Q: How did all this start?

A: Throughout the 1980s and 1990s, beginning with the Reagan era, Congress has engaged in an orgy of deregulation, doing away with the Depression-era safeguards that forced transparency and limits on US banking and financial companies. Regulations were repealed one by one; for example, in 1999 Congress passed a bill that repealed the Glass-Steagall Act and allowed commercial banks and investment banks to buy each other and combine operations under one roof. This era of massive deregulation also sparked the invention of creative and unusual investments, including derivatives, which were previously prohibited under earlier securities law.

So, before 1999, the financial industry consisted of commercial banks (with brick-and-mortar branches where you could deposit your paycheck and open a savings or checking account), investment banks and brokerage firms, mortgage companies, credit card issuers, insurance companies, etc., and they were all separate companies. After 1999, the gloves came off, and any of these companies could buy any other company, which caused a huge expansion in both the size and the profitability of US financial firms.

Moreover, any company could now issue loans. General Motors, for example, could now open a finance unit that issued auto loans, and they did. Customers wanting to buy a car didn’t have to go to their banks to get auto loans; they could finance the purchase through the company where they bought their car. This, of course, proved to be very convenient for US businesses, and very profitable.

Unfortunately, because of lax oversight and because of the explosion in the number of companies that were now issuing credit, it became impossible to track how much money was being loaned to whom under what terms, and whether businesses had the cash on hand to cover any shortfalls if a lot of customers defaulted on their loans. Nowhere was this more of a problem than in the housing market.

Q: I’ve heard about the problems with mortgage-backed securities, but I don’t understand how that could cause such a huge mess. What happened?

A: To understand the current crisis, you need to understand only one thing: what mortgage-backed securities really are. Starting in 2003, banks with mortgage units made a lot of risky mortgage loans. The banks then bundled these loans together and called them an “asset” (a mortgage-backed security). They sold some of these “assets” to investors and used the rest as collateral to borrow more money from other banks. Then they used that borrowed money to make more risky loans, which they called “assets” and used as collateral to borrow more money to make more loans, etc., etc. And banks did this in volumes that were so huge that it dwarfed the amount of cash and real assets that these banks owned.

So now our financial industry is struggling under layers and layers of bad debt. Risky subprime loans started going bad in 2006, but the first big wave hit the financial industry in Aug. 2007, when banks finally had to own up to the problem and declare huge write-downs in the value of their mortgage-backed “assets.” This made their stock prices fall, which affected the value of their companies and made it harder for banks to borrow the cash they needed to cover their bad debts. It’s been a downward spiral ever since.

Q: Why is the collapse happening now? Why didn’t it all happen in Aug. 2007?

A: Because in Aug. 2007, nobody knew how bad the problem was or how long it would take all the bad loans to come due. In fact, today we still don’t know the depth of the problem. Investors, the public, regulators, the Fed, even the CEOs at the banks involved in this whole Ponzi scheme still can’t come up with a figure for exactly how many bad loans are out there. It’s been a year–a psychologically important timeframe on Wall Street–and banks are still taking write-downs and scrambling to borrow more cash to cover their bad debts.

The fact that nobody knows the size of this problem is key to understanding the current panic. Without information, everyone is free to image a doomsday scenario. And they may be right, we just don’t know.

As an example of how clueless everyone is, we need only look to the Fed chief, Ben Bernanke, and Treasury Secretary Henry Paulson. Bernanke and Paulson will be presenting an industry-wide bailout plan to Congress in the coming days that’s estimated to have a price tag of $500 billion. But where does that figure come from? Keep in mind that Bernanke and Paulson have avoided putting a dollar amount on the bailout plan themselves–members of Congress are the ones who came up with the $500 billion figure. Nobody has explained the basis for it, but my guess is that they took the IMF’s estimate of the crisis ($1 trillion) and subtracted the amount that the Fed and the Treasury have already poured into the financial markets (about $500 billion) and came up with the difference. So $500 billion is just a guess, a number pulled out of a hat. The total could be much higher. Or it could be lower, but I wouldn’t count on that.

Q: Explain more about the government bailout. Why did the Fed bail out AIG and not Lehman Brothers?

