Thursday, October 09, 2008

Understanding the Crisis

If you're like me, you probably have a very hard time understanding what's going on with the current financial crisis on Wall Street and around the world. Before last year, who had ever heard of the mortgage backed security? Before this summer, who had ever heard of credit default swaps? I hadn't, and neither have most people who are presently concerned about their jobs and their retirement savings evaporating into the wind. Back in May This American Life did a comprehensive program on the subprime mortgage mess, which explained how it came about and where it could be heading. This past weekend, they did a show on the global lending crisis that has been set off by the subprime mortgage crisis. If you want everything explained to in laymen's terms, but in a way that'll help you understand what's really going on now, I highly recommend listening to both shows, one after the other. If you're like me you'll be both infuriated and frightened after doing so. You probably already know that as home prices collapsed in the United States, mortgage backed securities that were being created and traded so briskly on Wall Street, began to collapse as well. That would be a large enough problem on it's own, as hundreds of billions of dollars in debt began to disappear into a black hole as the value of these instruments collapsed. But a far larger problem is that of the credit derivatives market, and credit default swaps in particular, many of which were tied to these now collapsing mortgage backed securities. You might be stunned to realize that these swaps amount to a market of roughly $60 trillion, an amount greater than the GDP of all nations on Earth combined and an amount that is tied to "only" about $5 trillion or so in bonds and other securities (and that's only part of a market of $540 trillion in derivatives being traded around the world.) These credit default swaps were utilized by parties who had nothing to do with the instrument that the CDS referenced; third parties merely speculated as to whether debt would be serviced or not (like you or I might gamble on a football team.) As mortgage backed securities have collapsed, they've produced demand for payouts on these credit default swaps that simply can't be met; hence the collapse of giant firms like AIG, which bled capital when investors realized that AIG could not possibly meet the debt obligations it had incurred engaging in risky CDS'. Why can't demand be met? Because firms like AIG sold these contracts far beyond the ability to pay them out, assuming-like everyone else at that level-that the mortgage backed securities that they were tied to were as good as credit rating agencies said they were. They were wrong. And the market for CDS' is completely unregulated thanks to an act of Congress in late 2000; as a result of this and the utter lack of transparency (credit default swaps are an entirely private transaction) no one knows how much anybody owes to anybody else, or how much of what they're holding is still worth anything. No one wants to loan anybody any money in this situation, including large and small businesses that need the money to operate on a daily basis, and all the way down to people like you and me who can't get a car, house or student loan.  At one point in the TAL show on the current crisis, economist Satyajit Das, trying to summarize the entierty of the problem we're seeing in the global markets, has this to say: "Essentially, the world just has far too much debt...There will enormous, enormous losses that will beggar relief." 

Anyway, that's the Economics for Dumies explanation. Listen to the programs and get caught up, and then you'll be ready for stories like this one, or this one

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