In a past series of posts, I looked at the financial crisis created by the collapse of the subprime housing crisis.

In the wake this week of the massive federal bailouts of Fannie Mae and Freddie Mac and AIG (American International Group), the collapse of the venerable Lehman Brothers investment bank, and the sale of another giant Merrill Lynch to Bank of America that staved off its own bankruptcy, it may be good to see how all these are linked.

This crisis is the inevitable result that follows ‘bubble’ economics’, the runaway (and unrealistic) growth in the price of a commodity due to the belief of investors that the price of that commodity will either always increase or that they can sell out before it drops. In this case, the commodity is real estate. At every stage of the process, the firm belief that the value of homes would increase, coupled with little or no oversight to ensure that minimum caution was exercised in lending money, resulted in this runaway train that is now crashing and causing massive damage.

The foundations of this bubble lies with the providing of mortgages to large numbers of people who simply could not afford the homes they sought to buy. How was this done? One culprit was the creation of mortgages that had very low introductory rates that enabled people to pay the mortgage premiums, at least initially. Of course, such an artificially low rate could not be sustained so the premiums would suddenly rise after a few years, to a level the buyer could not afford. This seems like an unbelievably stupid plan for both the home buyer and the people providing the mortgage. And it is, unless you believe that the price of the home would increase in value, because then the homebuyer could sell the home before the mortgage went up, repay the money to the mortgage lender, and still make a profit. Everyone wins. There seemed to be a free lunch, just for the taking.

As a result, all kinds of shady practices arose. Mortgage brokers working on commission actively sought out even ineligible buyers for properties, inflated their income to meet the minimal requirements for eligibility, and sold them properties. The banks providing the money did not bother to really check on the credit worthiness of the buyers because they immediately sold off most of their mortgages to investment banks. These investment banks then ‘securitized’ their collections of mortgages, bundling them into huge packages of thousands of mortgages, then dividing them up into smaller pieces, and selling the pieces like other securities such as bonds.

Since investors believed that home prices would always go up, there seemed to be little or no risk. But as a result of this bundling and slicing and dicing and no strict accounting or transparency requirements, no one knows exactly which mortgage is in which bundle, even now. But who cares? The idea was that by this bundling, even if a mortgage here or there went into default, it would be a small part of the whole package, hardly noticeable. Wholesale defaults would not happen since home prices always go up, don’t they?

The investment banks then bought and sold these securities, their huge commissions adding to the price. They were aided in this by the credit ratings agencies (like Moody’s) that gave these securities the highest ratings of AAA, which made them seem to be very safe investments. Why would the credit rating agencies give high ratings to securities whose origins were so murky and about which they seemed to know so little? Because it is a little known fact that these rating agencies are paid by the very companies they rate and so have a vested interest in pleasing their clients. Of course, they also felt there was little risk in giving these high ratings because, as we all know, home prices always go up, don’t they?

What about those cautious investors who were still a little nervous about buying these securities despite their high ratings? No problem. Along comes AIG, a huge insurance conglomerate. They created a new division that sold things called Credit Default Swaps (CDS). These things act like insurance in that they guarantee to reimburse the investor if their securities should lose value, thus reassuring them that these mortgage-based securitized investments were a safe bet. Although the CDS were sold like insurance, they are not actually called insurance because insurance is a regulated industry monitored by the states and as soon as something is called insurance it comes under that regulatory umbrella. But no one really paid much attention to such petty details since home prices are sure to go up, aren’t they? Thus no one was likely to lose money. So AIG was raking in huge amounts as ‘insurance’ premiums, while feeling it ran little or no risk of having to pay out any money.

And as long as home prices went up, they were all making money and no one was paying close attention, except for a few worrywarts who didn’t like to see trillions of dollars moving around in an unregulated and opaque manner. And for awhile home prices did go up, as was inevitable as more and more people were being encouraged and enabled to buy homes they really could not afford on the expectation that prices would go up yet higher. Thus were created the classic bubble conditions.

But all bubbles are inherently unstable and eventually collapse. And when it does, who gets hurt the most depends on who ends up holding the worthless investments. In this case, it is the US taxpayer.

Home prices started to drop. As homebuyers realized they could not pay the suddenly increased mortgage payments and could not sell the houses for a price that covered the amount they owed, they defaulted. As those defaults spread rapidly and became well known, investors started getting nervous about the value of the mortgage-based securities they were holding and started to sell them, rapidly lowering their value. This meant that banks and other investment houses that had these things as assets suddenly found their value drop precipitously and had to announce huge write-offs. Furthermore, those companies could no longer use those worthless securities as collateral to raise money and thus could not pay their own debts, making them risks for default and bankruptcy. This decreased investor confidence in those institutions and their share prices dropped dramatically.