A: Lehman was hovering on the verge of bankruptcy a couple of weeks ago, but they had the opportunity to work out a sale to a group of investors. The investors, however, didn’t offer Lehman enough money, and the CEO of Lehman turned down the deal. He was hoping to get a better deal from the Fed, similar to the bailout of Bear Stearns. But the Fed turned him down flat. When that happened, Lehman’s stock price plunged drastically, and the investors who’d offered to buy the company said, “No way, this isn’t a good bargain for us anymore,” and took the deal off the table. Lehman was forced to declare bankruptcy.

Merrill Lynch, on the other hand, could see the writing on the wall. Instead of holding out for help from the Fed, Merrill agreed to be bought out by Bank of America for about 50 cents on the dollar.

Within hours of the Lehman collapse, the insurance industry behemoth AIG was driven to the wall. Because AIG owes hundreds of billions of dollars (no one is sure yet exactly how much they owe, but it’s a lot) to foreign banks and foreign governments, the Fed simply couldn’t let them fail. To do so would be a global economic disaster. It would also have serious political repercussions and shake global confidence in the US financial system. So a bailout was necessary to prevent a run on US banks, a huge sell-off of US corporate stocks, and–this is the real nightmare scenario–a massive sell-off of US government treasuries, which are owned by most foreign banks and governments around the world. If the US government loses the ability to borrow money cheaply through sales of treasury bills and bonds, then it becomes impossible to come up with the cash to pay the interest on the federal deficit and pay for the war in Iraq, much less find the money to bail out anyone.

Q: So how did AIG get into this mess? Isn’t AIG an insurance company, not a mortgage lender?

A: That’s right. AIG didn’t issue mortgages or mortgage-backed securities; instead, they sold massive quantities of a derivative called a “credit default swap.” Essentially, that’s a form of insurance that hedges against mortgage-backed securities.

Here’s how it works. If an investor owns a lot of mortgage-backed securities, they might want to protect themselves against a fall in the value of their investment. So they might buy insurance that would protect them against the loss in value of their mortgage-backed securities. That’s what credit default swaps are. By buying credit default swaps, the investor would be “hedging” their investment.

AIG sold some of these derivatives to US banks and investors, but they sold most of them to foreign banks and foreign governments, because foreign markets operate under different rules. Many foreign governments have regulations requiring their banks to limit risk or hedge their riskier investments. When the market in mortgage-backed securities tanked, AIG’s customers came knocking, looking for payouts on their credit default swaps. AIG was able to cover the payouts for a while–for more than a year, in fact. But shareholders looked at AIG’s business and got nervous about AIG’s ability to keep paying. AIG’s stock took a pounding, the value of the company fell, and suddenly they couldn’t borrow enough cash to cover all their debt payments. They simply ran out of cash.

Q: Just a second … define “derivatives” for me. Just what the heck are they?

A: Defining “derivatives” is almost impossible, since the term encompasses so many different types of investments (which is why you can search high and low for a definition and not find a satisfactory one). Maybe the best definition would be: “a catch-all term to describe non-traditional types of investments. Derivatives can be any immaterial thing that people are willing to pay money for.” An example of a derivative might be a piece of paper representing the likelihood of an event that may or may not occur in the future. As long as people are willing to buy and sell that piece of paper (make a market in it), then that derivative has a value. When people lose interest in buying that piece of paper, the market for that derivative collapses and the investment is deemed worthless.

It’s important to note that mortgage-backed securities are not derivatives–they’re bonds made up of individual mortgages bundled together and sold as a package. Unfortunately, when investment banks put together these mortgage-backed bonds, they grouped good mortgages with lots of really bad subprime mortgages and “liar loans” (mortgages issued to people who didn’t have to show any proof of their income or assets). Investment banks, along with the major ratings agencies (Moody’s, S&P, and Fitch), colluded to market and sell these bonds as extremely safe investments, when in fact they were extremely risky investments. So when a lot of subprime mortgages began to fall into arrears in 2006, it took a while for that to impact the value of mortgage-backed securities, but the collapse of the mortgage-backed securities market was inevitable. It proves that, while derivatives are extremely risky investments, high-risk securities can be created anywhere in a system with little or no regulation.