once they’re big enough, the government will be there to step in because they’re “too big to fail”. So the new business paradigm isn’t “do it better”, it’s “protect yourself by getting into a position where the government will bail you out.”

    - Posted by Ian Randal Strock”

    This is my take away as well.

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  197. Mckenzie Richards says:

    As an afterthought, so am I correct if a little overly simplified, but the government sets up a separate entity which will take all of the bad paper held by banks, financial institutions, insurance companies off the hook, these institutions will be able to write-off all of their bad paper, loans and I assume they will get some remuneration and the new government entity will be financially responsible (meaning we the People are responsible)… then what? So this new government entity ends up with what? a million-plus empty houses and in order to recoup some marginal amount so “the People” won’t feel as though we were totally Fu**’d, and it tries to sell those houses for what 10-cents, 20-cents on the dollar? Is that the scenario?
    More of this administration’s surrealistic nightmare. Everyone in the Republican party seems to be against welfare, socialism and here we are in the midst of the biggest socialistic corporate welfare give away in a hundred years and they are asking me to pay for it… well, actually no one has asked me, they are simply going to make it so. If however, anyone asks, I vote NO. Let the corporations and financial institutions find their own level, they managed to get into it by themselves with the help of congress and this administration my theory is, let the SH*T find its own level without any help from “we the People”. But that’s just the View from My Trailer Park.
    Thank you.
    MJ Richards

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  198. Frank Remarque says:

    Nader was right. In 2000 he predicted big trouble ahead and was very specific. So if you’re looking for predictive smarts instead of hindsight brilliance, check out his web page. You’ll also find concrete suggestions for remedial measures. Anyone who prefers political content to reality tv politics should be happy.

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  199. George Shen says:

    “Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures.”

    If a financial firm is too big to be permitted to fail, then it should not be permitted to this big at first place. Simple and clear. Fed should force all those big financial firms to break into small firms on top of more control and transparency.

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  200. Juan says:

    As I am not an economist I did not understand a thing. lol
    it is nice to be dumb

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  201. Tom Zaremba says:

    The part of the explanation they missed is that the big 5 investment banks/brokerage houses were all given an exemption by the SEC in about 2004 that allowed them to ignore the standing SEC rule that limits the debt to net capital ratio of securities firms. That allowed them to greatly expand their debt leverage (and potential market participation and profits) but also to greatly leverage their risk. While the SEC abdicated its regulatory responsibility, we now have to collectively pick up those risks to our pension plans and retirement funds, as well as the costs as taxpayers. And no one is yet asking the question of how much financial weakness has this caused to the Treasury, or what the cost to the taxpayers will be.

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  202. Vicky Boynton says:

    What if Bush had been able to let Wall Street handle our social security in private accounts as he fought so hard to do?

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  203. Ollie Bland says:

    “[W]ithout stifling innovation”??? Isn’t innovation in the form of credit default swaps and other derivatives, coupled with a complete absence of oversight, extactly what got us into this mess in the first place?

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  204. CSTAR says:

    Now one of your conclusions clearly falls under the rubric of “moral hazard” A reasonable reading of the recent bailouts suggests a simple rule: if a firm is on the verge of collapse and its ties to the financial system will lead to a cascade of chaos, the firm will be saved.

    So the next Lehman will make sure it’s really inextricably tied into the financial system. I’m sure somebody’s already thinking about how to do this.

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  205. Hal says:

    I strongly disagree with other commenters here about the ultimate cause of this problem.

    The reason we do not have capital now is because we spent it in the past few years. We spent it on big screen TVs, boats, vacations, iPods, and other expenditures that were enabled by people refinancing their homes and by selling their homes at a profit. These profits and refinances were false, they were illusions. But the TVs and boats and such were real. The economy was diverted to producing these goods at an unsustainable rate, and it produced them in place of capital goods that the economy needed.

    We borrowed from the future to enjoy life in the present; but now it is the future and the enjoyment is past. Now we will pay the penalty for our extravagant lifestyles of the past ten years. We as an economy are like the young couple that goes deeply into debt at the start of their marriage, living it up for a brief while, and then endures years of financial hardship trying to get out.

    One of the unyielding lessons of this situation is that trying to ease the hardship, make the burden lighter, ensures that it will take much, much longer to get over it. The only way to get past it quickly and get on the road to improvement is to take a very serious hit, to endure real suffering and hardship. But the will is usually not there for such a course.

    What is suffering and hardship in this context? It may manifest in different ways, but ultimately it is deprivation. It is an absence of luxury, of comfort. Maybe it’s unemployment, maybe it’s inflation, maybe it is low wages and expensive goods. But the bottom line is that just as we consumed more than was sustainable for the late 1990s and early 2000s, we are now constrained to consume less than would have been sustainable under other circumstances, and probably for many years to come.

    There is nothing any government can do to fix this. The laws of economics in this case are as immutable as the laws of physics. We have eaten our seed corn, and we will reap a harvest of shortages for many years as a result. At most a government can redistribute the pain, perhaps taking more from the rich and spreading it among the poor to ease their burden, if politics allows (or demands).

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  206. Andy McLennan says:

    And your policy prescription is?

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  207. alanb says:

    “…the Fed had very imperfect information about what was going on at Bear. The Fed was not Bear’s regulator, the amount of publicly available information was limited, and its staff was not versed in all of the ways in which Bear might have been connected to other parts of the financial system.”

    Considering the universally now-obvious interconnectedness of the various players… WHY WASN’T IT THEN-OBVIOUS to the Fed?!?!?

    ———-

    “Since March, the Fed had also studied what to do if this were to happen again; it concluded that if it modified its lending facility slightly, it could withstand a bankruptcy; it made these changes to the lending facility on Sunday night.”

    On a related note… who is to blame for the fact that the Fed hadn’t worked this all out long before Bear required rescuing?!?!?

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  208. Steve says:

    I think that this is a sorry set of excuses for a panicked and undisciplined reaction by our government to this crisis. The writers echo the standard justification that these institutions were too big to fail. Instead, the United States is now the proud owner of barrels full of monopoly money.

    With the exception of Fannie and Freddie, which were quasi-governmental agencies, NONE of these other bailouts should have been made. The Fed’s lending window should never have been expanded. We should never have lowered our collateral requirements — we are buying garbage with taxpayer dollars. And a few of these greedy behemoths should have been allowed to come crashing down. Instead, we have only delayed the day of reckoning — and are frittering away trillions of dollars of national wealth on these ill-advised handouts to the rich. This is outright thievery, plain and simple, and I am just disgusted that my hard-earned dollars are going to pay off the irresponsible and criminal actors who created this crisis. These corporations should not be getting bailed out — people should be going to prison instead…

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  209. Nick says:

    Here’s a simple explanation of the financial turmoil we are witnessing: it is the largest margin call ever made on the largest number of actors at once on funny bets they made of slips of meaningless paper.

    8 years of Laizze-fair(sp?) is the cause.

    The Fed is treating symptoms, NOT causes. The problems will continue until house prices reflect ACTUAL values. A 3-bedroom, 2-bath standard ranch house in Portland Oregon is NOT worth $375K.

    Nor $275K.

    MAYBE $175K if and ONLY if it is REALLY nice house in good repair.

    Get it?

    Too much speculative bullcrap, people. GET REAL!!

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  210. Steve says:

    To those who are asking where all this money is going to come from, the answer is simple: your pocket.

    Our government is borrowing money to meet these obligations, and you, I, our children, and our grandchildren are responsible for paying off these loans. This obligation will come to tens of thousands of dollars PER PERSON in the United States. I work hard for my money, and my government is giving it away to the greedy financial “wizards” who are responsible for this problem in the first place.

    This is just a sickening exploitation of the American taxpayer. Just sickening…

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  211. susan k. (NYC) says:

    So funny…the chicken and the egg.

    GREED ACCORDING TO REPUBLICANS: People took out mortgages they couldn’t afford and spent money they didn’t have!

    GREED ACCORDING TO DEMOCRATS: Companies lent to people who didn’t have money so that the company could become more bloated!

    Guess what? Both are true. Sadly, this is the nature of Homo sapien. To act responsibly–or without greed–is the exception to the rule whether you are a street sweeper or chairman and CEO of Lehman. Am I wrong?

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  212. Bob says:

    What you have explained still does not get to the core of the matter; why were so many subprime borrowers defaulting. I have an explanation to suggest: an economy, even as big as ours, cannot long sustain the diversion of so many dollars to the wars (wars producing little or no ROI like schools, bridges, research, etc.) the jump in the price of energy, and ironically the unfathomable salaries paid to a few. All these dollars could have remained in our economy, simulating demand and growth and keeping low wage earners with sub-prime mortages employed and solvent. The loss of those dollars to unproductive (and unnecessary)wars , the oil companies who have not innovated or added to the nation’s refining capacity in almost 30 years and the ultra-wealthy few who’s spending is largely meaningless to economic stimulation was enough to begin the cascade of defaults with their now evident results. Why is no one telling this part of the story?

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  213. dave says:

    As usual, these guys are not nearly freaky enough.
    Where is the fundamental information on why freddie and fannie were created in the first place?
    Why should gov be involved with the market?

    Taking a different tack, imagine this scenario: suppose that what could be done by gov about this situation would be good for the average citizen but bad for the bankers. Do you think all the bankers would be in favor of such action?

    Notice how very few people are questioning the wisdom of the gov (taxpayer) bailout. Notice how those commenting are the ones who will most directly benefit. It is all very self-serving: the rich benefitting the rich.

    Instead, I suggest questioning the legal fiction of the corporation; the rules that set up banking in the first place; etc.

    I previously emailed the freakonomists about the health care situation: they don’t question the assumptions that ground the health care business. They only tinker around the edges.

    Not nearly freaky enough, guys!

    I went to the U of C, too, but I think for myself rather than conform to some academic line.

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  214. William Schroeder says:

    Very good antiseptic article. But what happened to all the finanicial wizards with the brilliant computer models? No one at these companies knew a year ago that they were headed down the drain? Are you kidding me? Lehman still had there website up as of yesterday and I looked at their quarterlies for the last few years and the comments by their CEO. Gee, everything looked roses and sunshine, billions in profit, huge office buildings going up all ove the world, and now we are supposed to believe that the collapse just happened out of nowhere and no one knew about it? Let’s face it (and realize that there is nothing anyone can do about it), these shysters were filling up their mattresses as fast as possible until they couldn’t keep the charade going anymore. These guys would have pushed pregnant women out of the Titanic’s lifeboat to make room for themselves. If anyone thinks these HEEPS are losing sleep over all this, you are sadly in error. Most of them will surface again in a year or two, just like the guys in Times Square who run the shell games. They see the cops coming, fold up the table, and move the game to another part of town.

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  215. lusciousbobby says:

    Even the smart people who built this tower of absolute fraud and betrayal seem to be panicking. This must be serious bad.

    I told my mother I cannot protect her any longer. She doesn’t want to hear what I have to say. She just insults me, my intelligence, and my predictions. Ironically, it all hurts me in every way in the end, but there’s nothing I can do. I no longer have the strength to fight.

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  216. Jim says:

    The first thing I learned at U of Chicago was to answer the question that was asked. Leavitt asked them for an explanation of what happened, not a critique of regulation (or lack thereof).

    I also learned to read things very carefully. Hence phrases used by the authors, like “weakly supervised” were not lost on me as they seem to have been on others.

    I also learned about externalities, market failures, game theory, capital structure, and adverse selection. I learned that behavior usually follows incentives, and that the investment decision is not the financing decision. I learned that in periods of stress, uncorrellated assets become correllated and backwards-looking risk models fail. I learned to create scenarios that stretch my thinking and to surround myself with people who challenge my assumptions. Above all, I learned to let data, not ideology drive my decisions.

    These and other tools have helped me to understand what’s happening and to stay out of the way. I doubt some of the “Chicago” critics actually attended the school; if they did they were among the very few who weren’t paying attention.

    Professors Kashyap and Diamond, thank you for your summary of what’s happened.

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  217. Steve says:

    Not only a lack of effective regulation and money supply management that built this catastrophe. Interesting to consider the role of the press in this debacle, too. Consider that a week ago our hallowed national business paper, the Wall Street Journal, was still focusing on lipstick, hair-dos, and eyeglass styles–and other important qualifications for higher office in this land–rather than the debacle brewing right under their noses. Why are helpful blogs/discussions like this one not showing up on the front page of every paper (and the TV “news”) so that our electorate can make more informed decisions? Wake up people and save America! Country First (not Party).

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  218. jorge says:

    Paul O’Neill quit on December 6, 2002 and the reason was that the president Bush was blind and deaf. Now you trust on all these acts of this administration. Tell me then, why Paul O. quit before the beginning the war in Iraq.

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  219. cr says:

    A comment for the New York Times editors…why all the apostrophies (e.g., C.D.S.’s)when speaking of these things in the plural? That’s no mistake a world-class newspaper should be making.

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  220. David says:

    re: #121

    I’m not an economist, but I’m not convinced that your logic holds. Just because someone can correctly (or coincidentally) predict that the markets will experience a recession/depression, it doesn’t mean that your alternative system of a gold standard and restricted credit would be on balance a better way for the world to be run. To follow-up your analogy, everyone knows that an airliner is going to crash one day; would you rather live in a world without airplanes?

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  221. JpS says:

    If I remember correctly previous chairman of Merril Lynch was fired for negotiating to sell company.Present chairman was praised for selling company.I believe if company was sold year ago price would be three time of present price.Life is unfair.

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  222. jsb says:

    This is an exceptionally lucid analysis of the events of the past weeks. Missing is the analysis of alternative uses of the capital which was forced into an overheater housing market. Also missing is a warning about the complexities and explosive effect of dirivatives. They were the building blocks of financial ruin.
    Anyone who watched the markets today understands why the Fed had to act. Simply stated the markets were in a death spiral from which, by definition, they could not recover on their own. A lack of response, indeed a slow response, would have taken the American economy and much of the world toward the dreaded “D” word. An unacceptable risk.
    The key question now is NOT who was to blame (the causes were too complex and varied for quick and easy answers- however comforting to the spleen). The question is “whats next” and the answer is that no-one knows. If we are all very lucky the markets will stabilize and we may go about the business of recovery. In that case we will soon forget that the crisis existed and will again swoon at the thought of small government and limited regulation of markets and industries. Should the spiral resume (as it may for any of a thousand reasons that create a lack of confidence) the Fed. may find itself out of bullets. In such a case the only option is to ride out the storm with calamitous exceptional consequences. No American will be spared.
    True leaders in these times act deliberately and with caution. They secure facts, slog through endless permutations of cause, and resist rash action until broad changes can be enacted over time. Fools call for heads to roll, cast blame and aspersions in all directions and hope to quickly move on to another matter. Americans must avoid stampedes or risk the most dire of results.
    Beware of the fools.

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  223. EH says:

    A word of thanks for providing this information. I have been looking for just such an explanation and could not find it in other publications. I am so happy that I found it. You have satisfied my curiosity for a time.

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  224. ShineOn says:

    I too would like a discussion of why the subprime mortgages got us into this mess. But I have some very specific questions about this so bear with me.

    Mortgages which first had fixed rates were issued with the borrowers believing that they would go on paying the low rates forever. At some point interest rates went up and that happened to be concurrent with the adjustable rate kicking in. So suddenly the borrowers couldn’t meet their monthly payments.

    OK, in the old world, the bank which issued the mortgage would still have it on its books and could do something about adjusting the rate. But, someone got the bright idea of selling the mortgages to a “repackager” who combined a whole bunch of them, sliced and diced the group to create a financial instrument. And then sold it off to the genius investors in financial firms across the world.

    So all of a sudden is seems that there is no way to know who owns what. Right? There is nothing that can be done about the interest rate on the mortgage because the mortgage is somewhere is the ecosphere. Right?

    OK, so here a main part I don’t understand. All these people are paying the monthly mortgages to someone? Who is that someone? Where is the money going? Someone must be keeping track of who gets what or else how do the investors place a value on the bonds?

    Why was the government unable to declare a freeze on mortgage interest rates. So what if there is a legal debenture for the mortgages, Congress can pass a law to change the rules.

    Yes, it is a bad idea, but what has been happening is worse.

    Finally: how can so many smart people who earn so much money be so dumb? The subprime mortgage market was just like the 1920′s people buying investments (houses, instead of stocks) on borrowed money (mortgages in place of margin) and then when the value of their investment goes down (higher interest rates reduce the value), they have to invest more (more monthly interest as a margin call) which they can’t and then things just spiral down. Didn’t any of these bankers study economic history?

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  225. GW Bush says:

    So where the hell were you geniuses beFORE this crap all hit the fan?

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  226. Tom B says:

    It seems to me that things become a lot clearer if one thinks of the financial system as a huge shell-game in which complicated instruments are developed not for their ostensible aims, but rather as methods of funneling large funds from sundry sources into a limited number of pockets…. As long as the individual interests of individuals are ignored and we talk in terms of ‘institutions’, we will always miss the real motivations behind the incredibly complicated system of instruments. Individuals have motives. Institutions are simply their tools.

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  227. Greg says:

    I understand the underlying theme pervasive in the downfall of these large companies. My question is whether it would have been better for the Treasury to guarantee the mortgages until they could be converted to something more stable and rebundled as such. Wouldn’t that reduce the fears of lenders to these institutions and given rise to long term stable financing or higher paying equity buyers? I feel like we’re treating the symptoms when we could be hitting the underlying cause and possibly helping the people who need it and haven’t been playing chicken with shaky financing.

    Greg
    Kentucky

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  228. Kate says:

    I am amused by some of the posters. This is not a failure of the regulators–we’ve been in a deregulation frenzy for the last 28 years. The protections put into place in the aftermath of the 1928 crash have been dismantled. This is what a free market looks like. But it isn’t very free, is it? The party ends at some point and all those rabid free marketeers who demanded the “freedom” to do exactly as they please with other people’s money now demand a bailout. And regardless of whether or not they get one, the folks who helped create this mess will walk away with billions. In this column, the authors gave a nice, plain-spoken description of what happened as far as it went. The trouble is, they limited themselves to a vary narrow interpretation of the question that was asked. The are still free marketeers from a School of Economics that has an increasingly bad smell given its penchant for finding brutish regimes who would impose draconian economic programs in countries ill-prepared to withstand the shock. They still can’t or won’t face the real root causes of this debacle: the gutting of the regulatory safety net and the embracing of a fiscal policy that pretty much makes disasters like this one all but inevitable.

