The Financial Meltdown: A Five-Step Primer

One of my problems as a blogger is discussing the economic mess without writing another version of my dissertation.

But it turns out that the whole financial crisis and upcoming government intervention boils down to five easy steps.

Liberal blogger Atrios hits three of these in one sentence.

Again, the problem is that [1] lots of bad loans were made, [2] lots of people made highly leveraged investments in those bad loans, and [3] still more people bet on those loans by insuring them.

That's exactly right.

There are two other steps as well.

[4] The banks and money-market funds covered their butts by beginning to shut down the economy.

[5] The Bush administration wants to prevent total economic collapse by buying the whole load of bad debt from everybody involved.

That's the whole story in a nutshell and readers can stop here if they like.

But, because I'm an academic, I feel an obsessive urge to explain the nutshell further.

First. The "really smart guys" at mortgage banks like IndyMac and Countrywide Financial made billions of dollars of "really dumb" sub-prime mortgage loans that large numbers of people were unlikely to pay back.

Second. The "really smart guys" then sold those loans to the Wizards of Wall Street who inflated a derivatives market with a dazzling array of financial instruments rooted in bad mortgage debt. At this point, lenders like Countrywide Financial, investment banks like Merrill Lynch, and supposedly safe money-market funds were heavily invested in the bad mortgage debt and in all the derivatives from the debt as well. So were all of the stockholders in these companies and everybody with money in the money market funds.

That's not good.

Third. Companies like AIG wrote insurance contracts for the sub-prime loans. It also appears that there was a market for the insurance contracts. AIG lost more than $100 billion over the last six months, but there might be a lot of other entities on the hook for the insurance contracts as well.

A Reality Interlude. At this point in September 2008, the first waves of sub-prime loans have gone bad (there will be more), several of the major players have collapsed under the weight of bad debt, and the spectre of bankruptcy hangs over everybody playing in the sub-prime mortgage, derivatives, and credit default swaps markets.

Here's where we move to step four.

Fourth. Financial companies started to cover their butts by bringing the economy to a halt. According to the Wall Street Journal that's what Secretary of the Treasury Henry Paulson saw on Wednesday. Worried about their obligations from the derivatives market, banks had stopped making the short-term loans that allow American companies to function on a daily basis. Money market funds were also hoarding cash to cover their butts as large numbers of people began withdrawing money from their accounts. In other words, the financial wheels were grinding to a halt.

Fifth. The Federal Government was forced to change its policy from addressing one company at a time to resolving the problems of the whole financial system. As a result, they've decided to buy up the bad debt that's hanging over the marketplace and give all the players in the financial system a new beginning. The details haven't been fleshed out yet, but the "bad debt" probably includes the sub-prime loans, the complex obligations entailed by derivatives instruments, and the bad insurance contracts.

The current price-tag being floated around is $700 billion. My own non-expert and extremely humble opinion is that we'll get off lightly if the final cost is only twice that.

As Atrios and others on the right and left point out, the banks, insurance companies, money-market funds, and other entities don't deserve the massive bailout they're getting.

What really needs to happen is that the "financial game" needs to be reformed and redefined in a much more highly regulated way.

Given that it's all about "depression prevention" in the short term, Congress would do best to build structural remedies into the short-term legislation.

Specifically, the banks, insurance companies, investment companies, and insurance companies should be forced to meet a series of conditions to be eligible to have their debt assumed by the federal government. It's especially imperative that banks resume "normal lending" for business operations and home mortgages as William Greider suggests in The Nation. That would loosen up the short-term credit crunch that was threatening the economy. There should also be a demand for tight caps on top executive salaries, bonuses, and stock options, limits on the amount of debt that can be accumulated in merger transactions, and some sort of federal oversight on risk management.

Given that the Bush administration is proposing to wipe away so much of the "debit" side of financial sector balance sheets, the players will now be operating with government money under government protection.

They should pay a high price for that.