"Chain of Fools"

Here's an informative post called "Chain of Fools" on how the whole deal worked, with a cool graphic.

Whither Now?

The Giant Pool of Money episode on This American Life talks about how the former Fed Chief Alan Greenspan sewed the seeds of the current crisis. He was fighting the previous credit crisis (I need to connect the dots here, but I am pretty sure it was connected to the aftermath of 9/11 and the resultant economic contraction), and he basically held interest rates too low for too long (in retrospect). All that easy credit led to the housing bubble in the US.

Flash-foward to 2008: The current Chairman of the Fed Ben Bernanke has been dealt the same bum hand. He has no choice but to keep credit easy and plentiful! Now that money is going to necessarily have to find a place to invest in - grown in - speculate in - leading to, you guessed it, the next bubble. The only question is: where? Stay tuned; my crystal ball is in the repair shop.

It's All the Credit Rating Agencies's Fault!

There are 3 major agencies in the US (world) that rate commercial loans based on the payment history, cashflow analysis, creditworthiness of the borrower - Moody's, Standard and Poor's and Fitch. What "grade" they give your debt is critical. The higher the grade you get, the lower your borrowing costs. Also, the higher the grade, the lower your costs to insure against default (remember CDS?). Here's what seems to have happened:

• The financial alchemists on Wall Street created a CDO.
• Then they sliced this up into higher and lower grade tranches.
• They somehow got the rating agencies to rate the highest grade tranche AAA! Remember these are still the lowest quite mortgages out there. It baffles me that some of the smartest credit cops would rate this junk AAA.
• Once these tranches are rated AAA, everybody in the world wanted to buy them, because of the promised high return.
• AIG got in on the CDS side as well, likely based off of the same ratings.

The point is that there is no way these tranches should have been rated AAA.

Culprits?

When a crisis of this magnitude hits, there is the natural human tendency to look for culprits. I tend to look at systemic issues that caused humans to behave in a particular way. There are a few "irregularities" that stick out:

1. Everybody in this system (from Lehman Brothers to Fannie Mae) depended on computer simulations to predict default rates. It is obvious now that the data on which these models depended were not exactly applicable in 2007 and 2008. Historical data always depends on context and that conext-dependency limits the usefulness of projections based on those data.
2. Why did AIG keep all the CDS transactions off the books? Was there malfeasance or were they just clueless? There is a big push afoot to regulate CDSs and create exchanges to trade them. Will that solve the problem?
3. Another big issue is highlighted here: "This ability to buy insurance on things that you have no insurable interest in transformed this [CDS] market into a huge casino." 'Insurable interest' in this case means buying insurance even if you do not own the underlying bond. As an example, you are prohibited from doing this with life insurance. You, dear reader, cannot buy a life insurance policy on my life. It creates too many conflicts of interest! Think mafia...
4. Mortgage brokers were the agents that built the shaky foundations of this mess. There certainly was some outright fraud. But there were also global forces at work compelling these brokers to commit fraud. After all, humans have been committing fraud throughout our not-so-illustrious history. Why should this particular instance matter so much?

How did Countrywide and WaMu Collapse?

Countrywide Credit and Washington Mutual were two regional thrifts (primarily banks that gave mortgage loans to homeowners) operating on the West Coast. They basically went under because the borrowers of some of the mortgages stopped making payments. All the lower quality loans were working out fine while house prices were skyrocketing in the early 2000s. When they stopped going up, the game was up.

The Un-doing of AIG

AIG was a global insurance giant that came crashing down two weeks ago, precipitating the Credit Crisis and launching the $700 billion rescue plan. Here's an article that explains what happened. Here's the outline:

• It all started with Credit Default Swaps or CDSs. When you lend money to somebody, you naturally want to protect yourself from loss in case the borrower defaults on the loan. CDSs are basically the same idea, only extended to much bigger companies. This primer from PIMCO explains the process.
• Pension funds and banks and other institutions around the world wanted to invest in the CDOs and CMOs created by Wall Street investment firms. But they also needed to protect themselves.
• That is where AIG came in. AIG created CDSs for all these institutions promising them to pay up if the CDOs defaulted. The only problem? This was all done completely off-the-books. AIG either chose deliberately not to handle this as a legitimate insurance product (following due process such as setting aside reserves for losses etc.) or they just plain did not know how (CDSs being a new product).
• In either case, once CDOs default wave started, AIG ran out of capital very quickly. Now they were entangled in this giant global web that would unravel and cause a global crisis. This is when US Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke recognized the depth of the problem and stepped in and provided AIG capital in return for part ownership.

Demise of Bear-Stearns and Lehman Brothers

How did these two venerable names on Wall Street end up in bankruptcies? This American Life did a fascinating show on NPR, called: The Giant Pool of Money. The basic outline is as follows:

• The great news around the world is that we are getting richer! Humanity has never been richer in its history. It is also getting older, especially in the industrialized countries. As a result, there is the so-called giant pool of money, all the savings from everybody in the world. This money needs to be invested somewhere. When it ran out of super-safe avenues to invest (mainly bills, notes and bonds of US Treasury), it started looking for higher returns (at the cost of higher risks) such as pools of mortgages in the US.
• Bear-Stearns, Lehman Brothers and other Wall Street investment banks went to work creating investment vehicles to satisfy this enormous demand. They kept going to lower and lower quality mortgages in order to supply the need.
• All this was fine and dandy while the US house prices were going up. Once they stopped going up, the show was over.

Here's another link that explains this. Warning: It uses (completely unnecessary) foul language.