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  229. john talbott says:

    And why was there no regulation of these banks, investment banks, realtors, mortgage brokers, FNM and FRE – because they were all in the top ten of biggest lobbyists and biggest campaign contributors in D.C. Congressmen were being bribed to look the other way and not enforce real applicable laws, not pass new regulation and deregulate and eliminate traditional regulation.

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  230. HildaCMS says:

    Not bailing Lehman Brothers shows other banks that they are not necessarily backed up and that they better step up. But all of this basically happened because many thing that happened in Wall Street were unmonitored since it was “Wall Street” and oh, they know what they’re doing and consequently they were giving out horrible loans and now have all these mortgage issues. And according to CNN, the bid to AIG (85 billions usd) is equivalent to financing about 200 days in Iraq, that is more than half a year, and also you could buy about 40 countries in Africa w/ this amount of money. This shows us that it was definitely a big sum. We will soon see if it was worth it.

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  231. fred schumacher says:

    The debt-asset ratios of these investment firms were so fantastically high that the only way the system could continue working was if revenue came in on time so that it could be disbursed on time.

    Timely flow of revenue was absolutely crucial to the functioning of the system. When revenue stopped flowing in in a a timely fashion at the bottom of the system, it propagated through the system like a wave, causing the top of the system to crash.

    Why did revenue not flow in on time? Because of speculation driven run-ups in the cost of housing; poor evaluation of borrowers’ true ability to pay; and the continuing rate of growth of income inequality leaving the middle class cash-flow short. By aggrandizing more wealth to themselves in the short term, high income people ensured the collapse of the system that kept them wealthy.

    As any millwright knows, when the timing system on a machine fails, the whole thing can fail catastrophically.

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  232. SW says:

    My concern about the recent problems with FNM, FRE, AIG and the investment banks is that the root cause to the problem is not in the home mortage crisis per se, but that the lack of available credit is the root cause. Providers of funds are no longer willing to fund U.S. homeowners as well our huge budget and trade deficits. Any opinions?

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  233. William Seymour says:

    As professional economists, Messrs Diamond and Kashnap can and should do much better. This article is far too superficial to be useful, and will simply serve to convince some people that they think they now know what happened.

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  234. Ben says:

    There is no free lunch in life, nor is there a quick Buck.
    When you hand-over any business to a salesman you always get the same result – financial distress.
    Why did anyone ever think that just because the man you would never buy a used car from worked for a big league bank or insurer was capable of actually understanding a balance sheet, risk and basic fundamentals of liquidity and capital ratios?

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  235. David says:

    Wow! I’m glad you didn’t try to say our recent financial problems are due to the rise in abortions during the 70′s.

    Analyzing the past 10 days is all well and good, but lets not forget the history. Bank deregulation, Lack of oversight from Greenspam, the blind eye of the FBI, etc.

    Market forces, my a**! Greed, plan and simply.

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  236. Eric says:

    How is it that we end up with socialism on wall street? We end up bailing out the Capitalists? Aren’t these the very people that have been telling us that a free market is the best approach to health care? Is the economy really more important than our health?

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  237. Tim Andres says:

    As a working person in the construction industry I know that this kind of shoddy business practice must be implemented in the design stage at the outset. These collapsing banks are a plan in action with complete cooperation from all oversight agencies. The entire global capitalist system is forming into a few manageable banking cabals owned and operated by the several few wealthiest entities on earth. My question is what will they do when they have all the money? Capitalism is like playing with mercury, it all eventually ends in one pile. Part of our collective evolution will no doubt involve solving out of this predatory struggle and into one of meeting the needs of the species as a whole. We gain insight as we go.

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  238. GS Chandy says:

    One thing is for sure: in these (or any) times, ‘predicting’ the financial future will only work as hindsight. (Comment No. 8 has nicely pointed this out).

    What individuals and organisations need to do is to be very, very. VERY careful indeed! Clearly there is not a great deal of caution and care being exercised by organisations or by individuals – for evidence:

    – this rash of failures of supposedly top-grade financial institutions (which were doubtless advised by leading ‘economists’ and other experts) – and there will be more of these failures, not a doubt about it, whatever reductionist measures governments and their instrumentalities might like to take;

    – witness at an individual level the utterly crazy behaviour of millions of otherwise reasonably sane people in regard to their credit cards!

    One major problem faced is that conventional means of thought and discussion do NOT enable us to understand the effects, positive and negative, of our actions from day to day on the goals we wish to reach. None of the sophisticated economic analysis that is available enables such needed ‘synthesis’ that is essential.

    Remarkably enough, basic tools that can enable effective analysis AND synthesis that could in turn enable us (people at large AND economists) to exercise somewhat better control of our lives and others’ lives through discipline of our thought and actions have in fact been readily available for decades in the seminal contributions of Professor John N. Warfield to systems science. More information about Warfield’s works are available at: http://www.jnwarfield.com and at the “John N. Warfield Collection” maintained at the library of George Mason University, Fairfax, VA (check out: http://ead.lib.virginia.edu/vivaead/published/gmu/vifgm00008.tp).

    Based on Warfield’s seminal contributions, i’ve developed a powerful aid to problem solving and decision making that helps individuals and groups see and understand with clarity (and in a truly integrated way) how specific things we do from day to day may *contribute to* our goals that we wish to achieve. Economists (and ‘freakonomists’) would discover significant benefits in applying this tool to the basic issues that have led to the financial debacle we are facing worldwide – and to the basic issues of learning to live with sanity in what appears to be a crazy world.

    – GSC

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  239. Chris says:

    Great job with the in-depth look and parsing of the current financial crisis.

    Since this is the “freakonomics” forum, how about the following “freaky” answers to the FAQs:

    1) What has happened that is so remarkable?
    All but one of the iconic investment houses in the US are wiped out. Investment banks as we know them are gone!!

    2) Why did these things happen?
    Because it was like someone who was fed a toxic brew over a period of time, the person died.

    3) Why did the Treasury and Fed let Lehman fail but rescue Bear Stearns, Fannie Mae, Freddie Mac, and A.I.G.?
    Because they were interested in stabilizing the economy, but not in the business of bailing out investment banks.

    4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?
    Because in general equilibrium, everyone is affected.

    5) What does it mean for the Fed and Treasury going ahead?
    They have to better regulate qua-si government bodies like Fannie and Freddie, they simply don’t fit into the free market model.

    6) What does this mean for the markets going ahead?
    Not sure about this one, save more? Whatever the case, mortgage could definitely become a dirty word.

    7) When will the turmoil end?
    The toxicity was so high that there was not enough good blood (capital) for the transfusion. Catalysts, good or bad, can turn the market either way at a moment’s notice. When will greed end? When will risk management be in place? Maybe we have to ask these questions first.

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  240. BS says:

    BS! Let these firms fail. If you don’t then every firm has a great incentive to take on all kinds of risky obligations and investments precisely of the kind that the gov would HAVE to bail out. If we didn’t bail out worst case scenario is that a good percentage of banks would fail. This is okay. Firms that take bad risks should be able to fail. And even if credit markets did seize for a little bit, the remaining good firms would regroup and pick up the pieces within a few months. All the fed gov should do is guaranteee its FDIC obligations to individual savers if commercial banks were to fail. And you know what, a few months of slowed growth isn’t the worst thing. The economy doesn;t akways have to grow. It moves in cycles. Over the long term there is growth but intermittent periods of non-growth or even contraction are fine. That the federal government should even be large enough to do these bailouts is a travesty. They’re just bailing out with tax money they didn’t earn. Give us back the tax money and stop playing big brother to banks. Let them fail. Also, a major contraction in the availability of credit is okay too. We don’t all have to buy cars and houses and fridges and vacas on credit we can’t afford. How about you buy what you can afford? If this slows the economy that is okay because there is no shame in living within your means. Also, the obsession with homeownership is silly. Freddie and Fannie were forced to exist so that every schmuck could buy a house even if his income wasn’t nearly enough. How about renting instead? No shame in renting. The government doesn’t need to prop uop an institution just because of some fanciful notion that everyone is ENTITLED to own a house.

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  241. shashi dalal says:

    Marxist analysis of the crisis of over production and under consumption in the economy may explain quite a bit of what is going. The financial market is divorced from real production in this country, hence the crises that we witness…….

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  242. Patricia says:

    I did not have time to read all 236 posts that came before this one, but I have a question for the economists: what would happen if all the upside down subprime mortgages were refinanced at current market rate of the home with a 30-year fixed rate loan at market rate – and inflated value written off? Could this stem the tide of foreclosures (which is aggravating loss of value to all homes), monetize losses in a way that re-focuses everyone’s attention on a discrete, fixed problem, and opens the door to something that’s bound to happen: some years from now, home prices will rise again, providing equity to these now struggling homeowners. Like many, they will likely use the equity to invest or buy stuff. Bottom line: If my taxes are going to pay off socialized losses for private profiteers, I want my fellow citizens to benefit in a way that promises to grease the economy’s wheels in the future.

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  243. Freddie says:

    Glad to know ManU is safe. Never was a big fan of AIG or Bear Sterns or Lehmann.
    williambanzai7: would just like to say, ‘Love your work’. Keep it up!

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  244. JC says:

    The ability of regulators to understand financial innovations is just appalling. One need to ask, why banks are incentivize to create innovative loans that would not even pass the credit smell test. The answer lies in the ability of investment bankers to take if off the banks’ balance sheet in so many creative ways: SIVs, CDO, CDO squared, CDO cube and credit default swaps.
    Are regulators appalled that Bears is at least leverage 35:1, Morgan Stanley and Goldman 22 – 25 to 1. They are more leveraged than hedge funds.

    Many financial products today do not need or need only marginal capital. This is a house of cards. How much leverage is predetermined by the capital base? Like all derivatives, once the underlying (mortgage) goes sour, the magnitude amplifies. The asset multiplier here is the ability of such financial innovations to create an inverted pyramid of wealth.

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  245. Steve in Langley says:

    America is a land living beyond its means. Whether it’s a nation of overeaters eating to excess or consumers floating paper to buy more foreign goods than you can afford, all Americans are to blame for this debacle. Look in the mirror; the i-bankers are just giving you what you want: a free lunch on other nations.

    Expecting that today’s solution of quarantining the bad loans will work – is a typical American look for the simplistic band aid approach that will reduce the pain and allow the band to play on.

    But how far down does the rot go? Into consumer loans, credit card debt, business loans. It’s probably best to paper over this rot and let it become someone else’s problem. What did Keynes say? “In the long run, we are all dead.”

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  246. Richard H says:

    Let’s stop worrying about some overpaid kids on Wall Street who have lost their jobs or lost daddy’s bank while gambling in Vegas or Miami. It’s not the end of the world.

    10 years from now, the US economy will be twice the size it is today and this market correction will be a quaint memory.

    The real problem is the re-emergence of dictatorship in Russia and the flight of capital from the Russian markets. BRIC without Russia is now BIC.

    You read it here first. It’s BIC not BRIC.

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  247. SD says:

    I never borrowed beyond my means. I never lent money to a bad risk. Why am I and the millions of americans like me paying for everyone else’s greed and poor judgment? I say let’s make those responsible foot the bill for their mess. Defaulters with garnished wages at rates their incomes can sustain to make the government whole. Seize properties and assets of all directly responsible for the perfectly “legal” but clearly immoral practices that put us all here. They are resourceful, they will be fine. Congressionals and presidents who supported also held accountable, pensions wiped out and revert to treasury. They too won’t suffer. Maybe this will instill the era of personal responsibility that conservatives love to promote, and protect the innocents that liberals love to defend.

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  248. GS Chandy says:

    No. 235, Ben, wrote: “There is no free lunch in life, nor is there a quick Buck.”

    Well, there are exceptions, it appears: The CEOs of the failed investment banks and other broken companies – those ‘fortunate souls’ got away with their free lunches and quick bucks of many, many millions of dollars!!

    – GSC

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  249. Max Patkin says:

    You forgot to mention Barney Frank’s role as Chairman of the Financial Services Committee. He hasn’t done much besides take tons of money from Fannie, Freddie and Wall Street. Shout out to b-frank!

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  250. Joe Stratford says:

    As usual, the brainiacs at the University of Chicago are the only one that comes out to tell regular folks what is happening – and explain it well, too.

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  251. Dan says:

    Thank you. This was a very clear and understandable explanation

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  252. Jason Sjobeck says:

    All of these CEO’s ought to be prosecuted. All ought to forfeit their pay. All ought to be remembered forever as the greedy, stupid, shortsighted, ogres they are.

    The AIG deal is unclear to me how I & my daughters who now own that dog with fleas get our money back? After we break it up & sell it off, does that money go back in to the Fed & Treasury for us to use for the other “bills” we have to pay (ie: two failed wars, healthcare, SS, rebuilding our country, et cetera)

    And, last, and most notably, the most responsible person on the face of this spinning mudball: one Mister Dubya Criminal in Chief. Nice job, man, nice job, are you happy now. Just let the market sort it out, you got brush to clear.

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  253. Richard G. says:

    What about the credit rating agencies? They rated as AAA firms whose survival depends on rolling over loans every month. Can a firm which depends on a AAA credit rating actually deserve such a rating?

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  254. Puniha says:

    It is an excellent ex-post, proximate explanation. It does not trace the root cause of problem. In 2001, dot com strategists forgot that computers are tools to assist real economy and not a replacement for brick and mortar sector. In 2003-07, wall street forgot that extraordinary profits were a return for excessive risk and not a return for ‘smart entrepreneurship’ of financial whiz kids. Policy wonks of present administration must answer why were they as ignorant as a man on street. Or were they active partners in earning big bucks?

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  255. GSB says:

    Jim (8:22 p.m.):

    I congratulate you on your ability to read carefully. Apparently, you did not learn while at the U of C that the purpose of the school is to ensure its existence in perpetuity. Think! The question was formulated with the (simplistic) answer in mind. This is a bit of fluff, a U of C PR piece. How convenient that they don’t even have to pay for it.

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  256. Shailesh Dhuri says:

    I think the reasons for mass failures of financial institutions in developed world are:
    1. Agency issues:
    a. Rewarding somebody immediately for creating a long-term liability for an institution. In ideal world, the reward payout plan should reflect the term of liability.
    b. BIS II regime, which allows banks to calculate their own capital requirement
    2. Regulator Failures
    a. Investment Banks have an incentive to create new markets (read CDS and other derivatives) and keep those markets away from public regulation. It is a job of a regulator to bring transperancy and efficient “entity neutral” price finding and settlement systems in a new every market which finds wide acceptance
    b. Unified regulation of entities playing across multiple traditional roles of commercial banks, investment banks and insurers
    c. All financial market regulators needed to be subservient to the monetary policy (Central Banking) authority
    3. Lack of Financial Planning
    a. If one has short-term funding, one needs to have short-term assets of equivalent maturity, currency and size. An institution which hopes to create wealth by riding yield curve is doomed to fail
    b. Control on Leverage. The leverage of institution should be such that the instition should have capital remaining after a synchronized adverse 6-sigma movement in its entire portfolio. (If we can achieve 6-sigma quality in physical world, why we cannot create financial institutions with 6-sigma survival chances, and still make money)

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  257. Steve says:

    Ok a couple of items
    First, for all of you who are arm chair economists (a.k.a “know the real reason why…”), you really don’t understand how far you are out of your league. I would suggest at some point in your life you go to a university and read a prominent peer reviewed journal in economics or finance to find out what constitutes real scholarship. Then you should look at how hard it is to get a Ph.D in econ, finance, etc at a top tier university. Then you might want to look at what type of scholarly work earns a Nobel prize in economics. If you have a half a brain it will hit you will realize that your contributions in the comment section are pretty lame attempts at dressing up your personal political views in some sort of “evidence based” explanation for what caused recent market turmoil. I’m not saying that experts are always right or don’t have the same biases. I’m just saying that the chances of some profound piece of scholarship emerging from the fray of a blog comment board are remote given the level of education and training of most people commenting. Should you happen to stumble onto something profound I have my control-C/V fingers ready and a separate window with a blank Outlook email to a .se address.

    Second, on Fannie Mae and Freddie Mac, many experts (i.e. Ph.D Economists) warned this could happen for, let me remember, since fannie mae and freddie mac have practically existed! That is a slight exaggeration but I mean come on. Maybe people should read more or better sources. I’m happy to reveal my bias… the only thing I ever read on the NYT website is this blog. I don’t think they have much interest in publishing most op-eds that forecast warnings like the one below from a heritage foundation report in April 2005. I would love to be proven incorrect here, as then we could just conclude that people who read the NYT must be incompetent instead of simply misinformed (or not informed at all).

    From Heritage Foundation Report (“Time to Reform Freddie Mac and Fannie Mae” – Ronald Utt Ph.D. April 2005)
    “Lest one think that such an occurrence would be a distant possibility, the record reveals that federally sponsored financial institutions, including those that the federal government closely regulates and insures, have a knack of frequently exploding in hugely horrific and costly ways. Since the mid-1980s, massive losses have occurred in the federal Farm Credit System, the Federal Deposit Insurance Corporation, and the Federal Savings and Loan Insurance Corporation. Worse, the heavily regu lated and supposedly closely supervised savings and loan industry collapsed more than a decade ago, and repairing the residual damage cost the U.S. taxpayers $130 billion”

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  258. Ed says:

    The time has finally come for the entire American Financial Industry of ALL stripes to have new Regulations put in place to insure that the American econony NEVER AGAIN has to face the pure unadulterated CRIMINAL NONSENSE that has been allowed, ne, Fostered to happen,, by one stupid move after another,, by both political parties over the last 60 years since WWII, in their blind quest to attempt to gain control over all the population of America. They BOTH seek to be BIG BROTHER, from the womb to the tomb. For the future; ALL Companies MUST have 100% Transparancy of all accounts, especially those in charge of the IRA accounts that have been the only savings accounts for retirement for most. We, the people, can no longer allow Wall Street to run Main Street into the ground like it has, with astronomical Board payrolls, obtained by Contract Lawyers who must be insane. If Congress does not act to correct the way business is done, then we are truly doomed. For Congress; ALL Lobbying for EVERYONE must cease and desist doing business with “contributions” {i.e. GRAFT} no lobbying to be allowed within a 7 mile radius of the House or the Senate. Television time MUST BE FREE, aka DONATED, for all candidates for President to debate. ALL, not just 2! Are we Free or not?? If we don’t start running this Country by REAL ETHICS, we will have no Country LEFT to worry about.
    It is time for Business Ethics to become a required course of study for ALL colleges, IMMEDIATELY,,, and for all the current crop of crooks to be Jailed, stripped of all their assets, and never allowed to re-enter any part of the Financial community. Until this is put in place, we are on the shakiest ground that has been seen since the Crash of 1929.
    If you had told either of my Late Grandfathers that it was possible NOW to screw up America more than what the Depression ever did, they would not have believed it to be possible. That IS where We are right now.

