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.