Crisis of Credit Visualized

[David]

Here's a cool little video which does a pretty good job of explaining how this financial crisis started and who is really to blame. Short, sweet and simple to follow:





He does mention Credit Defaults Swaps in the beginning, but he forgets to wrap them up at the end. The CDS was basically an insurance policy you bought along with the securitized mortgage (mortgages turned into investment vehicles, like mutual funds).

So, the mortgages are a little risky? Buy a CDS for a few dollars extra to hedge your investment against potential loss. If the securitized mortgages bomb, the insurance pays off and all is well.

AIG was a big issuer of the CDS -- remember that AIG is an insurance company. But, since they called it a CDS and not an insurance policy, they weren't bound by any of those pesky federal regulations, like the ones requiring them to keep a portion of the premiums in reserve in case they have to pay off one day. Instead, AIG just pocketed most of the premiums as profit up front. Time came to pay off, and the poor babies didn't have the reserves to do so. Voila! Bankrupt! But fear not, the US taxpayers come to AIG's rescue. Yay Us!

And now for the ultimate point of blame IMHO. This scenario would have never been possible were it not for the undoing of the Glass-Steagall Act ( Glass-Steagall Act - Wikipedia, the free encyclopedia ) in the 1990's. Glass-Steagall was enacted after lessons learned from the great 1929 Crash. The act separated the Investment banks (like Goldman Sachs, Lehman Brothers, etc) from the the day to day banks on every street corner where we keep our checking accounts. Were Glass-Steagall still in place, the investment banks would have never been allowed to turn mortgages into CDOs and sell them as investments.

And who are the dastardly rats who tore down Glass-Steagall? The Wall Street investment banks spent millions lobbying Congress (Citibank was among the largest contributors) and the Republicans led the charge (Phil Gramm, McCain's financial advisor) under Democratic President Bill Clinton and it was no doubt voted on by many Republicans and Democrats alike. ( Mikulski was one of the few Dem Senators who voted against it, while Hoyer voted for it (meaning his vote helped cause this mess), See: Final Vote Results for Roll Call 570 )

 

[Tilted]

Those videos do a pretty good job of explaining a lot of the issues in a cartoon-ish way.

But, they certainly leave out some fundamental dynamics that came into play.

For one, a lot of the CDOs were very intricately packaged instruments that contained slivers of multiple securities. They weren't comprised of just good or just bad risk elements, they were comprised of a complicated (and somewhat unclear) mix. ‘Wall Street’ was able to construct them so that they received high ratings from rating agencies, even though they contained a lot of high-risk assets.

This is, in part, due to two inherent failings of the rating mechanism. First, they use historic models to access an instruments risk, instead of more dynamic, proactive models. And, second, they are paid by the people who create the instruments, that they are being asked to rate.

Then you had investors (mutual funds, pension funds, government municipalities, etc.) buying these CDOs, despite the fact that they really didn't know exactly what they were buying - the instruments were so complicated. They just naively took the rating agencies’ word for it that the investments were safe. They wanted a safe, easy, and relatively high return on their capital - and were just happy that somebody was telling them they could get it. Like so many others in the equation they were irresponsible (and lazy).

Also, it doesn't touch on the role of Fannie and Freddie in the fostering of the mortgage-backed security mechanism. Wall street stepped in and expanded on what they were trying to accomplish. Government wanted everyone to be able to buy a house (even though many couldn't afford to), and blessed this whole process while things seemed to be going smoothly. It's politically expedient to allow the populace to believe that they are more prosperous than they really are. Politics does indeed make strange bedfellows.

There is little doubt that there are a lot of players to blame in this situation. There aren't many associated with the cycle who don't share some of the responsibility - home buyers, the real estate market, investment bankers, wall street wizards, investors, government, rating agencies - you name it. But fundamentally it all stems from the same lie - the delusion that society has chosen and has chosen to cultivate - that we are more prosperous than we really are and that we are entitled to a higher standard of living than our real productivity justifies or can support in the long run.

But, on the whole, Ill give those videos a thumbs up with respect to what they are trying to be.