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  259. Stephen says:

    So the greedy turn the game upside-down, the financial system implodes. The masters of Capital show once again that they know how to manage money-HA!

    The little guy gets stuck with the bill, the greedy little buggers who caused the mess get off scott free to pillage another day, and the most secretive, conservative administration in recent memory turns into over-sized New Deal whole seller of houses no one can afford.

    No oversight. No responsibility. No accountability.

    Sounds like all is well in America. What was the problem again?

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  260. gb says:

    Six months ago I felt very uneasy and told my husband to liquidate all of our stocks (which are tied to his company’s retirement 401K), and fortunately for us, he put them into a low-yield money market fund, so at least we didn’t lose with the current crash. Yesterday I realized that he’d better check as to whether the money-market fund is insured… and we found that it is not! Needless to say, we’ve done another transfer to insured funds. That said, we are now searching for undervalued real estate in a rural yet stable area, because our cash held at 2 percent interest is not keeping up with inflation, so either way we are losing money. We figure that the continuing crisis and inevitable unrest that will follow makes such a move appealing and a heck of a lot safer than living in our current city (not NY btw). We’re not “survivalists” but we are heading for the hills!

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  261. DEG says:

    Bla, bla, bla …. stochastic success …

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  262. Simi says:

    Absolutley insightfull!! Any takes on how this might affect the British economy…

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  263. Just another guy says:

    The post was clear, but in my view incomplete. It doesn’t explain fully that the problems are partly caused by the reigning ideology — anti-regulation, anti-tax, pro-debt, pro-war. Without a change in ideology, the problems can only be lessened in the short term, but they’ll recur sooner or later, probably sooner. Needless to say, John McCain has been a long-term supporter and enabler of the reigning ideology. At the moment he seems unprepared to change his mind, offering instead pure demagoguery, as witnessed by his remarks on the “fundamentals.”

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  264. a.e. says:

    What this all means is that it’s time to SCRAP the plans for the ‘Milton Friedman Institute’ at the University of Chicago.

    -that is- if the U of C wants to maintain any credibility and avoid being the laughing stock of the world.

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  265. Charles Goodman says:

    Good reading.

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  266. TAC says:

    The real layman’s explanation is the same story that has been occuring for centuries.

    Greedy people made very silly decisions behind a wall of financial trickery and fudged numbers. It again proves that Sarbanes-Oxley does nothing to prevent people from making horrible decisions – it only punishes those who explicitly lie or falsify claims about financial performance.

    In addition, it shows that going along with the pack is a terrible financial policy. We’ve heard over and over that “everyone was doing it,” which is a recipe for disaster. Seeing that Joe and Jane SmallInvestor were getting into real estate speculation and taking out 2nd and 3rd mortgages to finance risky real estate transactions made my wife and I sell our two homes in 2006. Just looking at what everyone else was doing made us run away from this sector. When we hear about things, the proverbial financial horse has already left the barn.

    It’s happening all over again. Gold and silver are the latest buzz word salvation of personal fortunes. Do people really know how much gold exists globally, and how “non-precious” a commodity it really is? How would a market truly survive on gold and silver bullion exchange? The cure for what ails us is liquity and people are now going underground and pulling the covers over them.

    Last, the most plain rationale for what occurred is that we are undereducated epicurian laggards on the world stage, and we overspend in every area. Our government could have staved off disaster is we weren’t sending literal truck loads of green paper over to the Middle East, with no reckoning or accounting for its subsequent whereabouts. The world understands better than us that a greenback isn’t worth what it is printed on, and we are suffering because of it. And now our major debt holders are China, Russia and Venezuela – countries that are NOT friendly to us and do not seek to see us rebound.

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  267. Arun says:

    Great article by Diamond and Kashyap.

    Given that the burden of the failing financial firms is likely to be shifted to the taxpayer, perhaps it is obligatory for the government to try to ensure that this does not happen again. Perhaps Diamond and Kashyap might venture into the far more controversial area of what the taxpayer-voter ought to demand as public policy to avoid being saddled with private debt?

    This reader would really appreciate it.

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  268. Arun says:

    Reply to jblog: But ultimately, none of this would have happened if it were for people who knowingly and willingly borrowed way over their heads on the assumption that the variable rates on their mortgages would stay low and housing prices would rise infinitely.

    Sorry, but the burden lies on the lender. If I stand on the street corner handing out hundred dollar bills, no one is obliged to ask whether I’m putting myself in financial trouble by such largesse.

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  269. Dushyant Kumar Singh says:

    The article was very good, making lucid a very complex problem of bewildering demise of financial institutions who were flag bearers

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  270. Bill Franklin says:

    For the start of the current housing problem, re read Liars Poker by Michael Lewis. See when Louie Raneri got Congress approval to bundle mortgages and sell them as securites. Nobody knows what kind of value they hold any more. No one cares.

    If a class of 5th graders cannot understand a “security” the instrument should not be publicly traded.

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  271. Arun says:

    Diamond, Kashyap write that Freddie Mac, Fannie Mae “appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market.”.

    Sorry, this does not parse. If Freddie and Fannie had taken minimal profits, then they would be squeezing the private sector; but taking huge profits seems to leave open room for any competition willing to work at a somewhat lesser profit margin.

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  272. atd says:

    What is obvious is that the fundamental causes are very simple and straightforward – it is all the result of the assumption that large corporations will “do the right thing” if left alone without regulation or control. Obviously, this is not true – we need to reestablish and enforce the rules that require corporations to behave properly.

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  273. Arun says:

    The essential nature of investment banks – their ability to rapidly change their risk profile – and how that makes lenders extend only short-term credit, does not change when the investment bank is part of a larger corporation. In fact, as with AIG, we can see that one part of the business can drag the whole behemoth down.

    The lesson to the investor is that unless you’re able to monitor constantly and able to pull out your money rapidly, you should keep away from any corporation that includes investment banking business, because the investment bank part of the business can rapidly change the risk characteristics of the overall business.

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  274. Jim S says:

    Fundamentally, two problems – one with poor quality mortgages and second with poor quality paper (security). In the first case, the real estate developer got rich – and he is still voting McCain. Who got rich in the second case? Someone received par value for all that third rate paper!

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  275. Ed says:

    It appears that Warren Buffet described the mortgage derivative schemes that have led to this fiasco as a time bomb about three years ago. How is it that a man who was being described as “senile and out of it” back then had such foresight and directed his financial subsidiaries to get out of that market?

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  276. Mike says:

    Outstanding summary of the mess to date. Now if you can get them to update it on a daily basis…. :-)

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  277. Brian B says:

    Thank you.

    This is exactly the type of information that is sorely needed, and strangely lacking, in newspapers. More clearly written “what’s it all mean” pieces from time to time would be greatly appreciated across all topics.

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  278. Kate says:

    #259. Surely not quotes from the Heritage Foundation? You are cherry picking your facts. Fannie and Freddie were sold off a while back and were not, until this recent contretemps, Governmental entities any longer. THey got into trouble precisely because there is no regulatory oversight and has not been for a very, very long time. The management team traded on the public’s misperception that there were government protections in place, which was not true. It’s telling that Heritage faults the Farm Credit System, the Federal Deposit Insurance Corporation, and the Federal Savings and Loan Insurance Corporation for losses incurred in the mid-1980s–AFTER the first big deregulation push. You are blaming the victims. But this is classic Milton Friedman–bullying disinformation designed to browbeat vulnerable peoples and organizations into giving away their birthright in the name of “freedom.” Freedom meaning that a small coterie of opportunists get to privatize–another name for grabbing all the valuable, publicly-owned assets, bleed them white and then walk away with the spoils while the public is left to clean up the mess. The emperor has no clothes. You’re backing a failed system. When will the University of Chicago repudiate Frediman and the rest of his Chicago Boys?

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  279. P Stetson says:

    This is a terrific, concise post. It may not have all the answers ( particularly the answers that we may WANT to hear ) but it does, at least, give an explaination in the context of the situation. I will share this w/ my clients…

    I am interested to hear thoughts about the thousands of hedge funds (which are unregulated ) and their role in the “short” selling process that enables the more rapid decline of company’s in good standing.

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  280. Nirmal says:

    What do the duo mean “stifle innovation”?
    what exactly do they mean by “innovation” in this industry? Long Term Capital’s model? CDS? The art of chopping up your risk and spreading it so far so wide, that no one believes that there’s an animal called risk? Maybe giving oneself the ability to create the ’97 asian crisis at the flick of a finger?
    De-regulation and other Reagan-esqe policy directions have played havoc from the S&L crisis till today.
    The reality is the finance industry has failed us regularly irrespective of “innovation”. I say that as I don’t have any cause-effect data to tie innovation with greed but I personally believe that any innovation that comes about here is about innovative detours around regulation, lobbying to end regulation and product innovation that hides risks in nano-lettering to over-maximise profits

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  281. tanya m. says:

    I don’t think I’m stupid, but I can’t follow this.
    If this is the “boiled down” version — yikes.

    What do average Americans need to know and understand to vote and live wisely?

    Blame our education system, but this Master’s Degree-toting citizen still doesn’t get it.

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  282. john favre says:

    Aside from the corruption at Fannie Mae and the huge bonuses for Reines, Johnson (Mondale’s campaign chairman with no prior financial experience and no knowledge), and Jamie Gorelick (the Wall Maker whose policy while at the Department of Justice in the previous administration hampered the discovery and prevention of the 9/11 disaster) we also have the Fed of the prior administration using a corrupt and politically charged study to promote No Standards Mortgages.

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  283. David Heigham says:

    Superb post, and incredibly quick off the mark.

    As to why things went so wrong, I am afraid the basic fault was that many major banks who were and still are short of capital had bosses that were too proud/greedy to pay the market price for that capital. They had long enough. The capital shortfall has been evident for the best part of a year. Things are looking better today because Morgan Stanley have signalled that they are willing to pay the Chinese (and HSBC who apparently think that the Morgan Stanley offer is a better use for their capital than a takeover of a Korean bank) that market price. If Morgan Stanley do it, so will the others in the US and Europe. AIG are not a bank. But when they needed extra capital they also refused to pay the market price.

    Teaching aids on the Bear Stearns, Lehman’s and AIG cases are below.

    Simi.

    The effect on the British economy of the reluctance of US, British and other European banks to pay the price for the capital they needed is likely to be that the recession/slowdown due to the collapse of the British house price bubble (a home grown recession or slowdown) is a sharper recession; but possibly a shorter one.

    READINGS FOR INFANT MBAS

    1. Pity For The Bear

    In the forest there was a very grumpy, very large Bear who was greedy for honey. One day he found two hollow trees full of honey. He reached for both, and both his paws got stuck in the hollow trees. Bear hides are tough, but the stings of hundreds and thousands of bees began to get through. The Great Spirit heard the Bear’s agony from afar and feared for the peace and order of the whole forest. The tribe of the JayPeeMs felt the Great Spirit’s trouble, and said “Oh Great Spiit we will put the Bear out of his agony to give peace to the forest, but it is a very great thing for a modest tribe to do. To undertake it we need a promise of your bounty so that we do not risk starving next winter”. So the Great Spirit promised the JayPeeMs his bounty should they need it; and when he finally approached found the camps of the JayPeeMs redolent with roasting bear meat; and the medicine man of the JayPeeMs dancing in the skin of the Bear.

    2. The Land of Lehman

    King Richard the Full-Dressed looked out over the land of Lehman, and saw that beyond the borders of its rich and smiling valleys there were other untended valleys which could swell the revenues and glory of the land of Lehman. So he sent out his soldiers and peasants to occupy and cultivate these rich valley lands.

    And the nomad tribes said “Aha! King Richard’s troops are spread thin, and our spies report that his reserves are few. Let us raid the riches of the land of Lehman.” And the word spread amongst the nomads. Day by day more of them troubled the borders of the land of Lehman. And King Richard’s reserves became very, very few.

    But lo, an Eastern prince with a strong army appeared ready to aid King Richard. For his aid, he asked half of the land of Lehman. King Richard replied “Welcome are you, and you shall be well rewarded; but half the land of Lehman I will grant to no man!”. At nightfall, the Eastern prince folded his tents and marched away.

    On the morning’s morning, the land of Lehman was no more.

    3. Rancho AIG

    Many and varied are its beasts, and endless are the acres of Rancho AIG. But its straw bosses heard of a Really Sure and Certain thing. There was a race that they could bet on known as the “Super Senior CDS Regulatory Handicap” in which it was Really Sure and Certain that their horse would always win. And sure enough for many months, every time the race was run their horse won. So they bet the Ranch on the race, and did not lay off their bet. And as with every Really Sure and Certain thing since time began, they lost the Ranch

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  284. EP says:

    Isn’t it possible that the gov’t bailed out Bear but not Lehman for no other reason than Bear had the good luck to go first? When Bear collapsed, they didn’t know they were going to face so many more in the coming months. The authors’ explanations on this matter, while plausible, strike me as overly “narrativing” and ex post facto. If the sequence had been reversed, couldn’t many of those factors be employed in reverse, to explain why Lehman received the bailout at Bear didn’t, if that’s what had happened?

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  285. kevel says:

    Many of these problems are caused by business practices which reward short term activities. Loan officers usually received commissions or bonuses on the dollar amount of loans placed, in total disregard of dollars collected on loans placed. My experience showed that companies which paid commissions on sales made at the time the contact was signed with no follow up on receivables collected, had lots of high flying salesmen signing contracts right and left with little regard for either the companies ability to successfully and timely complete the contract or the customer’s ability to pay timely. ALWAYS FOLLOW THE CASH. From a former auditor with a national CPA firm. (Not a guarantee of anything in particular, just a testament to my experience.)

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  286. Melinda Toumi says:

    Does anyone else have an opinion on the Commodities Act passed in December 2000 and signed into law by President Bush? I think it should be repealed. It effectively de-regulated many different aspects of our economy, and created an entirely different, and more secretive, tier of high-risk “investments” – aka bets.

    One more question: Why don’t we get out of the “credit” capitalism all together? I’ll just go without that which I cannot afford. Does no one else have the same intestinal fortitude?

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  287. ben says:

    This is very interesting although I don’t understand a lot of it. There
    are still a lot of questions.

    If I am an investor (stocks, 401K, pension plans) and credit will tighten,
    won’t tighter credit make rates paid on investments go higher?

    If AIG is invested in insurance companies all over the world, what are
    those companies and how are their policies affected? What kind of
    insurance? whole life? universal life? term life? health?
    fire/casualty?

    If Merill Lynch was sold, does it continue to operate under the same
    regulators?

    What is the affect on other brokereage houses? Do this week’s actions and
    loan guarantees help them, who have no government guarantees?

    etc.

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  288. Anne says:

    I wonder… if the Fed has control over AIG, can this be the first step towards a socialized insurance system in US? It is a big opportunity to do the switch.

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  289. KevinM says:

    “The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.”

    Sounds like congress giving the president the authority to invade Iraq, but they didn’t really think he would do it.

    Congress, please give me access to the US Treasury so I can buy a new car this weekend. I don’t expect to actually do it (and since I said so nobody can blame you, right?).

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  290. Jim in Atlanta says:

    First question: In what country is the parent company of AIG based? Just enough information to stir up the uniformed pot. All the Bush bashing bloggers on the bandwagon can research to find that he resisted and refused to appoint the mandatory board members for Fannie because he wanted no part of the “implied” government backing. He knew that government backing, implied or not, promotes reckless abandon without regard for accountability. As for the credit card banks screwing us now? The Senator from MBNA authored those laws by which they are bound to screw us. Significant help from the banks’ lobbyists allowed rationalization of the screwing. Reagan: ” …government cannot solve the problem, government IS the problem…”. Step up and hold ourselves accountable as the sheep we are. Let’s start by reviewing and understanding the respective roles of each branch of our government with their checks and balances. Consistently our national debacles have a common thread which runs through both parties and both aisles and all of it keeps “us” divided about what to do about “them”.

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  291. Chris Watkins says:

    The lesson to management from these crises is to continue to speculate wildly, but to extract as much money as possible in cash bonuses before any failure.

    Perhaps we will see bonuses being set at six month intervals rather than annually in future?

    The shareholders of an investment bank have, in practice, little influence on its day to day activities and the risks it takes, and they have almost no influence on the cash bonuses of its senior management.

    The catastrophic losses of the shareholders will be little deterrent to future management behaviour of this exact same type.

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  292. Brent says:

    To Arun – #274

    “Sorry, this does not parse. If Freddie and Fannie had taken minimal profits, then they would be squeezing the private sector; but taking huge profits seems to leave open room for any competition willing to work at a somewhat lesser profit margin.”

    Normally you might be right. But Fannie and Freddie leveraged the market’s assumption (now proven true) that the organizations’ securities were (are) guaranteed by the Federal Government in order to obtain debt financing at rates significantly lower than market.

    As a result, Fannie and Freddie were able to make fat profits AND squeeze commercial competitors out with lower overall costs.

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  293. len sive says:

    This fiasco made by Republicans (like McCain and his pushing for de-regulation!) makes me sick. As a nation we are sick–and tired of Republicans ruling and creating scandal after scandal. Has there been an elected Republican President since the 1920′s that has not been involved in, created, or allowed, some heinous financial scandal? Who in their right mind would ever trust a Republican with any position of responsibility?

    The AIG chief walking away with 50 million after hurting his company is symptomatic of how Republicans work. There is simply no accountability. Wasn’t their complaint against welfare that it encouraged immoral behavior? Well, the pot is calling the skillet black.

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  294. Robert says:

    Ultimately this is a problem of scale. Why do we worship size to the point that any individual player can take down a system? Two players left in the industry?!!! We need 1) many small firms and 2) way more transparency – No one can even assess how much recursion is in these transaction!

    If a deal needs such large firms perhaps it’s natures way of saying it’s out of proportion.

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  295. NicRic says:

    I just travelled across the US by car and I just don’t see hundreds of foreclosed houses on every block. The last I heard is that around 6% of homeowners are having trouble making their mortgage payments, which of course means that 94% are making their payments just fine. Is this really truly about a mortgage crisis or is it something else?

