Financial Crisis 101: What happened? Why is everyone freaking out?

posted by Josh Ran

Over the last week a lot of people have asked me what I think of the Wall Street meltdown and the looming government bailout. As a finance campaigner, I have to admit that my response has been pretty flippant: “fewer banks for us to campaign on!” But the reality is that it never feels good to be proven right when the consequences are so dire. Sure, anyone paying attention could have predicted that the financial house of cards based on mortgages peddled by over-zealous twenty year old’s with six-figure salaries to people with bad credit was bound to topple. And that the last twenty years of free market dogmatism coupled with deep tax breaks for corporations and absolute deregulation of commerce was bound to come crashing down eventually – but man, it ain’t pretty.

So….what is happening exactly?

The current crisis is rooted in the sub-prime meltdown that we started to hear about in the summer of 2007 as the real estate bubble burst and mortgage defaults started to climb. During the boom years, mortgage brokers, lured by the heady combination of big commissions and little regulatory oversight, talked buyers with poor credit into accepting expensive housing mortgages with little or no down payment and no credit checks. Banks and other financial institutions typically repackaged these debts with other risky debts and sold them to worldwide investors as ‘collateralized debt obligations’ (those CDOs you’ve been hearing so much about – basically, bundles of bad debt).

As it started to become obvious that the banks’ had also significantly leveraged their exposure to the bad loans by dealing in trillions of dollars of turbo-charged financial derivatives, investors began to lose confidence (freaked out) and starting in June 2007, the system began to unravel. Share prices tumbled and banks began the process of attempting to unload these bad investments (ie bundles of mortgages that would never be paid back) at fire sale prices to raise capital. This in turn, brought down their value for all other banks and financial institutions that held the same bad investments on their books, forcing them to either raise large buckets of new capital and/or dump their bad loans on the markets as well. Inter-bank lending slowed to a trickle as banks increasingly questioned the financial health of their peers, and like a poorly lubricated engine, the financial system starting grinding to a halt.

What resulted was a death spiral….Bear Stearns was taken over by JP Morgan, Lehman collapsed, Merrill Lynch was bought by BoA, the government stepped in and essentially took over Fannie May and Freddie Mac, the biggest funders of mortgages and AIG, the world’s largest insurance company. BUT, in spite of shoring up these companies by injecting billions of dollars, things kept getting worse, and now the government is proposing to step in and essentially buy, not the floundering companies themselves, but their bad debt, to the tune of $700 billion.

Again, they’re not stepping in and taking over control, they’re just buying up all those shaky, bad mortgage backed securities that the investment banks have accumulated (including international banks), with taxpayers money, taking them off the banks’ books and leaving taxpayers with the burden. This bailout for billionaires comes at a cost of up to $10,000 per person in the U.S.
Then yesterday came the announcement that Goldman Sachs and Morgan Stanley, the last two remaining investment banks are becoming Bank Holding Companies (essentially commercial banks like Citi or Bank of America) – a move that will give them the ability to take deposits, bring them under tighter regulation and require them to reduce their leverage.

What does this mean for Wall Street? Well for starters, the complete elimination of stand alone Investment Banks – those bastions of big money and home of high-rolling risk-takers that profited so much during the boom years.

Times will be leaner for bankers, and that means that times will also be leaner for those businesses and individuals seeking credit. Basically, this affects everyone from Wall Street right down to Main Street and everywhere in between.

What’s to be done? Stay tuned…