This is what happened to Bear Stearns, Lehman Brothers, and Merrill Lynch. But they are just the most highly visible institutions. Huge numbers of banks are owners of similar mortgage-based assets and are nervously trying to figure out how much (or little) they are worth and what impact the revelations of their true value will do to their viability to survive. Eyes are now looking nervously at other banks like Washington Mutual and Wachovia and the two remaining large investment banks Goldman Sachs and Morgan Stanley.

British comedians John Bird and John Fortune back in August 2007 explained how subprime mortgage crisis came about. I have shown this before but it remains one of the clearest explanations.

Fannie Mae and Freddie Mac got hammered because they were the ultimate purchaser, the backstop if you will, of these mortgage-based securities. By buying them from the investment banks, they pumped money back into the mortgage system, enabling further cycles of dubious homes sales. As a result, these two giants ended up holding trillions of dollars of such worthless assets. They were able to buy these securities because they were easily able to borrow money since, although they were private companies, their incorporation charter gave them a quasi-government status, encouraging investors (especially foreign governments like China and oil-rich states with a lot of money to invest) to loan them money, since it was widely believed that the US government would not let these two institutions collapse. This is what the government did last weekend, essentially nationalizing those companies.

The US government desperately needs these foreign governments to invest in the US because that is the chief way they finance the deficits caused by the tax cuts for the rich and the two wars that are currently being fought. So essentially the US cannot do anything that will discourage future investments by these foreign governments. By taking over Fannie Mae and Freddie Mac, the US government is reassuring the foreign governments that they will get their money back since now the US government is directly responsible for paying back the money.

Meanwhile AIG, which had been eager to ‘insure’ these securities because of their safety (since home prices always go up, don’t they?) had to pay out huge amounts of money when the value of the securities collapsed and was on the verge of financial collapse itself. Although their regular insurance business was sound, the action of its little known CDS division was threatening to bring down the entire company. Since many other large institutions (mutual funds, pensions funds etc.) had large investments in AIG, the collapse of AIG was believed to be potentially disastrous over the entire financial sector. So on Wednesday the government essentially nationalized that too.

But as a result, the taxpayers are now suddenly the owners of these three shaky companies with all their dubious assets. Furthermore, the trillions of dollars in debt owned by these companies now become part of the national debt, effectively doubling it. So while these companies made a lot of money for their executives and investors while the going was good, the taxpayers are now stuck with the bill for their recklessness. This is what capitalism has become, privatizing profits while socializing losses. Capitalism in the US has become socialism for the rich.

John Bird and John Fortune discuss how the belief in markets always going up usually end up as government bailouts.

How will the US government (i.e., us) pay back all the money it now suddenly owes as a result of the unregulated greed that ran rampant over the last decade and that enriched a few at the expense of the many? How much bad debt still lurks in the financial sector and how many firms are still hiding the true extent of their liabilities?

I would hope that all those people who were gung-ho for privatizing social security, like George Bush and John McCain, would now realize what a bad idea that is.

The next president is going to have a lot to deal with.

POST SCRIPT: Explaining the current crisis

On April 3, 2008, Michael Greenberger, in an interview with Terry Gross on Fresh Air provided a very lucid explanation of what was roiling the financial markets.

He paid a return visit two days ago (September 17, 2008) to explain what was behind the most recent developments.

Both interviews are well worth listening to.

Last Tuesday, the Federal Reserve Board said that it would guarantee up to $300 billion worth of the highly devalued assets held by those banks that had been speculating in the subprime real estate market, thus enabling those banks to borrow money because of the federal guarantee. Nobody else would accept the subprime mortgage portfolios as collateral for loans. So in effect the taxpayers were being put on the hook if the loans could not be repaid. The stock market that day reacted with glee, skyrocketing upwards. (I explained what was going on here.)

That party ended on Friday. The big investment bank Bear Stearns said that it could not meet its obligations and requested a loan from another big investment bank JPMorgan Chase. The latter, unlike the general public, was aware of the nature of the assets held by Bear Stearns and said nothing doing, unless the Federal Reserve was willing to guarantee that loan too. The Fed, always eager to please the big financial interests on Wall Street, readily agreed and in a single day the whole transaction was approved. This is pretty amazing speed when you consider that $30 billion of taxpayer money was involved.

But the news of Bear Stearns’ troubles, which came just two days after a cheery message of confidence by its head just two days earlier that everything was just fine and dandy, sent jitters down the spine of investors who wondered how bad the situation really was and what dark secrets existed in the vaults of other big financial institutions.