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  296. Sky says:

    This is an extremely carefully crafted article. The source, perspectives on explanation, tone, everything seems to be crafted in a way that convinces readers to solidify their thoughts on the economy… who gave a request to write about economy this way?

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  297. Frank says:

    Great explanation .. though I confused as to where the Treasury and Fed are getting the money to buy up all the bad debt and to loan out? How much is appropriated taxpayer money? And how much is going to be simply created by the Federal Reserve’ exercising their authority to make money?

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  298. Kelly says:

    Thank you so much for this piece. I am similar to your “man in Main Stret,” except that I have outstanding law school loans. I appreciate your explanation of how this all affects those of us who don’t have their money tied up in the market, but rely on indirectly.

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  299. Christine Bork says:

    Solutions:
    ban use of credit default swaps
    halt shorting
    raise interest rates gradually to 4.5%
    resurrect and revivify anti trust legislation
    Reexmine and update Seigel Act
    Impose usury laws
    ban use of no down and no verification mortgages

    CB

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  300. gw says:

    Financial terrorism. We must track down the folks who benefited during the greed cycle, including politicians and wall street fat cats, and confiscate their ill gained windfalls. Now we are in the fear cycle and it looks like amnesty is being granted to the evildoers. Its amazing what a 700 point gain in the Dow can do to blind us to the truth.

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  301. Martin Weiss says:

    The Ultimate Wall Street Nightmare
    by Martin D. Weiss, Ph.D. 09-15-08

    In the wake of Lehman’s demise, Fed Chairman Bernanke and Treasury Secretary Paulson will try to put out the word that it’s no great trauma.

    But it’s a lie and they know it. If they openly admitted that the Lehman collapse will paralyze Wall Street, torpedo the stock market and sink the economy, they’d have to pony up $100 billion or more to support it. Instead, their agenda was to push big banks to put up the money. And they failed to do so.

    No matter what, there’s no denying that the Lehman debacle is a massive and immediate threat to U.S. and global markets. At the latest reckoning, Lehman had $691 billion in assets. That makes it bigger than Wachovia, twice as big as Washington Mutual, and over sixteen times larger than Schwab.

    Lehman’s debts – at $668.6 billion – are also enormous. Even if you added together all the debts of TD Ameritrade, E-Trade and Schwab, you’d still have only $108.5 billion, or less than one-sixth the total debts which Lehman reports.

    In fact, among brokers, there are only two other U.S. firms that beat Lehman in the debt category: Morgan Stanley, with $1 trillion, and Merrill Lynch, with $988 billion.

    Can you imagine anyone in his right mind making the argument that a Merrill Lynch downfall would be “no great trauma to investors and financial markets”? Of course not.

    The reality: The collapse of America’s third-largest brokerage operation is very serious business with equally serious consequences. The primary concern …

    Defaults on Derivatives

    We’ve lost count of how many times the authorities have virtually sworn on a stack of Bibles that “our financial system is fundamentally sound.”

    But no one could possibly lose count of their recent desperate efforts to prevent the system’s collapse – actions which directly belie their words:

    One – the coordinated efforts by central banks to flood the global economy with liquidity in the summer of 2007.

    Two – the hasty bailout of Bear Stearns in March of this year.

    Three – the giant Fannie and Freddie rescue announced just eight days ago.

    Each time they intervene, they say “we must not reward CEOs who deceive the public and walk off with multibillion dollar bonus checks.” And each time they say it’s the “last time we’ll make an exception to that rule.”

    But then they go ahead and do it anyhow, not only breaking their own word … but also trashing the long tradition of restraint established by their predecessors since the Great Depression.

    Why? Because they had neither the courage nor the audacity to confront Wall Street’s ultimate nightmare: A collapse in the giant mountain of derivatives.

    Derivatives are essentially bets on interest rates, foreign currencies, stocks or specific events like the bankruptcy of a particular company. The interest rate-related bets are by far the biggest. But the bets on bankruptcies – called credit default swaps – are the fastest growing and the most volatile.

    These derivatives were originally designed to help hedge investments reduce risk – like insurance policies. But in practice, they’ve been increasingly used to leverage investments, increasing the risks of participants.

    Here are some essential facts that illustrate the enormity of the problem …

    * The amounts are absurdly large. The total “notional,” or face value, of derivatives held by U.S. banks is $180 trillion, and it’s three times that much globally. This figure is said to overstate the actual market risk. But it does not overstate the risk of defaults such as those that could be triggered by the failure of a company the size of Lehman Brothers.

    * Over 90% of all derivatives are traded outside of regulated exchanges. Consequently, other than very general information, the authorities have no mechanism for keeping track – let alone efficiently cleaning up the mess in the wake of a giant failure.

    * Off the balance sheets. Some companies report nothing more than the total value of their derivatives in footnotes to their financial statements. Others don’t report at all. Consequently, the actual risk, amounts and even the very existence of derivatives is often poorly disclosed to investors.

    * Disclosure in the brokerage industry is especially bad. Many brokerages are private and do not disclose more than their rank and serial number. The SEC collects sparse data and does not publish it. So if you want to figure out how much derivates risk your broker is exposed to, good luck! Getting the information can be like pulling teeth.
    Big Banks Risk All with Danger of Defaults on Derivatives

    * Concentrated in the hands of five major players. Nearly 97% of all U.S. bank-held derivatives are concentrated in the hands of just five major U.S. banks – JPMorgan Chase, Citibank, Bank of America, Wachovia and HSBC.

    * Far larger than assets. As you can see in the chart to the left, the pile-up of derivatives greatly exceeds the total assets of the firms. At the same time, in most cases, the default risk related to these holdings greatly exceed the banks’ capital.

    * Big brokers are also loaded with derivatives. Merrill Lynch has $4.2 trillion. Morgan Stanley has $7.1 trillion. As best we can determine, Lehman Brothers has significantly less – $729 billion. But in proportion to its dwindling capital, its exposure seems to be among the worst.

    * The capital of major firms has been further weakened by recent losses and the failure to raise enough capital to cover them. The chart below tells the story in a nutshell:

    Recent mortgage and credit losses greatly exceed new capital raised

    Consistently, in bank after bank, the losses suffered from the mortgage and credit crisis have exceeded the amount of new capital they could raise. This was true when investors still had confidence in their ability to overcome the difficulties. It’s even more true today.

    Here’s the great dilemma: The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults. And if Lehman is not that player, the next one will be.

    To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

    Let’s say you’re personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

    By itself, that would be a huge risk. But you’re not worried because you have a similar bet with Bank B that interest rates will go up.

    It’s like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can’t lose.

    Here’s what happens next …

    * Interest rates go up, reflecting a 2% decline in bond prices.

    * You lose your bet with Bank A.

    * But, simultaneously, you win your bet with Bank B.

    * So, in normal circumstances, you’d just take the winnings from one to pay off the losses with the other – a non-event.

    But here’s where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can’t raise additional capital from investors. So it can’t pay off its bet. Suddenly and unexpectedly …

    You’re on the hook for your losing bet.
    But you can’t collect on your winning bet.

    You grab a calculator to estimate the damage. But you don’t need one – 2% of $500 billion is $10 billion. Simple.

    Bottom line: In what appeared to be an everyday, supposedly “normal” set of transactions … in a market that has moved by a meager 2% … you’ve just suffered a loss of ten billion dollars, wiping out all of your firm’s capital.

    Now, you can’t pay off your bet with Bank A – or any other losing bet, for that matter.

    Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well … it defaults on every single one … and it throws your firm even deeper into the hole.

    So now do you understand why bookies belong to the Mafia and why gamblers who welsh on their debts wind up at the bottom of the East River? It’s because defaulting gamblers are a grave threat to the entire system, just like Lehman Brothers is today.

    Now do you see why the $180 trillion in U.S. derivatives, supposedly overstating the true risk, is actually a lot riskier than almost everyone cares to admit? It’s because defaulting banks or brokerage firms are also a grave threat to the entire system.

    And now do you understand why Mr. Bernanke and Mr. Paulson are probably bluffing?

    Don’t let them fool you. The Lehman Brothers debacle is a far greater threat than anyone has dared tell you. And if you haven’t done so already, you must take the urgent defensive action we’ve been recommending day after day, week after week.

    In a nutshell: Sell all your vulnerable stocks and bonds before it’s too late, stashing the proceeds in cash with short-term Treasuries or a Treasury-only money market fund. And to the degree that you’re unable to sell, buy inverse ETFs to protect yourself from devastating losses.

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  302. Roger says:

    Still don’t get it!

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  303. Jeff says:

    The root cause of all this mess seems to be subprime mortgages — or way too (or wildly) aggressive mortgage lending. And I just don’t get how that could happen. I was in banking years ago (ending in 1990), and was always struck by how very conservative mortgage lending was. Smaller banks like the one I worked at always wanted to make sure that the mortgage loans that they originated were “conforming” so they could be sold on the secondary market to Fannie Mae, Freddie Mac, or other BIG banks. And the conforming loan standards were very clear and very strict: 80% loan to value on a conservative outside appraisal; very strict income verification requirements, usually requiring 2+ solid years of salaried employment at a good job immediately preceding the making of the loan; virtually spotless credit with a requirement of letters to be written explaining even the smallest problems; a 28% maximum “front ratio” (total house payment versus total monthly income); and a 36% maximum “back ratio” (all monthly debt payments versus total monthly income). Given all these stringent requirements, I always thought, “How can the mortgage industry ever lose?”

    Apparently all of these mortgage lending guidelines in place up until at least 1990 have been completely thrown out the window since. Since 9-11, evidently 100% loan to value mortgages on suspect appraisals, no income verification, and no or lax credit checks, became all the rage. All while the obvious housing bubble grew and grew. How on earth the masters of the universe on Wall Street allowed themselves to get completely blown away by this is dumbfounding to me. Was it because Wall Street didn’t understand mortgage lending? Was it because they were just greedy, and hoping to pawn off bad mortgage securities on unsuspecting investors? Whatever the motivation, mortgage industry lending guidelines VASTLY changed in the last 10-20 years, and that appears to be the problem. Now we have to bail out all these greedy geniuses out. How ridiculous.

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  304. Captain Democracy says:

    Senators Barak Obama and John McCain are circling there wagons with the U.S. Congress and Wall Street for the second coming of, “CUSTER’s LAST STAND!”
    http://www.captaindemocracy.wordpress.com
    p.s. “If” you believe that bunch of “Rackeetering Frauds, then I have, “A Bridge in Brooklyn I will sell you for one U.S. Dollar!”
    Robert E. McCullough B.A., Arch. North Beach, S.F.

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  305. Eric says:

    So if there’s a root cause, what is the root solution?

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  306. robert says:

    the fundamental failure in thought that allowed this to happen is the notion of a “free” market. there is no such thing, and anybody advocating such exhibits their limits. further anybody who automatically says government in the economy is bad just admitted to being too stupid to manage their own affairs. since keynes it has been obvious that its not a zero sum, either/or game. that was true until the mid 70′s when capitals’ assault on the middle class began again in earnest. here is a revolutionary concept and its not trickle down, when everybody does better, everybody does better.. now what is so hard about that. support the interests of the “middle” class.

    we still got major problems, the deficit, and the assault on wages and the middle class, because without the middle class your economy is similar to any third world nations. looking around and saying “i got mine” wont work. we need to commit to the idea that government not only can lead but must lead. general economic ignorance and stupid ideologies will no longer carry the day.

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  307. Leslie says:

    Thanks for this post! I’m glad someone broke it down in a way that makes sense to those of us not active on Wall Street.

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  308. Donna says:

    What does “wipe out shareholders” mean? That the stock won’t be publicly traded anymore? That the only shareholder will be the Federal government? Are there other instances where this happens?

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  309. allison says:

    Thanks for trying to explain this situation to the average person. I am a medical student at an Ivy League school, have received years and years of great education, but have zero background in finances. I would love if the authors could take the explanations one step further — I was still left with a lot of questions and confused at points during this explanation.

    Especially when they explain what this will mean for the average person and they said that it will “slow growth” and potentially even “decrease GDP 2 percentage points”. I need him to go one step further. Why should I care if growth slows? do my groceries get more expensive? will i get fired? will my house lose value? why do i give a hoot about the GDP if my salary isn’t changed? stuff like that…I was lost. and when he talks about “credit being more hard to obtain”, i also don’t know what that means… Will Fannie Mae (which i think is my medschool loan company) no longer give me a loan for med school? what does that mean? Will credit cards will stop sending us free ones in the mail?

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  310. grossman says:

    !!WE ARE ALL SOCIALISTS NOW!!

    This “Wall St. Rescue” is pure unadulterated SOCIALISM and you elected the dudes who are promoting it, including the Bush Administration. I don’t want to hear a peep from those on the right pompously promoting “the efficiency and fairness of the FREE MARKET.”. That model is over!!!!

    Let’s now look at single payer health insurance without the BS of “competition” and “free markets”. Single -payer, the socialist model, IS EFFICIENT, far more than the maze and small print of the so-called FREE MARKET model.

    It was the small-print that got us into this mess.

    Otherwise let AIG, Bear Stearns, Fannie, Freddy and the rest of the fat cats FAIL like many INDIVIDUALS, millions of them, that have made poor decisions.

    If you buy this “RESCUE BS” currently being promoted in DC, I’d like you and everyone else to pick up the rest of my mortgage. Oh! I’m solvent (so far) but that shouldn’t matter. All the CEO’s and top managers of these companies are solvent, you can bet on that.

    Any takers?

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  311. Richard Graham says:

    Did anyone else read #4? This means absolutely nothing to the average American who is not in the business of borrowing money.

    I like how he slips in the comment about small businesses. This is a huge load of BS.

    America we are being fleeced! Rich people are using our money to keep other rich people rich.

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  312. Peter Fraterdeus says:

    Thanks to Ronnie Reagan for the good times, eh?
    The ‘free-market’ dogmatics seem to think that the Law of Gravity is also subject to their whims. But what goes up must come down.

    The sad thing is that the same lessons are given decade after decade, even century after century, but the reality is that humans are not wise.
    Our perspective, neurologically, is barely 24 hours. The global economy is much too large to be entrusted to the selfish biological drives that covet McMansions and $10 million condos in Manhattan or Houston.

    Unfortunately, American politics panders to the lowest common denominator, with the results of the last eight years a clear example.

    Peter Fraterdeus
    blog: fraterdeus.com

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  313. michael Reynolds says:

    …. uh, they aren’t going to hire the same crew to run Frannie, Freddie, and AIG that they used in “Imperial Life in the Emerald City” are they? ….

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  314. Brent says:

    Post #311 Donna

    “Wipe out shareholders” means that the ownership of the comany is taken away from the owners of the stock, and is given other classes of investors, for example bond holders.

    The company can then be liquidated with the proceeds being doled out to the various investors in a predetermined priority (stockholders generally are last in line), or recapitalized with new owners. Often both happens, with some assets being sold, and some being retained in a “new” company.

    My guess, though some else needs to answer this, is that this happens every day; it is just unusual for large companies, and even more rare for the Gov’t to become involved.

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  315. Edith Folta says:

    In response to Jeff in #306, listen to Ira Glass’s episode on This American Life from May, where he interviews people in the sub-prime mortgage business. They had so much money they had to give away that no standards were enforced — and nobody looked at more than a piece of the picture. A real eye-opener:

    http://www.mefeedia.com/entry/this-american-life-episode-5-12-08-sub-prime-mortgage/9514530/

    Here is a written transcript if you can’t access the podcast, but I strongly recommend listening to the original if at all possible:

    http://www.thisamericanlife.org/extras/radio/355_transcript.pdf

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  316. martin g says:

    Still sounds like a case of trying to keep the superstructure afloat while the hull of the ship is falling apart. It isn’t the “psychological state” of the American worker/consumer that ultimately determines the stability of our economy, it’s their ability to make and spend money, as opposed to borrowing/spending it. Ever since the stagflation of the 70′s the cost of labor has been cast as the primary cause of inflation. Since then wages have had the combined efforts of business and government holding them back- NO FREE MARKET FOR LABOR (except freely opening that market to foreign competition and getting rid of “monopolistic” labor unions).

    I fail to understand how anyone could think that an economy could then be run on the old “company store” model: Support your workforce by “lending” to them instead of actually paying them. It could work for the coal companies because once the mine was played out they left and abandoned what ever debt was remaining, they accomplished what they wanted which was to get people to work for a lot less by convincing them that “credit” was a “job benefit” equivalent to actual wages.

    This problem won’t go away by making the taxpayer pay for the debts that working people simply cannot afford to repay.

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  317. Pablo says:

    Someone smarter than me said it all boils down to “socialism for the rich, capitalism for the poor”.

    Perhaps we all need to stop paying our mortgages until this mess is cleared up.

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  318. Marty says:

    Great post. Now explain: who is going to bail out the U.S. Government when, like Lehman brothers, its foreign creditors lose faith in its ever increasing massive debt and demand their money? This shell game hasn’t made the toxin in our economic system go away: it’s just moved it from the banking system to our government. Our country – and your homes – are now completely owned by the Chinese, who will prop us up only so long as they need us to buy things from them, then will cut us lose as soon as it suits them. The American century is now officially over.

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  319. Ira says:

    Question: In effect, was PIMCO guaranteeing AIG’s paper while AIG was guaranteeing paper that PIMCO had bought?

    I take this from the following paragraph in the article (which is a great article, thanks):

    “In addition, other large financial firms – including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world – had guaranteed A.I.G.’s bonds by writing C.D.S. contracts.”

    If so, it seems that a demise of one would “guarantee” the demise of the other in a large-scale event as has happened — and, therefore, there were no insurance-guarantees at all. In other words (if I understand this), it’s as if Allstate and State Farm issued reinsurance on each-other’s homeowner insurance policies in a hurricane-prone state and then a huge hurricane strikes.

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  320. Jonathan says:

    You say, “[t]hird, now that A.I.G. has been lent to, how will regulation have to be adjusted? …. How does [the Fed] prevent a replay of this scenario, and can it be done without stifling innovation?”

    Has anyone ever done a careful study that has found evidence that the sort of financial innovation that has been going on for the last few decades actually helps the economy, helps you and me get more hamburgers or more iPods, rather than simply helping I-bankers get rich at our expense?

    Clearly, regulation to end the practice of socializing the risks and privatizing the gains is needed, and “innovation” should not be used as an excuse to avoid it.

