It is a complex and interwoven mesh that forms the structure of the vessel that holds the liquidity of the world's financial markets and is really responsible for the mass failure of the credit market that we are now experiencing. This complexity is little understood by the general public and has been inadequately explained by the government or Wall Street.
Predatory lenders, overanxious borrowers, an overvalued market, and the desire of the government to get as much of the middle class as possible to partake in the "ownership society" by owning a home, formed the foundation of the crisis we are now in. But it was what followed that made a manageable problem, into a crisis.
The first step was the reselling of hundreds of mortgages, by bundling those mortgages, without regard for the potential risk involved in any specific mortgage in a bundle. The volume of these bundles became so great, that the Investment Rating Agencies, such as Moody, became so overloaded, that they just rated all bundles as "AAA". These bundles are known as "Collateralized Debt Obligations", (CDO) and were purchased by many investment bank and commercial banks.
The next complicating step was to insure these CDOs by issuing "Credit Default Swaps", (CDS). As long as there were few, or no, defaults, this was a lucrative business, as described below, and was entered into by many financial institutions. A CDO could apparently be insured by many CDSs, making the income from premiums very inviting.
The first pinprick of failure that began the disintegration of the structure of the vessel occurred when sub-prime mortgages, with teaser rates and onerous increases in payments when adjustments came due, began to default. If there had been clean and clear ownership of these mortgages these defaults could have been handled without far and wide ramifications.
But because of the system's interwoven structure, it wasn't clear as to which of the collateralized debt obligations contained what percentage of these mortgages, so the value of all of these instruments, including those held by Fannie Mae and Freddie Mac, which did not finance the worst of these mortgages, lost value to the point where a government takeover of these Government Secured Companies (GSC) was required.
If not for the extensive interaction throughout the financial structure, this takeover, or leak in the vessel, would probably been easily absorbed. But the financial institutions, like Lehman Brothers and Merrill Lynch, were also heavily invested in collateralized debt obligations and credit default swaps, and so they too had to be taken care of. These instruments caused the leak to become a hole in the vessel.
AIG was an example of a company that did not have to get involved in any of this. There insurance entities were doing well and making good profits. But a small London office of the company headquarters got heavily involved in credit default swaps, as a way of making inordinate profits, most recently more than 80 percent of gross, until the levee was breached and the losses came pouring in. The entire company might have floundered if not for a major intervention by the government.
With banks and other financial institutions holding so much paper that is of unknown value, and real estate values dropping as foreclosures rise, is it any wonder that banks won't lend money and the economy, that relies so much on credit, is in danger of drying up completely.
While we may each have our own desires as to which measures should be taken to plug the hole in the vessel and get the financial markets flowing again, we should accept any quick repair and then reexamine the essence of the vessel's structure and build something that is far less likely to fail. Appropriate regulation, transparency and oversight must be a significant part of any new financial structure.
Leon