They found out on Sunday when it was announced that JPMorgan Chase was actually buying Bear Stearns for the astoundingly low price of $2 per share, with the Fed once again guaranteeing the transaction. Just last year that stock had been trading at $172 per share. In just one year, the bank had lost almost 99% of its value, a collapse of Enron-sized proportions, but this time affecting one of the oldest and largest investment banks in the country. The total cost to JPMorgan Chase to buy this former financial powerhouse was only $236 million. Given that the Bear Stearns’ fancy headquarters building alone was estimated to be worth about a billion dollars, this fire sale price indicates that Bear Stearns was in even more terrible shape than previously thought.

To understand what is going on here, we need to know that banks invest the money deposited in them to make money for themselves and their depositors. They do this by buying and selling securities of various types. But they are expected to keep a certain percentage of that money in cash to meet the routine demands of depositors who need to withdraw money for whatever reason. As long as not too many people want too much money at once, the banks are said to have sufficient ‘liquidity’ and the system works well. Even if the banks run out of cash, they can get short-term loans from the Fed or other banks using their securities as collateral. The interest on these loans is what is called the ‘discount rate’ and it is much less than the interest that we pay on loans. These kinds of loans are routinely done and are meant to ease any short-term liquidity problems.

But if there are suspicions that a bank is in trouble, that can lead to a stampede of depositors all demanding their money at the same time and we have a ‘run’ on the bank. If the banks cannot convert enough of their securities to cash or raise large enough loans, it can go bankrupt. This can happen even if a bank is perfectly sound. All it requires is a rumor of trouble to cause a run.

It was to prevent such problems that the FDIC system was set up. This said that whatever happened to a bank, the government would guarantee to reimburse depositors up $100,000 each. This was meant to reassure depositors so that they need not panic and withdraw their money suddenly. This is what possibly saved Countrywide Bank last year when it was discovered to have had huge losses by investing in subprime portfolios. I, for example, have an account at Countrywide but did not panic and ask for my money back when I heard the news of its troubles, precisely because of the guarantee.

In return for this government guarantee, the commercial banks have to submit to supervision by the government to make sure that they are not making too many risky investments, though we see in the case of Countrywide that the system is not foolproof.

But investment banks like Bear Stearns are not like the commercial banks ordinary people deal with. There are two kinds of investors in banks like Bear Stearns, those who buy shares in the bank and those who give the bank their money to manage. These banks are outside the FDIC system and the federal government has not previously assumed any responsibility for them or their depositors. Those banks are not like the ones where most ordinary people have accounts. These are meant for very wealthy investors for whom $100,000 is just pocket money. It is presumed that these wealthy depositors and investors are financially savvy people who are capable of evaluating for themselves the risks involved and do not need the government to protect their interests.

These investment banks can and do take much greater risks with their investments in return for much higher rates of return than we get on our checking and savings account. This is capitalism in theory, where there is supposed to be a correlation between risk and reward.

But the trouble was that Bear Stearns was one of the worst culprits causing the subprime mortgage debacle, underwriting many of the transactions and causing the inflation in values of those securities that had little relationship to the actual value of the properties. So when the party ended, they got stuck holding a lot of securities which they had paid high prices for and which were now worthless. When investors started suspecting that things were not going well and started trying to take out their money, Bear Stearns did not have the money and could not sell its securities to raise anywhere near enough money, and nobody would lend them money using those worthless securities as collateral.

Except the government. In an unprecedented move, the Federal Reserve decided that they would intervene to try and prop up, at least partially, Bear Stearns so that it did not go bankrupt by offering guarantees for loans given to it, essentially putting an artificial value on its securities. In essence, the government is using taxpayers’ money to try and protect the wealthy financial interests associated with these investment banks. It is true that the people who held shares in Bear Stearns have lost money due to declining share prices but there is little the government can do about that. But by guaranteeing the value of the mortgage collateral, it bought those investors some time

So rather than seeing capitalism in practice what we have is capitalism in theory but a perverse socialism in practice, where the risk is borne by all taxpayers but the benefits in the form of profits accrue to just a few. All those people in government and business who preach financial discipline to the poor and say that people should be held accountable for their decisions, tend to conveniently change their tune when it is themselves or their friends who are affected.

I have shown this clip by British comedians John Bird and John Fortune before but I am showing it again because they describe precisely how we got into this mess and mention by name Bear Stearns and discuss the two funds owned by them that lie at the heart of their problems.

It is unnerving that two comedians in another country in October 2007 could finger the problem that is just now rocking the financial markets in the US.

Once again, I am not an economist so people who are more knowledgeable can chime in with corrections.