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  321. Ido says:

    Good post!
    I would suggest to have an executive summary at the top (or bottom) of it – so people with less time could also enjoy this important inforamtion.

    http://idojava.blogpost.com

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  322. TD says:

    So, as a person who has worked many years, squeezed pennies until they cried, and built a large nest egg, how best can I preserve into the future, short of paying off my house and converting everything to gold and platinum bullion (hid under my mattress, of course)?

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  323. jgj says:

    There is nothing free-market about Freddie & Fannie; they were both started as government sponsored enterprises (GSE), the ‘F’ stood for federal. As the article points out they were given non-competitive advantages, allowing them to become “too big to fail”.

    Those GSE’s failed, they did not meet their objective prior to failing (as the article points out); and their mess got into everything. It was a failure of Government trying to work its objectives into the market.

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  324. Bleh says:

    Instead of borrowing money with interest owed from Central Banks (ie PRIVATE Banks, ie privately owned companies) we take back control over the issuance and print our own money with NO INTEREST owed to anyone?

    Seems like the logical solution instead of paying interest to the Private Bankers. (9 TRILLION and counting owed, plus interest… WOW)

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  325. 219kimrod says:

    Would like to know your root cause analysis conclusion. Mine, most simply stated, is:

    1.Paying via stock options forces them to drive the share price up in order to cash their options. This is not pay for performance – it is pay for smoke and mirrors.

    2. Company execs are driven to meet or exceed analysts predictions to retain their jobs, thus the pressure to creative accounting, risky products, little understood risks.

    3. The law permitted short-selling manipulation of the market and firms and individuals (responding to 1 & 2) used this to their personal advantage.

    4. Too big to fail creates an inherent risk of failure.

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  326. Janet says:

    Isn’t the government’s willing to put money into Wall Street an example of “trickle down” economics? Since the capital or anticipated capital collected by these companies comes from millions of Americans who pay their mortgages, wouldn’t another solution to the credit problem be for the government to give a large tax rebate to every family. That money could go into savings accounts or be used to pay mortgages, which in turn would provide money for others to borrow. Would that have the same results as the federal government giving money to AIG or Freddie and Fannie?

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  327. Jerry Kahler says:

    In July 2005 I bought a beautiful home on three city lots for $129,500. I expected to pay at least 20% down, and borrow the rest. However, the broker talked me into a 0% loan and I leaped at the opportunity. My plan was to make improvements on the property and to resell it as soon as I finished. A few months later I took the time to read all the contract fine print and discovered that I was in a house I couldnt afford. Luckily, I found a buyer in February 2006 who paid $135,000. Even more luckily I only lost about 7 months of hard work and $5000 on my “great buy”. My problem was stupidity, an undetermined amount of greed and listening to the advise of my broker. I now feel fortunate to still be living in my fully paid for ($7000)”immobile” home on the Arkansas river enjoying my retirement, clipping coupons, fishing and drinking the occasional beer. No more subprime loans for me!

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  328. mrs Ben says:

    I follow the arguement that investment houses like Morgan Stanley and Goldman Sachs now need more robust sources of funding in place, but I am surprised at the comment that they rely exclusively on short term debt. I thought from their recently announced results that both were not emmeshed in the subprime market and had enough liquidity to last for up to a year without going to the short term debt market.

    So yes they might need to revisit how they raise money medium term but that should not put them at imminent risk of failing short term. Their falling share prices seem to be the result of the market panicking at the current model of separate investment banks(although merging deposit and investment banks is in fact a bad idea as history shows) and being targeted by short sellers.

    As for asking why Wall Street got dragged into the sub prime market, well the risk managers sliced and diced bundles of mortgage debts so many which ways they thought they had eliminated the risks of bad loans or made them neglible in what they thought was a secure housing market. And, if house prices went on rising, the debts would have been worth something, even if the owners defaulted, only of course some were mortgages on imaginary properties and others for sums of money the owners of others had no hope ce of repaying.

    And of course there were too many inadequately regulated mortgage brokers and greedy or gullible home owners at the bottom of the chain. All the brokers cared about was their commission with predictable results.

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  329. Gail says:

    Sorry, this was not a very clear presentation of the issues. If you want to understand what is happening and why, listen to WHYY Fresh Air, 9/17/08.

    To Post#25, in 1999 the Dems had enough votes in the Senate to support a veto of the legislation to repeal Glass-Steagall. However, THEY FAILED TO ACT RESPONSIBLY, in a manner befitting their party heritage and charter, and all but 7 Dems joined the Republicans in repealing the act which CLINTON signed into law.

    Finally, we are not nearly out of the woods yet. We are experiencing what the Soviet Union experienced after their economy collapsed 25 years ago. The culprit for them is the same as it is for us, unchecked spending on an unwinnable war. The cost of the Iraq war is predicted to run as high as $3 trillion once interest and energy costs are calculated. Osama is rejoicing.

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  330. Peter G. says:

    That’s the best explanation I’ve seen so far. Maybe the only good one.

    Makes me wonder whether the capital available to the financial markets has actually declined. If so, it could indicate that capital has been withdrawn, which creates the possibility that these markets have been manipulated by capital-rich entities, most likely overseas.

    I can’t begin to guess at the total amount of capital available for investment in the world. I suspect it’s many trillions of dollars, and I doubt any particular collection of entities (the banking industry, the oil industry, the Chinese government, etc.) can dominate this supply, but– I don’t know.

    And I don’t know how sensitive the markets are to manipulation. It could be that that the markets depend on the predictable availability of 99% of the available capital, so someone managing only 2% of the supply could create this kind of result.

    I’d sure like to know, though.

    . png

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  331. lisa sauerbrey says:

    this is educational–at lest it was for me!

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  332. CS says:

    I will blame this financial mess we have right now squarly on the Federal Reserve and its chairman, Ben Bernanke. His management of the crisis is absolutely pathetic.

    He raised interest rate to fend off the inflation at the beginning of his term when there was no real threat of inflation; these interest rate increases created real confidence issue and the housing collapse we are suffering right now.

    He should address the real problem of the market THEN by what he is doing NOW.

    He did not address the inflation and recession issues when he is at helm; he created both. I think he should resign.

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  333. YOGI says:

    Thanks. Answered a lot of questions, for me, at least. The explanation of the AIG bailout was especially good. Now I know that the $85B that he government paid AIG is an “option” to buy 80% of the company. Only if that option is exercised will the AIG shareholders be wiped out.

    I had wondered at the lack of human interest stories of moaning shareholders.

    Dare I say, as a non-economist, viewing the housing finance market, that the option WILL, eventually, have to be exercised?

    Has anybody put a dollar figure on the amount of “value” in the housing market that has vaporized so far?

    Cordially,
    YOGI

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  334. Makes you think says:

    I think Bear Stearns had a better chance of bail out because of the political connection of Henry Kravis who used to work at Bear Stearns and is still a big contributor to Bush, McCain.

    Profiteers like Henry Kravis and others are like sharks at a feeding frenzy..this is prime season for those type of takeovers/bailouts/ public-private mergers. Private profeers off of public risk.

    Wonder why no one is getting those junk mortgage loan profiteers to issue refunds to those unknowing yet willing participants. Those who issued junk loans ought to be blamed.

    Derivatives, high risk and junky credit products ought to be banned. No good can come of it.

    People are embracing junk kings, businesses, etc (like the newly reinvented Micheal Milken and his “highly” regarded ( what a joke) Milken institute think tank.

    And the Bush administration is partial to those other high profit low payout rip off artists in the insurance industry like AIG.

    THAT whole insurance sector and the individual companies need HEAVY regulation, not bailouts.
    Regulate to prevent the disasters that lead them to rely on public bailouts to survive after they have run themsleves down the drain.

    Regulate and instill strict ethics standards that are the basis of receiving generous excuse ridden cash infusions.

    Since AIG is now publicly “owned” does that mean that everyone can now be extended coverage at an affordable rate? They need to change their ways as a condition to the bailout. They may even now be the first official step towards affordable insurance for anyone who applies. America can be the country with the highest percentage of Americans with insurance instead of one of the lowest.

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  335. Dave says:

    The amazing thing to me is that the people given the chance to borrow money to buy homes they could not afford in small local America are now connected to the bankers and insurance execs on what will formerly be known as Wall Street. And both are suffering from bad decisions on opposite sides of the same equation enabled by lack of any intelligent gov oversight. The lack of regulation that permitted insurance companies to get in bed with investment banks by providing policies to mitigate the risk of mortgage backed securities seems to be the crux of the present situation. We now have a logical conclusion to the laissez fare philosophy of capitalism and were days away from suffering the same fate as was experienced by the Soviets when they reached the logical conclusion to the opposite completely controlled economy. Both economic ideologies seem to suck when played out in real life as we have just seen.

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  336. Barton G. says:

    Everybody wants to make money and not products. Ross Perot got it right- the giant sucking sound- manufacturing jobs are gone. Now everyone just wants to trade paper, and not make things. The basic problem is we are no longer creating wealth, just reallocating (or in this case trying to make it with alchemy) it.

    Short term everything. Overconsume. It’s time to tear the whole economy down back to the idea and start over.

    The banking crisis is just a symptom. Too much money in politics. The conservative revolution should be over, it failed drastically. Go back to Ike’s goodbye speech.

    We should fund the defense department with a tax on oil. That would decrease oil consumption and reduce defense spending, both of which we do way too much of.

    If Obama does not win we get what we deserve. Hopefully he is too fresh to have been bought by the large companies that run our world.

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  337. Mark Scott says:

    Nothing is “explained” here, it seems to me. The very things that need explaining are all taken for granted. The most basic questions are left unasked (to be charitable: the authors assume that its readers know the terms, know the procedures, and accept the premises of both). What do I mean? I mean this: “The common denominator in all three cases was the inability of the firms to retain financing.” Here, the explanation begins one step ahead at least: before one can retain financing, one has to obtain it. Why was the financing so readily available in the first place? On what grounds was it made available? The “subprime fiasco” raised this question: why lend money once, let alone a million-plus times over, for no money to people who have no money? Second: “Fannie and Freddie . . . began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards.” Why not explain this? “Subsidized financing” is “backed” financing. Here, then, we have promises used to buy more promises backed by more, other promises. Don’t we? Here, the authors assume all the problems; they explain nothing. But the authors see all this as easily as the lines in a newly painted parking lot: it all fits, for them. To me, all of that is opaque: who’s subsidizing the subsidizer? Whence the backstop of the first financing? Here, we have financing extended to the fourth or fifth generation, financing that must already have doubled back on its insubstantial self before the third transaction, if not before the second. Finally, is this clear to all of you? “A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments.” How could any payout depend on a loss? They depended, it seems more logical to say, on the subprime real-estate-related investments. Those investments had no yield or return; they were losses; hence, no payouts could be made. But that isn’t what that sentence says.

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  338. GaryB says:

    Isn’t the real story here that in situations where there is leverage at the micro or macro levels, you must regulate because, to exaggerate to make a point: Even though I could lose 1X my wealth, I could gain 100X. At the high end, there is no risk: The guy who lost the 1X of his business (Lehman Bro’s) walks away an extremely wealthy man. He’s sorry he couldn’t be 100X as wealthy, but no big deal, was worth the shot.

    That reality + human nature means you need to regulate even if this doesn’t fit the libertarian or republican *ought* of their market only meme; we have to deal with the *is* of the market reality.

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  339. John, Boston says:

    These two are shams. The problems at fannie and freddie were not that they picked up MBS (mortgage backed securities). It was the simple fact that they had always carried too high a debt to equity ratio and because the gov’t was their (wink wink) accomplice, everyone let it go. They were then pressured to continue to buy up new loans when the market dropped because no one else would do it. The value of their loans portfolios were also simulteously devalued because the values of the houses were decreasing as well. For these two reasons no one would buy their repackaged loans to finance their large debt to equity ratio. This is a de facto run on that bank.

    In effect, like our government, fannie and freddie were borrowing just to finance old debt. When no one would lend, mostly because they couldn’t (their funds were illiquid) they faced default.

    This is an ancillary effect of MBS not a direct effect.

    For those who were supposedly watching this carefully, you can’t see very well.

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  340. john wallace says:

    You do not have to be a University of Chicago Economics professor to figure this out. The REASON is that for the last 10-20 years the entire US enconomy has been based on “Buying stuff we don’t need, with money we don’t have.” This is what everyone has been doing and of course at some point it falls apart. It fell apart.

    - Posted by Gunning
    Right On The mark !
    Thanks Buddy

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  341. K. Vu says:

    I shudder thinking about the results of all this in the long run. The world at large, especially our “Friends” who believe in the US Capitalist/Free market system and bought up shares and invest in the US (to make moeny, of course), will love us, as their investment values are almost wiped out.

    And what the hell of a mess for whoever is elected the next President, and the majority party in Congress!!!.

    Here’s goes the argument for “Free Market, less government regulations, innovations”. The reason for government is to maintain order, to prevent abuse, to bring a decent life to the majority of its citizens, to create and maintain harmony in society. If basic responsibilities are thrown out the window, and “raw Capitalism” is allowed to run amok; if short term gains for individual country/group/belief with the us/them mentality rule, and the long term well being of mankind and the planet pushed aside, Armageddon will surely come, as result of the stupidity and greed of Man.

    Are these the new meaning of “sins” that are going to be punished?

    K. Vu

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  342. Erik S says:

    It seems from the article’s “Fed simple rule”, that investment firms now know that the easiest path to prevent bankruptcy and obtain a Fed rescue is to go extensively into C.D.S’s. That way, risk becomes widespread and a potential chaotic and cascading collapse will ensure the Fed comes to the rescue. I hope new rules prevent this easy path for financial institutions to secure future Fed (i.e. taxpayer) bailouts.

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  343. John West says:

    Great article.

    Was there a vortex created under these companies by shorts that pulled them over the edge? Did the Taxpayer end up patching up this hole? If so, our course is clear. Recover the windfall profits from those that profited from their demise.

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  344. Francis Rodgers says:

    I tried but could not finish it…I was assured there was no math involved. Now it is off to remedial or condemned to join Garrison Keilor’s ‘English Majors.’

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  345. John West2 says:

    If we acknowledge that the bad Real Estate caused a large part of the issue (I think that widely accepted), can we identify the forces of those that made it an eventuality? How about we add up all the “savings” corporations quietly enjoy from outsourcing of American Labor, and compare that to the size of the $$$ void that we are patching? Is that practice short circuiting the flow of $$ from local companies to local people responsible for collapse of real estate values, and thus the real estate market?
    its only a question of magnitude, but should be looked at.

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  346. ck 1 says:

    In Robert Rieve’s comments, least anyone be confused by them, gold standard’s have well known problems, as does any pegging scheme, and ultimately do not provide stable financial systems (namely, the unstable value of gold causes serious issues and the gold supply is not flexible enough to handling expanding and contracting economies). And Article 1, Section 8, Clause 3 of the constitution gives Congress the explicit authority to regulate commerce between the states (reasonably only accomplished through having a standardized national currency).

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  347. Jeff says:

    Edith’s post, #318, with a link to a May 2008 story on American Life is dead on point with the cause of this problem. No offense to the guys who wrote this article, but they’re still speaking in a lot of MBA financial world babblespeak. The American Life story explains what happened in thorough, simple terms that are easy to understand. Basically what the American Life story says, and with which I agree, is that beginning around 2000-01, Wall Street completely threw out decades of proven mortgage lending guidelines in a frenzy to buy up U.S. residential mortgages to bundle up and sell as mortgage backed securities. This was a good idea with conventional, sensible, mortgages. Where it became insane was with no income verification, no asset check, 100%+ loan to value loans — that Wall Street demanded as the frenzy progressed. It appears that Wall Street investment firms were like a herd of sheep diving off a cliff together. A person with 2-3 years mortgage lending experience could have seen what Wall Street was doing was not fundamentally sound. Unbelieveable. I don’t know how Wall Street is ever going to convince us to trust them again.

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  348. TomJ says:

    Under question 1) this article states that Lehman had assets of over $600 billion and AIG about three trillion. But most of these assets belong to investors in these companies, not to the companies themselves, don’t they? This is quite different from Worldcom’s “$100 billion in assets” which was supposed to be backed by physical and intellectual assets owned by the company.

    Perhaps this is part of the problem – that Lehman and AIG management thought that the investors’ assets were actually “theirs”, to do with as they felt.

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  349. Jennifer says:

    I’m surprised that “4) I do not work at Lehman or A.I.G. and do not own much stock; why should I care?” did not mention the tax consequence that all of us tax payers have to face.

    When our government is in debt, us taxpayers have to pay for it. Even if these corporations pay back these loans in several years, we will have to pay interest on the money we don’t have to bail out these wall street firms. And we are not guaranteed that these wall street firms can pay us back – because we’re not even at the bottom of the real estate cycle.

    Just as corporations took write downs and Wall Street each time believed that it was the last “one time” writedown, I doubt this will be the last time the fed bails out these huge financial giants. Many more loans are expected to default and go into foreclosure as option ARMs and AltA ARMs are expected to reset within the next SEVERAL YEARS. So then what, us taxpayers have to bail out more of these companies all over again?

    These Wall Street institutions better have enough foresight to raise enough money as these non performing loans continue to pile up. Or else we’ll be back to square one – us taxpayers propping up Wall Street.

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  350. Kent Williams says:

    This is the only coherent explanation to date I have heard about what is going on in this ominous crisis. President Bush needs to get Doug and Anil over to the White House immediately, so he has at least a few voices that understand something about what is happening. They make a complex situation understandable and with a little bit of extra effort they may be able to penetrate the ruling thick skulls in the Oval Office. I have no faith at all in the President’s current stable of so-called advisors, and these two gentlemen need to enlighten the relevant players. Maybe I’ll fax this excellent article to the White House to see if it gets through to you-know-who.

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  351. John says:

    Not quite a “BAILOUT”

    Banks and other investors have already accepted losses of over $450 billion on a total size of $900-1200 billion. This means that the majority of expected losses have been shouldered by investors.

    When we think “bailout” we think that someone at financial risk has been saved from virtually all ramifications of poor financial decision-making. This is not the case here. Banks and investors have taken a hit that is truly painful.

    This does not excuse the excesses of Wall Street but it does clarify the situation for everyone who has heard that the financial crisis will cost the tax payer $1 trillion or more. That is an estimate of the size of the sub-prime market, but doesn’t reflect the costs that the tax-payer will have to bear.

    Also note that when the RTC was established, the value of the assets that it took in was MUCH greater than the ultimate cost to taxpayers.

