bithead redux

My response to large scary events is to learn as much as I can about the event, and any contributing factors.

Because I didn’t really understand the current credit crisis, I tried to find out as much as I could. What really got me going were the two shows that “This American Life” did, one called “The Giant Pool of Money,” and the other “Another Frightening Show About the Economy.” The team that did those stories then created the Planet Money podcast, which I listen to obsessively.

This mini-essay is my attempt to express what I think I know about this matter. I am not an economist. I have made mistakes.

This is how I think it worked.

First, we have a few economic developments that ended up being intertwined:

Development #1:

With the rise of collateralized debt obligations (CDO), everybody wants more mortgages to put into new CDOs, so lending standards drop, and subprime mortgages become more common.

Financial companies use CDOs as collateral for even larger investments (leverage).

Development #2:

The “Credit Default Swap” is invented. Investors who wish to insure an already low-risk bond buy a Credit Default Swap to cover the bond. For a yearly fee, the company selling the default swap promises to pay the face value of the bond should the bond issuer default.

Not long after the Credit Default Swap was invented, in congress, a rider (106th congress, bill S.3283) was added to a must-pass bill, exempting the Credit Default Swap market from regulation.

Development #3:

Companies that need short term loans of large amounts of money (this is a multi-billion dollar market) sell financial instruments known as “Commercial Paper.” This is how companies pay their bills when the income stream is not steady, but the need for capital is. This is most companies.

Commercial Paper is considered to be among the safest of all investments. Because of that safety, it is one of the places that managers of money market accounts place their money.

These developments started to interact in problematic ways:

Problem #1:

Subprime-based CDOs start to lose value slightly, because of an uptick in the default rate for the mortgages contained in the CDO. Because companies were very highly leveraged against these CDOs, a small change in the CDO’s value results in a large change in the amount of money they can borrow against the CDO, and between margin calls and the selling off of securities to pay for those margin calls, these major financial companies start to run out of actual operating capital.

Many of these companies (Merril Lynch, Bear Stearns) were purchased or propped up, but some (notable Lehman Brothers) failed outright.

To prevent the larger failure of the major financial institutions, the United States Government passed the bailout, and is currently buying up “super preferred” stock in endangered companies (referred to as the “Stock Injection Plan”).

Problem #2:

Anyone with a bond issued by Lehman Brothers, which at any other time would be seen as an incredibly safe and conservative investment, is now out of luck, because Lehman Brothers has just defaulted.

If you were smart, and bought a credit default swap on your Lehman bond, the issuer of that credit default swap is now on the hook for the face value of the bond.

Because the market for credit default swaps is unregulated, it was perfectly fine for people to buy a credit default swap for a bond they did not own. It’s like buying insurance for a house that you do not own or live in.

It sounds nonsensical to buy a credit default swap for a bond you do not own. But, if you thought it was likely that the bond was going to default, it would be worth your million-dollar investment to get a potential billion-dollar payoff.

A significant number of investors did just that, buying credit default swaps on bonds they did not own, Lehman Brothers bonds among them.

Many of those credit default swaps were sold by the American Insurance Group (AIG). When Lehman Brothers failed, AIG (among others) was on the hook for an amount that was radically larger than the amount of assets they held.

Companies and pensions and hedge funds and mutual funds, and many more, had all invested significant sums of money in AIG. Worldwide. So the total collapse of AIG could be devastating, on a worldwide level.

Because of the potential consequences, the United States Government stepped in and effectively took over AIG.

Problem #3:

Lehman Brothers used commercial paper. When they crashed, all of that commercial paper defaulted. Money market funds lost money, most for the first time ever.

This made the money market funds, and other major participants that bought commercial paper, pull out of the market.

Companies could not get short term loans to cover operating capital, so they have to start cutting costs. One common but unpleasant technique for cutting costs? Lay off workers. Like me, just last Thursday.

Because the commercial paper market dried up, for the first time ever, the United States Government stepped in and started buying the paper.

Problem #4:

Major financial funds, trying to divest themselves of assets that they now consider riskier than they’d like, start selling off large portions of their holdings. This depresses the equity market.

People stop spending, because they fear even more losses. The economy slows down. Maybe even shrinks a little.

And here we are.