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  352. fjg says:

    I’m saddened by the obvious greed in this country… nothing but leverage, margin, buy through borrowing… the spread of fear and greed has reached a level that’s hard to overcome… upper rich get richer while the middle and lower class suffer much pain… where is the compassion for the disadvantaged… we might be headed into Depression.

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  353. Colony14Author says:

    And what caused the problem in the first place? THE GOVERNMENT – with its emphasis on lending money to anyone so that everyone could be a homeowner – even people who couldn’t afford the mortgage. But could the banks turn down applications from poor people? No, that would be “discrimination.” Yeah, well banks SHOULD refuse to give $350,000 loans to people who make only $30,000, $15,000 of which is government aid!

    This was NOT a failure of capitalism; it was an example of what happens when “do-gooders” INTERFERE in whet is SUPPOSED to be a free market. In a true free market, most of the bad loans wouldn’t have been made in the first place, and those who made them would lose their shirts.

    I assume now that this means the government will be printing moneylike crazy, causing rampant inflation. Those of us who did NOT borrow funds we could not afford to pay back are stuck paying the bills, and the idiots (both Democrats and Reoublicans, but mostly Democrats) who created the mess in the first place will be re-elected.

    I’m hiding all my money in my mattress. I’m tired of the producers having to support the parasites. If Texas or Alaska seek to secede from the Union… I’m on my way there in a heartbeat.

    http://www.colony14.net

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  354. wfv says:

    To TD in Post 325

    “So, as a person who has worked many years, squeezed pennies until they cried, and built a large nest egg, how best can I preserve into the future, short of paying off my house and converting everything to gold and platinum bullion (hid under my mattress, of course)?”

    This is exactly what you do as the next thing to collapse will be the US dollar.

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  355. Captin Democracy North Beach San Francisco, 'the city' says:

    It is very simple when you have seperation of powers, in the current case it was ‘collusion’, and now ‘they seek,’- “ULTIMATE POWER” both McCain and Obama are both U.S. Senators and if they get the White House (either one) then you have the “Ultimate Corruption of Power, Ultimately!”
    see:www.captaindemocracy.wordpress.com
    p.s. Now we all know why “JFK” was assassinated ultimately.

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  356. Singhal says:

    I am not sure if this is the right place to ask questions but this is the best explanation I can find so far. So if these questions deserve an answer, may be you can provide it.

    While this explain the events that have happened quite well, some questions about future remain quite unclear.

    1. By taking over Fannie, Freddie and now “BAD Securities”, has treasury taken over the problems of these two agencies. As i understand this availability of “easy money” for them is what got them into trouble and now there is “unlimited” amount of money is available to them (under different management – true). What keeps this from getting any worse?

    2. “Bundling” of poor quality debt after “chopping it up” along with good quality debt made all Mortgage Backed securities suspect. Is there any way of “unbundling” them, one security at a time? After all there is a house (or several) backing them, with someone’s name or credit score tied to it? We should only have to dispose “bad Debt” then and not worry about good one tied to it. (take the bad apple out of basket so good ones are not spoiled).

    3. Supposedly this is all tied into people buying houses that they can not pay for so money they borrowed is now “bad Debt”. Are we going to have devaluation of dollar and massive inflation soon? (Almighty Dollar is going to be worthless (or lot less) as bonds issued by Fannie/Freddie became)

    Thanks

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  357. P. D'Antonio says:

    I have been trying to devise a solution that preserves equity in a person’s primary residence while allowing the house to be sold for less than the going neighborhood market price. I’ve come up with this: Require homeowners to get a written appraisal prior to listing. Enact a major tax structural law: INSTATE a fully deductible 125% Capital Loss on the sale of a primary residence based on the difference between the appraised value and the selling price. Although it might appear that this would accelerate the drop in home prices, it seems clear that there is an abundance of people who are still able to pay top dollar to buy homes for what they are worth, which rightly includes neighborhood amenities: good local schools, low crime rate, quality of transportation, few illegal immigrants, fewer occupants per home, access to the beach, etc. Co-requisite with this: Permanently ELIMINATE the Capital Gains tax on the sale of a primary residence regardless whether the seller buys up or down or not at all. There are two schools of thought: One holds that one’s primary residence is the major investment in their life. The other holds that a home is not an investment and should appreciate only a few percent a year regardless of the expense outlaid for capital improvements in both the home and (via the taxes they pay) the neighborhood. Naturally, most people never buy stock or fancy financial stuff, so I favor the primary residence as the major investment of the majority. Now we are left with the problem that your IRA (or pension) or term life benefit won’t keep up with the inflation. This has been an ongoing fact of capitalism for decades. Your dollar won’t buy today what it did when you “invested” it. Unfortunately, your Social Security won’t keep you out of homelessness. Businesses will move to neighborhoods where the homes are not only nice, but also affordable. Hopefully, they will pay for their workers to move their aging parents with them.

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  358. AZ Saint says:

    As I try to sort through all of this I still can’t put together:
    1) How falling home prices and over-extended lenders are driving the problem. Is it too many foreclosures so the bank is stuck with a $100k loan on a now-$75k house, and no one wants to buy the house because i) the market is still falling in home values and ii) no one can get a mortgage?

    2) Where did all the “value” or money go? That is, there surely are folks (beyond Mr Paulson) who made lots of money during this “game.” Mortgage brokers, home investor flippers, etc. Where are these folks now?

    In the end I’m saddened that lots of folks who did make $Ms in this game are frankly walking away now (or have a while ago) with their happy money. us tax-payers and folks who didn’t walk from our homes are stuck w/less public programs for our tax $s since we’re now going to fund these bailouts, which to me sure feels like a secondary way to pay the same folks who make lots of $ in the first place…

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  359. RALPH says:

    IN THE CASE OF THE AIG SITUATION HANK GREENBERG HAD BEEN AWAY DUE TO THE SPITZER EFFECT. THIS ALLOWED IDIOTS TO RUN THE COMPANY, ESSENTIALLY RUNNING IT INTO THE GROUND. BUSH INTERVENED; FEW HAVE ANY IDEA JUST HOW INFLUENTIAL H.G. REALLY IS…… ULTIMATELY THE GOVERNMENT MAY GET ITS MONEY BACK FROM AIG, THOUGH NOT FROM THESE OTHER SINKHOLES IT IS ENTERING. HEAVEN HELP OUR CHILDREN WITH IMPOSSIBLE DEBT, WORTHLESS CURRENCY, OR BOTH. RALPH

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  360. Stacia says:

    I think point #7 is extraodinary, and implies a major paradigm shift: We no longer in a capitalistic society; we live in a “credit-istic” one. The economic models and presumptions we function under, as well as the regulation we apply (and the amount thereof we think is appropriate), will have to be majorly rethought and rebuilt to reflect this new reality.

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  361. Lyndall Pharm.D says:

    That’s why healthcare is the way to go. I’m a pharmacist working in a hospital and I have to be really frank–our economy thus far hasn’t really affected me in any way. In fact, pharmacists are in great demand in all areas of the US. With a competitive salary (100k-120k), flexible hours, sign-on bonuses, work satisfaction, what more can you ask for? And the best part about being a pharmacist? I’ll never have to worry about being laid off. ;)

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  362. GKM says:

    #271: “Sorry, but the burden lies on the lender. If I stand on the street corner handing out hundred dollar bills, no one is obliged to ask whether I’m putting myself in financial trouble by such largesse.”

    Exactly. “Caveat emptor” applies just as well to creditors, and even more so when they are going to lengths to deliberately manipulate people into the most expensive loans. My husband and I were shopping for a home loan five years ago, and although we had good credit histories and wanted a 30-year fixed-rate mortgage, the lenders kept dangling these ARMs and interest-only loans, and we kept having to say no. It’s lucky for us we had read up on the subject of home loans; even so, it wasn’t easy navigating the shoals. Think what it must be like for people who don’t read fluently or haven’t had college educations.

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  363. Buck says:

    “Where’ the FED getting the money. Everybody is asking this question but does anybody have an answer? ”

    They print it.
    The presses are rolling as we speak.

    What? You thought it was backed by, uh, uh, Fort Knox?

    Buy lots and lots of beans, may need them.

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  364. pablo says:

    I agree with the person that said the main problem here in the U.S. is that we have too many people making a living shuffling paper around. They produce NOTHING. Yet they continue to consume. AND, they want to make money by by investing in companies that also do not produce anything of real value (i.e. insurance companies).

    So, my advice is get a real job. Provide a service to others or work at a job where you actually make something tangible. My god, we don’t even make shoes in this country anymore. If China cuts us off we will all be barefoot. And then what?

    Also, stop paying your mortgage. Let the money changers sweat.

    Then we will see some real reform on Wall Street and Main Street.

    I’m available for consultation if the Fed, or Congress, or anyone in the Executive branch would like some clear and concise advice.

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  365. Frank from Illinois says:

    THINK BIG!!!

    This is all pablum for the masses who don’t see what is really going on, conventional wisdom designed to convince us that if we don’t send them all our money to rescue them and make good their losses, something REALLY bad might happen to us. Like the entire system collapsing.

    Subprime mortgages wasn’t the ultimate cause of all this; they were just the slice of the system that happened to go first, threatening the collapse of all the rest. For instance: people who can’t pay their mortgages, probably can’t pay their credit card bills or car payments. Hence, the next crisis will be banks with huge credit card operations, and if you think the automakers are in trouble now, you haven’t seen anything yet. One could go on and on.

    Why don’t you do something really useful, like educating us on what’s really going on? Like: the US financial system has been one unending series of scams, run by people working long hours how to get oodles and oodles of money from you and me, one buck at a time. Think back: the savings and loan debacle, in which the freewheelers treated the deposits like their own personal piggy banks until they collapsed, and we picked up the tab. More recently, the analyst conflict of interest scandal, the pump and dump system of getting the suckers to buy from them, so they get out before it all collapses. The stock option backdating system of betting on the horse race after it has already been won, thereby guaranteeing the confiscation of your profits. The IPO scandal, where the investment bankers (Citigroup, e.g.) gave huge guaranteed IPO profits to corporation heads (Bernie Ebbers, e.g.) in exchange for giving them billions in stock issues that the bankers (Citigroup, e.g.,) could pump and dump on the rest of us before they collapsed in the dot-com bust. The AIG kickbacks for insurance business, that raised everybody’s premiums to pay for them. I can’t even remember them all.

    So what does all this really mean?

    How about thinking BIG?

    Like: this is starting to look like a system organized solely for the purpose of getting all the little people to send all their money to a few rich people. And deluding them into thinking they freely choose it in a modern democratic society that enjoys free capitalism. Only the rescue shows it isn’t free capitalism. It’s: send me your money when it works; send me your money when it doesn’t work. And make no mistake about it: with today’s announcement of the rescue plan, you are going to be paying this for a long, long time. Your children and grandchildren will be, too. It will come, at the very least, in the form of higher income taxes that you would never have had to pay otherwise, to repay the Treasury securities when they come due in 20 or 30 years.

    They used to call it wage slavery. Didn’t Lincoln say it best? Something like: you work, and I’ll enjoy the fruits of your labor. Not unlike (dare I say it?), say, the slavery of old, say, in Roman antiquity. Or in 1000 years of feudalism in Europe in which the barons got the fruits of the peasants’ labor. Tell me the differences, other than they don’t beat us any more.

    THINK BIG:
    Like analyzing how the whole thing implements the main scheme.

    Or, even better: how much longer can it go on before the financiers (the Chinese, for example, who are actually making things, shoddy and dangerous as they may be, to sell us, so they can lend us money so we can keep on buying it) decide they don’t need us anymore, and decide to call it quits, and call in the tab? Economists, spouting the conventional wisdom, say they don’t really know; that the Chinese have no choice, and other evasions. Give me a real economist who actually tries to tackle such a question.

    I’d wager the answer will include a major reference to the–what, a trillion dollars that the government will spend buying up all the bad paper of these bad actors in the rescue announced today.

    Above all, I am disappointed to hear Obama’s preliminary remarks that sound like more conventional wisdom: we have to do the rescue. And nothing about the real change I had hoped he might bring: like reigning in the masters of the universe and telling them “You can’t have all our money any more.”

    I’m getting long of tooth. Same house for over 30 years (no subprime, just refinances for college tuitions–boy there’s another boondogle: Yale, for example, answering the question how much does it cost to go here: How much you got? Well, $20,000 more; and we’ll lend you the money–just keep sending us your money), no direct exposure to all this, but plenty of indirect, by financial stocks in a retirement SEP, even the S&P500s, suffering big enough losses, and, grand-daddy of them all, liability for life on that huge federal debt, that either I’ll keep paying on forever, or that may make it all collapse eventually.

    Come on, guys, give us something REAL. THINK BIG!!!

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  366. stephen lang says:

    To my and others’ reading, this crisis was the direct result of very purposeful decisions. It started with the Asian Flu problem in 1997 when the collapse of Asian stock markets was spreading to Wall Street. At that time the NASDAQ was at an overvalued but not yet obscene 3000. Instead of allowing a healthy correction, Greenspan caved in to the brokerage houses and pumped enough liquidity to keep the American market overinflated. The NASDAQ then ran to 5300 in 2000 before famously collapsing 80% over the next year and a half. This put the American system and economy into a crisis, which could only be cured by another bubble, ergo the equity line of credit and eased rules for mortgages to pump further money into the economy to replace what was lost in the value of stocks. Iraq factors in also, with 100′s of billions more given to American companies to ‘rebuild’ bombed infrastructure in many cases with inadequate or no work being performed.

    This could not have happened by accident. We are now in a situation where further help for American institutions might have to come from foreign investment at pennies on the dollar, with control being transferred overseas.

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  367. GS Chandy says:

    >>>
    308.September 19th,
    2008
    12:42 pm So if there’s a root cause, what is the root solution? – Posted by Eric

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  368. Guy from Ohio says:

    Thank you, Professors Diamond and Kashyap (and Professor Levitt as well). Your very understandable explanation is very welcome. I would ask that you add to / amend your commentary to simply discuss the further steps announced today (Friday, Sept 19) by the Fed and Treasury to take over the bad loans accumulated by the financial institutions.

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  369. h says:

    One question that I have always wondered is: Where does the money come from that the Fed uses to bail out these firms? Is it new debt that they raise through treasuries or tax payer dollars? And if it is debt, what is the collateral and who are the main buyers of this debt? Because if foreign countries own most of US debt, as in the illustration above, they will have enormous political leverage.

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  370. Satish says:

    this was very informative, thx

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  371. Vijay says:

    Now will someone explain why Stan O’Neal and Chuck Prince, particularly the former, walked away with booty that would make a pirate blush? And they remain unpunished. A class action suit by affected shareholders is long overdue.

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  372. James1776 says:

    Many thanks to the Chicago profs for this info. Read all 368 posts to blog. Have never taken time to do half that much previously. Freakonomics, please keep up your important work.

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  373. Sherry says:

    The only thing that is going to really stimulate our economy is to get the price of fuel down. Everything is affected by the high cost of fuel. When that happens our next step is to decrease our dependence on foreign fuel and rely more on natural sources such as wind energy, solar energy and increase our use of advanced technological knowledge to reduce our use of fossil fuels such as v2g , hybrid, generative braking, flex fuels, bio fuels. How can we even get a breath of air, seems soon as we do someone shoves our head under the water again. This time it is Ike and the big oil companies. Actually it is our government who seems unable to devise a plan to free us from our dependence on foreign oil. Interesting book coming out soon called The Manhattan Project of 2009 by Jeff Wilson. We all need to educate ourselves and each other on what else is available out there and put pressure on our congress and to promote and implement every resource available to us. We also need to educate ourselves on which presidential team seems most apt to devise and implement a plan. We cannot go on much longer as a nation like this. We are crossing into some very unstable economic times…

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  374. Jay Franke says:

    You did not address the “moral hazard” issues that have been raised — the problem (whether real or perceived) of “socializing risk and privatizing profit” that will fester on Main Street America and further divide the country culturally and politically. Populist demagogues must be put aside if we are ever to address the real problems of the next generation – energy, infrastructure, education, health care, and the public finance to pay for them.

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  375. Mike says:

    Some pundit on the tube last night inadvertantly put his finger on the problem: credit is the oil of the financial system. Shakespeare had it right — neither a borrower nor a lender be.

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  376. Leslie Bruner says:

    A few things…

    Thank you for the mostly understandable explanations, although it might have all been prefaced by saying “there is something W-rotten in Denmark”.

    Did the government remove/replace management at AIG?

    Is anyone going to jail over any of this?

    In the Great Depression the men with money lost it and jumped out of windows. Can we push them out? Seems to me the only people who feel compelled to jump are us little guys who put the 20-30% down on homes we purchase, keep credit card debt at $0 or no more than 2 monthly payments away, conserve on AC/Heating, drive fuel efficient cars and WALK, save, and act fiscally responsible in other aspects of life.

    I don’t fault Senator Obama (hopefully soon to be President-Elect) for commenting that we have to do the rescue, it appears we did. It’s unfortunate (perhaps) that this happened before the election, if afterward he could have taken an active role in solutions. As a candidate his hands are somewhat tied. Personally, I am comforted that he is being strident and thoughtful about this rather than, as McCain is, ranting daily with his finger pointing at someone, group, or company laying blame.

    And lastly, I am hoping that a competent group of Senate appointed investigators and economists are able to pinpoint criminal wrongdoing, and push perpetrators out the window.

    Leslie
    Prairie du Sac, WI

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  377. Mitchell Rich says:

    Thanks for the excellent synopsis.

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  378. roswellric says:

    “The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.”

    Mr. Levitt misunderstands the difference between cause & effect. The cause was the ability of these firms to obtain too much cheap financing without any underwriting standards. They were making a killing on the spreads between their borrowing and lending.

    In the case of Freddie & Fannie money was even cheaper since the taxpayers were “guaranteeing” the borrowings.

    That works until the borrowers stop paying. Then you will have the “inability of the firms to retain financing”. Ah…the effect.

    Once again…it was the easy-cheap money that the Fed poured into the system after 9/11 and the lack of regulatory supervision to go along with it that caused the problem. I think history is not going to be kind to Mr. Greenspan & company. Bernanke is just the fall guy.

    Freaks me out… :-)

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  379. Roger Zimmerman says:

    I agree with those that point out that this is a very lucid explanation, but only of the most proximate causes for these problems.

    The _fundamental_ cause of the financial troubles is that bankers were making ill-advised home loans to people with minimal credit worthiness. Why would a “greedy” banker do such a stupid thing? Isn’t the idea behind greed to make loans that you believe will be payed back, with interest?

    The answer is: bankers were coerced into making these loans by the Community Reinvestment Act, which made chartering and expansion moves (not to mention general political acceptability, which is, unfortunately, crucial these days) contingent upon having some percentage of loans out to individuals who were KNOWN to be less likely to repay them.

    As an added bonus to this irrational policy, Fannie and Freddie were then there to repurchase bundles of these bad mortgages (with some reasonable loans thrown in), with the implicit knowledge that they were not going to be allowed to go under, because of their status as essentially nationalized lenders. Let the good times roll!

    This “crisis” has the fingerprints of government control and meddling all over it. Since the reaction seems to be heading toward even more such meddling, we can expect more such crises in the future.

    That mattress is starting to look better and better.

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  380. esmiles says:

    AIG: private profits, socialized losses.
    Here’s an interesting answer to the question, is Paulson wrong? http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf
    Found this on Greg Mankiw’s blog last night.

    Thank you for the excellent explanation!

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  381. Tess says:

    I don’t think the answer to the second question really explained “why it happened”. There were a host of events that had taken place prior to the firms’ failure to retain financing. And still, why did this happen?

    In the scheme of things, a mortgage is a small layout/payout for banks compared to other incomes that an investment bank generates such as advising fees, corporate or sovereign loans, middle market lending, securities. Therefore mortgages are bundled into MBS to allow it to have big enough face value for investments banks to accept as a financial instrument.

    The investment banks knew that MBS were not huge deals for them, unlike an IPO offering, resources were not diverted to look at them closely. Mortgage brokers knew that they were simply making small sums here and there, couldn’t have possibly impacted long standing, financially affluent investment banks, so they kept on feeding them to the banks. Plus, the government seemed to have encouraged it.

    With the housing boom and quick profits, would anyone would’ve listened if someone had told them that this was not viable?

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  382. Per Kurowski says:

    And the lesson to be learnt!

    Never ever allow the financial regulators again to empower some few credit agencies to act as risk kommissars and operate with what almost amounts to a risk information monopoly, as this, sooner or later, has to take the world over another precipice.

    Without the credit rating agencies’ AAAs the absolutely lousily awarded mortgages to the subprime sector would have gone nowhere.

    Do not lie to yourself about the markets being free. Is a young boy allowed by his father to roam around only in the company of a governess really free? Of course not!

    In a letter to the Editor of the Financial Times published May 11, 2003 I said “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”. Unfortunately the reality was that those who really should know that, the financial regulators, didn’t, and perhaps did not even care about it.

    http://teawithft.blogspot.com/2008/09/and-what-about-folly-of-generation-of.html

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  383. Vinod says:

    The article is good. Still, I suggest please write a book about this crisis which a layman like me can understand.

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  384. RRM says:

    Good post, from the perspective of an economist. One of the elements that seems to be lost in these discussions — perhaps because it is too esoteric for the mainstream media — is Fair Value Accounting. Fair Value Accounting requires a financial institution that holds a securities for sale — such as a mortgage backed security — to mark those assets to the market. But how do you do that effectively when there is no meaningful market for those securities? Accounting rules, far more than the underlying assets of those securities.

    Bill Isaac, who ran the FDIC from 1981 to 1985, wrote an excellent piece in Friday’s Wall Street Journal describing this problem. In that piece he argues, (Marking assets down to market is…)”contrary to everything we know about bank regulation. When there are temporary impairments of asset values due to economic and marketplace events, regulators must give institutions the opportunity to survive the temporary impairment. Assets should not be marked down to fire-sale prices. Regulators must evaluate assets on the basis of their true economic value (discounted cash flow analysis).”

    Stay with this argument for a moment. About $1.2 trillion of sub-prime mortgage backed securities were issued. $200 to $3000 million of those were held by FDIC insured institutions, the rest were held by investors around the world. The likely losses on those assets (people who fail to repay their mortgage) was estimated at 20%. While painful, that would have been a manageable level of loss. But because of mark-to-market accounting, the seizing of the markets essentially ignored the likelihood that 80% of those assets will pay as expected. (It also ignores the fact that the institutions servicing these mortgages have no interest in owning foreclosed real estate and therefore have an incentive to minimize defaults.)

    If the SEC and FASB continue to force financial firms to mark assets to nonexistent markets rather than realistic estimates of economic value, this problem will not likely end regardless of how much cash the Treasury pumps into the economy.

    Be sure to read “How to Save the Financial System” in the Friday, September 19, 2008 Wall Street Journal. It is written by a regulator who helped guide us through he savings an loan meltdown. Someone with more credibility than Cramer.

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  385. Tito Gutierrez says:

    I see one comment compares our situation to the Argentina meltdown. I visited there in December 2004 and saw first hand the sad effects of a formerly middle class (indeed wealthy at the end of WWII) suddenly impoverished and that was not a pretty sight. “This can never happen to us in the Good Ole USA,” I reassured myself. How wrong! Our politicians have let us down, big time. But, then, as they say, you get the leaders you deserve. Is there anybody out there we can trust?

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  386. Debajyoti says:

    No one asked a very valid question – how much money Lehman executives made in the past years? Isn’t it like siphoning out millions of dollars as yearly bonuses as last few years of operation saw Lehman growing exponentially?
    Such massacre does not happen in a day.
    Why then the management kept turning a blind eye to the internal problem and allowed the disproportionate growth?

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  387. jim says:

    When the stock manipulation only affected the average guy IE to shoot the price of oil and gasoline through the roof or to loose ones house due to interest manipulation this administrations answer was to let the market run its course. No need for the government to get involved. Now when the big boys begin to get hurt the government need to do every thing possible to stem the loses. The person who has lost his house, his job and sees his family hungry,does not see how saving these companies can now make a difference to him. These free market people sure move fast when their money and their friends money is on the line. No amount is to much for the people to spend. I guess the plan is right on track.

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  388. GS Chandy says:

    Please check my message No. 370 – you have lost most of it!!!

    What on on earth happened?

    – GSC

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  389. Christopher Scott says:

    Over the last few weeks we have seen the socialisation of vast quantities of the debt of the richest people and organizations on the planet. In one way or another these phenomenally rich people and organisations are being absolved of the consequences of their actions and inactions.

    In this context a whole series of situations in our world have become truly grotesque:

    - the continued existence of the debt of the worlds poorest countries is now a true obscenity and must be eliminated. I suggest the debt of the 100 poorest countries be written off immediately, and that the debt of all but the richest 50 be reduced proportionately. Perhaps someone would like to put numbers to these debts in order to put them in context with the billions and trillions that are being thrown around at the moment. If there is to be any semblance of justice in this situation the poorest countries must also be absolved of the consequences of their actions and inactions.

    - AIDS treatment is desperately needed in many parts of the world. It is an obscenity that this is denied to hundreds of thousands of people for want of the financial wherewithal, either personal, or of their country, to pay for this. Ways must be found to provide free AIDS treatment to anyone who needs it, anywhere in the world, now.

    - Haiti (specifically, and probably many other places around the world) is currently in a desperate situation because of devastating natural disasters. The cost of providing all the funds, food, and equipment necessary for some semblance of normality to be restored must be absolutely trivial in the context of the debts being absolved at the moment. The necessary funds should be provided immediately.

    Perhaps others would like to add to this list. I am certain that there are many other similar situations around the world which are quite simply morally and ethically grotesque in the current context. All such situations were already unacceptable before the current crisis; now, their continued existence is quite simply surreal.

    How to pay for all this? Nothing in this crisis happened by accident. Every step along the way was taken as the result of the individual decisions and actions, indecisions and inactions, of thousands of managers and regulators in the US and around the world. Many of those positions were probably within in a hairs breadth of criminal. Some were possibly truly criminal. Words and phrases such as ‘breach of trust’, ‘withholding of information’, ‘misrepresentation’, and ‘deception’ come to mind. How many of those involved were encouraging, or doing nothing to prevent, the less well informed from becoming part of this financial merry-go-round, while in full knowledge of the fact that their companies were practically bust, or that the bubble was unsustainable. Crime is what a society judges to be crime in a given context. In the current context much of this behaviour must now be seen as criminal.

    At the very least there is a need for a Congressional Commission, or probably better a UN Commission, as this crisis is global, to unravel this tangled knot of decisions and actions, indecisions and inactions, in order to try and understand what happened and who was responsible for pushing the situation forward into crisis. If crimes are discovered they must be treated as such. They must not be absolved along with the debts. Punishment should be exemplary and financial, in the form of community service writ large. The individuals and organisations found guilty should be obliged to assume full responsibility for resolving, with both work and their own financial resources, some part of the global problems listed above.

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  390. Frank says:

    “Where does the money come from for these ‘bailouts’?”

    In the case of action taken by the Federal Reserve Bank, (http://en.wikipedia.org/wiki/Federal_Reserve) the money is obtained from the ‘federal reserve’; e.g., the reserve balances that private banks keep at their local Federal Reserve Bank. No taxpayer money is involved, hence no Congressional action is required. The loans made by the Fed used in the ‘bailouts’ of Bears-Stern and AIG were NOT MADE with taxpayers’ money (as erroneously reported in a number of news articles and opinion columns).

    Any actions taken by the US Treasury, however, do involve taxpayers’ money. So any costs incurred by the Freddy Mac or Fannie May conservatorship, or by Paulsen’s RTC-like plan, will require Congressionally-appropriated funds (e.g., taxpayers’ dollars).

    OBTW, in response to comment 366, the Federal Reserve DOES NOT make money. The US Treasury does. The Fed just distributes the money for the Treasury Department.

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  391. Pranav says:

    Ok. Great Article. Provides amazing clarity. But think about it. Essentially, its the pessimism on part of lenders and fake balance sheets made by many firms that has led to all this. The solution, well many big shots haven’t been able to find out and obviously so can’t I. But what I can tell is that essentially its money that has stirred up the entire world. C’mon guys, I think we have been giving undue importance to this aspect of life for many years now, which is why all the pessimism. Lets get out of this trouble for now and learn a lesson for future. Money is just one of those things we accumulate and let go once we are through with our physical existence. So it can’t be THE thing to be concerned for. After coming out of this trouble, its time to rethink, our priorities and act suitably. Let’s rise above all this and strive for achieving better things than just the stability of the materialistic world.

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  392. Walldill says:

    Thanks to Martin and John, posts 304 and 342. Finally some coherency ! Like John said: “In effect, like our government, fannie and freddie were borrowing just to finance old debt. When no one would lend, mostly because they couldn’t (their funds were illiquid) they faced default.”

    Bottom line – like Fannie and Freddie, when no one would lend, our government… faced default.

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  393. Ralph H, Malick says:

    Having lived through the last depression or rather survived rather than lived, I do not feel the least bit sorry for speculators and those with greed as their objective for all have had a hand in bringing this problem down on us…..its really called STUPIDITY for you never get something for
    nothing, that is basic so I guess with all this white hair on top I feel like an old worn out prostitute that is too worn out to fight anymore.
    Thanks.

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  394. Alan Hall says:

    Great job of examining the trees. You missed the forest. Not a word about psychology.

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  395. james wilson says:

    More simply put, the democracy is out of control; because it is to large, too self-important, and not a proper Republic any longer.
    The only way to make certain government does not abuse its power is not to grant it in the first place–Tom Deweese
    Powers once assumed are never relinquished. bureaucracies, once created, never die–Charles Reese

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  396. leo from atlanta says:

    Okay article. After the fact and just okay.
    It would have been great if it had the courage to be written beforehand. The guys who wrote this knew what was happenning looong ago. They are disingenuous in atributing the why of when action was taken.

    Back in August of 2007 the public got its first glimpse of us as a nation having a bad debt to cash ratio. Housing prices stuttered and we closed our eyes. Decisive action was needed, but wasnt taken because the public would have never tolerated what was necessary to be done.

    So we waited. We waited some more. We waited until the pain was shared by enough of the population in equity prices that we were collectively scared.

    95% of the people who invest in the market, both home and public equities dont spend a whole lot of time paying attention. They allow themselves to be part of the herd. All you had to do was spend 30 minutes each week looking at the net money flow out of financial instituitions to know they were headed for the toilet months ahead of their demise. Do the math, its easy these days. Whose fault is that ?

    Like it or not, the health of main street is linked to the ability of the banking system to move money. This is not a vacuum system folks.
    Be careful cutting off your nose to spite your face. If we werent so collectively ignorant of this fact we would have taken action far sooner.
    It just costs more now. And yes, certain leaders should have paid dearly with their pockets. They still should.

    So what next ? This is the discussion that means more. Put on your thinking cap. Keep it simple.

    What about the next couple of months ?

    Like someone who falls off a horse, we’ll have to retest this week’s low. Its human nature. DON’T invest in equities till you see this low held.

    Longer term ?

    Money will be more expensive to come by.
    In other words, cash will be worth more.
    The economy will slow to a crawl and jobs will be hard to come by.
    Commodities will decrease in price because we wont be using them as much.
    And what about the dollar that the ‘public’ laments will become the new peso ?

    Think it through.
    Go back in history and see what happens to the dollar when its hard to come by cash.

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  397. Gary Kern says:

    What I got from the article – the Federal Government took the business risk out of the Fannie Mae and Freddie Mac. With the Federal government as a sugar daddy silent partner, market place competition died. Those who ran these programs cooked the books, while both side of the political world got their cut and looked the other way.

    Character and ethic matter and judging from last week’s events both are in short supply and neither will be fixed by this bail out.

    Big government and big business; we, the American people, have put all of our eggs into one basket; this is a socialist basket not a capitalism basket. Those who still believe the out dated concept of our founding fathers; that government derives it power from the will of the people need to wake up and smell the coffee. It is time throw the nay sawyers (conservative idealist) out and get on board with the rest of us and help build our new country “Utopia”. In Utopia there are no risks. We will tax the rich distribute the wealth, everyone will be a king. Happy days are here again.

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  398. Mukundan says:

    Gentlemen,
    Thank you for the comprehensive article. I view the cash flow chain bottom-up as business activity to people (service providers) to mortgage payments to banks/institutions (that lend the mortgages). The current problem is at the start of the chain with the economy not picking up. The solutions including the latest $700 billion proposal prevents the failure of top of the chain institutions, through long-term debt ($2400/person) to the economy and people, further burdening the already hit economy and people.
    Is there a way to prevent a run on the institutions& financial system and not have the govt accept cost of bad mortgages. Remember, the bad mortgages are going to continue unless the economy picks up.
    Maybe, if there is no short term cash flow for lehman, they should immediately create some cash from selling assets. Similiarly for AIG. Separately, there has to be a framework for prevention of run downs on institutions. This sort of govt backing is going to burden the economy with long term debt. There is no benefit to the joe on the street who will face the same problems.

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  399. Wayne Hey says:

    We citizens are too blame, we took the loans wanted more square footage and more garages. Driving up prices and sucking up imports. Laying off our brothers and sisters, off shoring who cares, I just got another new loan. All the while causing the least along us to be priced completely out of the market.Causing, pushing homelessness further into our communities.

    As for the American dream some economist suggest we have too many home owners causing our workforce to not be fluid enough to be able to move to new areas of employment and need.Home works as anchor.I think many Michigan resident would leave too new work elsewhere if they could just sell their homes.American Dream a phrase made up by realestate folks.
    This above is now starting to happen with food and water.Speculation.
    The Government’s fix just more of the same borrow on decreasing capital. The US is loosing value just look at our road and bridges underground infrastructure decade old in many cases.No maintenance rundown all lose of value.

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  400. bobby benson says:

    I`m native American, We were here before America we will be here after America.This bail out is The RICH stay rich ,the poor get poorer. then comes total collapse, martial law,then REVOLUTION. Is`nt this the way it started?

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  401. Yasuko Sasaki says:

    I had E-mailed Steve a while ago, asking him about all that financial mess, and i wondered why the response took this long but now i know
    thanks Steve.

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  402. charles says:

    Not that hard to figure out since it looks like they are scrambling to figure a way to make a profit off of this too, and off of oil speculation, and who knows what else. A crisis of morality in the midst of decadent free marketeering at the expense of everyone but the profiteers. So it does happen to impact everyone and we have to jump in with corporate welfare cadallac dollars courtesy of good ole grandpa Reagan. First Savings & Loan bailouts and now its come to this. George Will is deathy afraid gov’t might impact business negatively while we all overlooks just how much business has been allowed to impact us negatively. With pollution and with dollars, and with increased healthcare costs and with wars for cost-plus profit!

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  403. Kari says:

    Does this mean the war will finally be over?

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  404. Chicago Grad says:

    Thank you to professors Diamond and Kashyap for a wonderful, simple explanation.

    I have to say I’m not surprised by the anti-Chicago comments. That being said, I think most of these are very misguided.

    Chicago is not responsible for the recent financial problems. Critics of free-market economics fail to understand that free-markets function on the ability to access accurate information for decision making.

    The problem is NOT that these banks did not have enough regulation, BUT rather that their regulators did not understand the complexity of the financial instruments involved and were THEREFORE unable to act appropriately. In fact, if a bunch of Chicago grads were running all of these agencies, I’d bet the chances that these practices would have been reigned in earlier would be much higher.

    The Cold War is over and Chicago economics won. Chicago economics isn’t about being a Democrat or a Republican – it’s about believing that restrictions create inefficiencies.

    One GLARING inefficiency: Why do we favor debt in our tax code? We should treat debt and equity equally. If interest payments are tax deductible, then dividends should be as well or vice versa. Why do we promote mortgages instead of giving renters the same tax credit? Now THAT is the underlying issue that no one seems to talk about.

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  405. Rod says:

    Give me a break. Missing the forest for the trees.

    The explanation is much simpler: We are a debtor nation living beyond our means, a situation that cannot be sustained forever.

    You don’t need a PhD in economics or a cutesy bestseller to know this.

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  406. Peter Stone says:

    Now that the American people are being called upon to bail out financial institutions that incurred massive debts through an apparent combination of greed,ignorance and mismanagement, the first thing the federal government must do to take some of this burden off the majority of us who are struggling to make it, is rescind those horrendously irresponsible Bush tax cuts for the very wealthy (many of whom are the same characters who are responsible for this financial nightmare.) The current system is designed to keep the richest among us rich and getting richer, while most of us are getting squeezed to a pulp. Our government has become the handmaiden of the very wealthy who have bought its favors. This transformation has been going on for at least 30 years right under our noses at the same time as our rights as individuals have been gradually stripped away, most recently sacrificed to the gods of the so-called “war on terror.” The US defense budget is now larger than all the defense budgets of all the rest of the countries in the world combined! “Country First,” the angry candidate bellows. I believe you have to consider the welfare of the people first. “Country First” is a formula for keeping the people subservient to a controlling system that obviously doesn’t really care about their welfare. We are blinded by the violently waving flags and made deaf by the thundering drums of war. A healthy, happy, unafraid populace means a strong country. First things first.

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  407. Brian says:

    Here’s a very naive question from someone who has, in fact taken post-graduate economics classes. I hear this is a trillion dollar problem. So where did the money go to start with? Money doesn’t just evaporate. A person can lose money, a corporation can lose money, but an accounting system should not. Did it go to executive bonuses (in which case, shouldn’t we ask for it back?)? Did it go for goods and services (in which case the GNP has been grossly inflated, but the people of the country have reaped a benefit and without this influx of capital we would clearly already be in recession)? Did it go to profit short sellers (in which case we are clearly under-taxing these folks)? Is it really not missing to begin with, but simply the result of changing accounting standards? How do you “lose” a trillion dollars?

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  408. elizabeth says:

    Thank you for explaining a bit of this crisis.

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  409. Kirk says:

    Thank you for this informative article! It is refreshing to read an explanation presented without lots of opinion and emotional bluster.

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  410. Kevin Waspi, CFA says:

    Thank you for the excellent account of THIS chapter of a very interesting book. I could be snide and suggest that anyone wanting to skip to the last chapter of this fascinating book rent the 1981 movie, “Rollover”. It Starred: Jane Fonda, Kris Kristofferson, Hume Cronyn, Josef Sommer, Bob Gunton, and was directed by: Alan J. Pakula, who also did “Klute”. The acting is enough to make you want to walk out on it, but the plot is fitting, considering that Asia and the Middle East have been financing the growing U.S. appetite for debt for 30+ years. If they loose patience with us, “heaven help us” in the words of Hank Paulson. As a final note, I would love to have you two comment on the Friday, 9-19-08 7:30am (CDT) announcement of the socialization of risk in money market mutual funds. PIMCO should eat their CDS losses they were so brilliant in writing, and money market mutual fund shareholders should be made to understand the part of the prospectus that says the sponsor “will make every effort to maintain a stable $1.00 net asset value, but cannot guarantee that it shall” Should I petition the Fed and Treasury to rescue me from betting my life savings on 17 Black too?

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  411. Juan says:

    Two Thoughts searching explanation still

    1. I remember Bush giving a State of the Union address where his stated goal was for every American to own a home thus he made certain regulations more lax. Can tyhis be considered the beginning of (or at least a watershed moment) the Housing Bubble?

    2. Just curious about Hank Greenberg. Ex-CEO of Bear Stearns, left there to become CEO of AIG. He was credited with coming up with “innovative and creative new ways to bring money to these firms”. Were perhaps these innovative ways actually reckless, endagering the global economy to the point where we find ourselves here now?

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  412. Richard says:

    I have a great idea; how about we find out everything we can about the people who actually defaulted on their mortgages instead of all the wild accusations against Wall Street.

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  413. Peter Sterne,Sr says:

    I haven’t read all of this article, not too mention the comments, but doesn’t this turn us into, at best, a socialist democracy? Upon what legal authority did the Fed take control of AIG? Not to mention that a free market might prefer a depression to a government takeover of the #! insurer on the globe.

    I don;t think the US Constitution supports this government takeover of the financial industry … I feel like I’m living in Venezuela!

    Viva Hugo .., oh, wait, I mean George!

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  414. Jonathan J. Horan says:

    Thanks. The first read on 21 Sep is good in Australia. i haven’t read your other contributors yet. Prudence is one concept. I think that is the opposite of lustgreed. Pepole got slack. People worked fast. People got slack and tricky and used the language to hide deceit.All those financial engineering labels. Mostly just a barrow full of sloppy swamp. We all seek wealth, growth, security. The swamp sellers just layer their deceit with the common gooals. Sounds like a crime in the mind. who needs a law before the crime?

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  415. Bethesda says:

    Interesting that nobody places blame where it should go, on the lax regulation by Clinton’s HUD secretaries who pushed home ownership for everyone including those least able to sustain mortgage payments in over-priced homes that they could not afford and several political appointees (like Raines and Gorelick at Fannie Mae) who cooked the books to reap millions and millions of dollars in bonuses.

    For years, I could see the mess coming with all these exotic mortgage derivatives (divided into tranches and resold, stripped IO’s and PO’s, and inverse floaters), where these things reside by the billions in your “ultra-safe” money market funds.

    How many money funds broke a buck last week? How many broke a buck in the prior 38 years of the money fund’s existence?

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  416. Kate says:

    The BBC has what appears to be a far more comprehensive answer to what’s responsible for the current mess.
    http://news.bbc.co.uk/2/hi/business/7525724.stm

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  417. cadmus says:

    Thanks for the story. Very informative. It still doesn’t change the fact that I feel very sick about the bailout.

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  418. spook says:

    Can we trust the government to manage the funds appropriately? Instead is there a way an independent body can be created, supervised by Congress, that can manage the toxic debts bought from the market?
    Currently, it seems like the boys at Wall St played fast and loose (with Govt helping them by deregulating everything). Now they are in trouble and want help. That is fine, given how a collapse of markets doesn’t help anyone. But can we just give them a blank check with no regulations, questions, transparency or demands for accountability?
    Socialism for the rich, capitalism for the poor?

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  419. Brian Macker says:

    “Clearly, regulation to end the practice of socializing the risks and privatizing the gains is needed, and “innovation” should not be used as an excuse to avoid it.”

    That. “socializing the risks and privatizing the gains “, is the regulation. How much time to you have to spend on the boards of the regulating committees, vs. how much benefit you would get by doing so? However, those being regulated have plenty of time and money to sit on those boards, or bribe those who do, plus reap large benefits. Is it surprising those “regulations” end up benefiting them, and rich congressmen.

    This isn’t free markets. This is a planned monetary economy.

    The FED itself was put in place because of the desire of rich private bankers to “regulate” their industry.

    Fanny Mae and Freddy Mac are also the results of government intervention in the economy. They are a form of regulation. They were set up specifically by the government in a way that socialized risk and privatized profit.

    This whole mess was predicted and predictable by means of Austrian Economics.

    It’s not done yet either. Massive inflation is in the works. Un-Fn-Believeable inflation.

    Due to below market interest rates we have been consuming our capital, our seed corn, for decades. Less capital means the production of less goods. This has been hidden by various schemes by the government to ‘keep the economy going’. One scheme has been an increase in the money supply. Well guess what, when you simultaneously increase the money supply and decrease the amount of goods you get, inflation.

    This has all been hidden by various factors that main stream economists are two dense to grasp. For instance, the Thatcher/Bush revolution opening up 3rd world markets was highly deflationary, and we should have let prices drop. Instead we tried to keep those prices stable, therefore distorting the markets and causing malinvestment.

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  420. Brian Macker says:

    “Here’s a very naive question from someone who has, in fact taken post-graduate economics classes. I hear this is a trillion dollar problem. So where did the money go to start with? Money doesn’t just evaporate. A person can lose money, a corporation can lose money, but an accounting system should not.”

    Money does “just evaporate”. Learn about fractional reserve banking. The best and shortest presentation on money is Murray Rothbards, “What has government done to our money”. It’s available online here for free: http://mises.org/money.asp

    You can read over the course of two evenings and it is written for the laymen.

    Short explanation: The problem of ‘money evaporating’ happens because of fractional reserve banking. It would not happen in a non-fractional reserve 100% gold standard economy. It will happen with a fractional reserve system on top of a gold standard.

    It’s easier to understand with a gold standard so lets start there. The gold is the base money supply, and is true money. The paper currency is claims on this true money.

    Start with one million ounces of gold and no banks. People use gold one ounce coin to trade. So there are a million one ounce “dollars”.

    Banks arise. Lend them your gold ounce dollars. Say everyone saves all their cash in the bank for simplicity. So banks are holding one million dollars in notes. These are short term accounts and you can withdraw at any time. So people collectively think they have a million dollars.

    Now the banks discover that not everyone uses their cash at the same time. They discover they can lend out say half the gold money long term. They do so. So $500,000 is lent, and is used to buy goods, and ends up in the producers of those goods pockets. They in turn deposit the money in the banks.

    At this point the banks have the full $1,000,000 in gold. However they owe depositors $1,500,000 in cash. Those depositors think they really have $1,500,000 cash, and can access it short term. They treat it as cash.

    This continues. 1,000,000 + $500,000 + $250,000 + …, which is the series 1+1/2+1/4+… which adds up to 2, or twice the currency.

    It turns out the multiplier here is the inverse of the reserves. If you hold half reserves then the inverse of 1/2 is 2/1. If you hold one sixteenth reserves the multiplier is 16/1.

    When there are bank runs this process reverses itself as people pull their cash and the banks go belly up. If 1/10 of the banks go belly up then 1/10 of the multiplier evaporates. That cash also evaporates.

    Rothbard feels that it is fraudulent to lend money long term and borrow short term. He’s correct.

    One of the big mistakes of this Fanny Mae/Freddy Mac business, plus the Mortgage backed securities, plus many other schemes backed by the government is that they are in essence fractional reserve banking.

    The fractional part is the leverage, and everyone was getting into leveraging thus inflating the money supply.

    Fanny/Freddy (FF) only had 2% private money at risk, essentially the deposits, against all the currency it had essentially printed up with government sanction. That’s a 50 to one ratio.
    Worse, the risk was backed by government so they were really lending against taxpayers all along, while sucking up profits privately.

    It can’t go into all the implications of this in a comment but this monetary inflation hides true prices, distorts investment from short term to long term, reduces savings, causes a trade imbalance, etc. All signals available to Alan Greenspan since early Clinton years.

    We are now in a situation where everyone is eyeball deep in debt. The economy is actually doing very badly but it was all concealed, plus the concealing was distorting prices causing people to invest where they should not. This will be uncovered in the long term. How it unfolds depends on government choices.

    A free market naturally balances all this stuff. You don’t need to do anything. Like your bodies own dynamic homeostasis system, or the govenor on a steam engine.

    Instead, the government has choosen a system that is unstable and has pushed that system to the bring of collapse. I continues to push the system to peaks of higher and higher instability.

    What we are experiencing is a bank run, where the bank has a printing press in the back room where it can print you all the money you ask for. It also has the arbitary power to decide who it screws, and the power to tax its customers directly.

    We US citizens are forced to use this bank. Others are not. Welcome to the forced economy. You do not truly live and work under a free market system. It’s gamed.

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  421. Brian Macker says:

    “I remember Bush giving a State of the Union address where his stated goal was for every American to own a home thus he made certain regulations more lax. Can tyhis be considered the beginning of (or at least a watershed moment) the Housing Bubble?”

    No, the housing bubble has the same roots as the internet bubble. Monetary inflation. If you artifically lower interest rates below market prices you get exactly the effects we have been experencing as predicted by Austrian Economics.

    Interest rates are the time cost of money, a price like any other. The government setting prices in any sector is a bad idea and causes either shortages or overproduction.

    In this case there was an overproduction of houses and a a shortage of savings. Interest rates are below what people are willing to save at, and thus people don’t save. Low interest rates make long term investment look very attractive. Things furthest from consumption. Not may things are more further from consumption than internet companies and housing. Artifically lower interest rates and both look more profitable.

    These manias have always followed monetary inflation. The tulip mania, the south sea bubble, the revolutionary French bubble, the roaring twenties, etc. were all the effects (not the cause) of monetary inflation.

    Even back during the bubble in revolutionary France there were level heads saying “Don’t do that, it ruined many an economy throughout history” yet the government inflated anyway. Same symptoms too, stock jobbing (stock flipping), backing currency with real estate, price bubbles, trade deficit, and so on.

    Why shouldn’t politicians inflate? It allows them to screw you, the little guy. That’s what the FED is all about.

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  422. Jean Knox says:

    It appears to me that we lost sight of one detail — what money is. With low interest rates on bank savings, real estate became a form of money and savings for many. It was such a good investment vehicle that the financial markets made it into a securities business. The banks are under strict rules regarding capitalization, so they could not have done what these other players in the market did. I don’t know current markets, but long ago, houses in California were so expensive that they often were not insured by Fannie Mae and Freddie Mac. That didn’t matter. Those organizations were for the poor who were buying their first, presumably less expensive house. Now, our young people are working many full time jobs with children just to afford those horrendously expensive houses — which the markets have driven up because houses are also an investment vehicle. It has often been this ways– that a house is somewhat expensive above the budget, but the beauty of it has been that people, once they own a house can live there a lifetime, even after they get old. There is a certain cap to that amount, perhaps. We need to seriously re-think housing, food, and economic realities for people. When things get too unfair, society falls apart. Our capitalistic system is good. Government meddling at the last minute to this degree — my mind is questioning the full necessity. I cannot do the math, but as a gut feeling, it seems that the interest rate should be raised, so that people could put more money into the bank savings accounts and the markets could be re-worked using real economic dollars.

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  423. DNB says:

    Thank you for the very informative FAQs.

    This one may seem trivial, but why did the Fed take a 79.9 percent stake in AIG? Why not 51 percent or 100 percent? I think you cannot consolidate a subsidiary for tax purposes unless you own 80 percent or more. Is that the reason?

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  424. Charles says:

    Democrats created the Fannie Mae and Freddie Mac problems years ago, in a well intentioned but failed effort to allow low income groups to buy houses. They stopped ALL eforts at reform until it was too late. Now they are trying to blame Bush, McCain and Republicans, everyone but themselves. That’s the Gods truth and here is the proof:
    http://strategicthought-charles77.blogspot.com/2008/09/democrats-created-fannie-mae-and.html

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  425. Terry says:

    Hard to imagine that anyone would give comment #426 much attention but here goes anyway…

    China.

    I’m very surprised it hasn’t really come up in 425 comments. The current financial crisis was not caused deregulation, investment bankers, short traders, commercial banks, entangled insurance companies, low taxes, homeowner mandates, home equity atm machines, foreclosures, unregulated CDS, CMO, CDO markets, Greenspan, Bernanke, Rubin, Volcker or Paulson. It was caused by China. Specifically, by the success of China’s economy.

    The US has an unprecedented export deficit with China. China is inflating. The US money supply has been inflating, but not the dollar (because of asset inflation). Imagine a see-saw tipping heavily to one side – China’s side. Restored equilibrium to the tune of about $1t has been inevitable for several years. Three ways to get there:

    1) China revalues currency – this is what Paulson has been working on for the past several years, to no avail and to much criticism.

    2) Crash – last time I checked the dow and the value of my house they were still ridiculously overvalued.

    3) Inflation – The silent killer.

    So, the fed has $800b to play with. We will see a $1t correction. The only question is the percentage that will be corrected through inflation and the percentage that will be corrected through asset depreciation.

    Bernanke and Paulson have been aware. It is rather obvious. They’ve been trying to orchestrate a soft landing. I suspect that they knew this would be difficult given the CDS situation but they gave it the college try. Bernanke has had plans A,B,C,D up his sleeve since Princeton. Current events are rarely accurate in judging fed chairmen. Remember the names people called Volcker? Remember “The Maestro”? We’ll see.

    The Great Moderation. Here are some ways to truly tame markets and prevent future crisis…

    - Elimination of all shorting (allow institutional swaps and synthetics)
    - Eliminate stock options (allow commodities futures)
    - Eliminate retail margin
    - Report all security transactions to central agency (*all* securities, *all* investors)
    - Regulate capital at the federal level for all financial institutions (bank, brokerage, insurance, funds)
    - Reinstate Glass-Steagall (separate bank, brokerage, insurance)

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  426. Leticia says:

    I don’t think this article got to the root of the matter AT ALL — it stays on the surface. Notice that in the “old” days (before the late 90′s) banks “owned” the mortgages that they issued for the entire 30 year life of the loan (e.g. they owned the risk). Therefore, it was deeply in their interest to ensure that they only made loans to people with high probability of paying them back. Since the Republican “free market” Phil Gramm-sponsored deregulation of the financial industry, banks were then permitted to buy insurance on those mortgages (off-loading their mortgage risk). This legislation then encouraged banks to become crazy people and approve anyone on earth for any size of a mortgage since it no longer mattered if the person could pay them back. Apparently, these insurance instruments are called “credit default swaps”. The lingo is not as important as simply noticing where are the incentives and who owns the risk. It is also important to note that Sen. McCain’s chief economic advisor is that nut Phil Gramm, the sponsor of the deregulation that led to this TOTAL MESS. Also, it is important to note that this mess shows how free-market greed can get out of control and lead to tremendous societal loss, if not appropriately restrained by regulation. Here is the best article I’ve seen on the subject: http://www.texasobserver.org/article.php?aid=2767

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  427. william says:

    Nice article.

    Maybe a follow up on this would be how the bailout package affects the public.

    -How can private losses become public good.
    -The bailout and externalities
    -How this positive reinforcement that for risk-taking, you are rewarded handsomely but if it failed, you will not lose your rewards.

    I find it sick and disgusting that the CEOs are still living life as multi-millionaires and getting their fat compensation package when they are the one who should be punished for this dismay performance. Shouldn’t the govt demand to take back all their pay and bonus for the last 2 year at least. or to agree that the compensation package should not be exercised as obligation ‘coz their actions have cost $700 billion of taxpayers money.

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  428. Marc Olson says:

    The missing link in all this for me still is the cause for all the run on credit. I’d be interested in learning more about this root cause.

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  429. Oldefarte says:

    If the “investment houses” and banks caused the problem, how is saving them with public moneys, for which they have even less accoutability than they had to their shareholders, the answer? If liquidity is needed and if government money is the only source of that liquidity, why not simply bypass these middlemen and set up a government loan program which channels cash directly to the end users, who can then retire high interest loans, returning that money to the capital markets? Wasn’t that part of what FDR tried to accomplish with the NRA when all the banks failed? We already KNOW what giving “cheap money” (e.g. the Fed rate cut earlier this year) to Wall St. does – it doesn’t retire bad debt and increase liquidity, rather it goes into oil speculation, driving the economy further into the hole. Now, with $85 BILLION in AIG’s account and the promise of more on the way, our tax dollars are once again going into the commodity markets, fueling a 14% jump in the price of oil almost overnight. Can you spell D-U-M-B? Let ‘em fail and let the Government, if it’s gonna loan our money, be in charge of it, not the people who created the crisis.