I've found a good post that does a very good job of laying out some of the long range and immediate factors that lead to our current economic woes. David Paul lays out how credit default swaps (CDS's) lead to the collapse of AIG (italics mine):
...AIG's collapse came as a result of the following sequence of events:
1. In the wake of the decline in real estate prices, the market value of mortgage-backed securities declined.
2. Under accounting rules that were established after the downfall of Enron -- implemented to require rapid disclosure of investment losses -- AIG marked down the value of its mortgage-backed securities portfolio.
3. These investment losses resulted in a reduction of AIG's capital reserves -- the core measure of its financial strength.
4. As a result of the decline in AIG's capital reserves, Standard & Poor's and Moody's Investors Service downgraded AIG from triple-A to the single-A level.
5. These rating downgrades to the single-A level triggered collateralization requirements under AIG's CDS contracts.
6. The amount of the collateral that AIG had to produce under its estimated $450 billion of CDS contracts approximated $100 billion.
And AIG did not have $100 billion in available funds.
This was the explosive event that destroyed AIG. It was not the market losses on its investments in mortgage-backed securities. It was not payouts on CDS contracts where default events had actually occurred. It was a collateral call.
One of the important things is to realize how this complex chain of events can lead to a lack of market confidence--that is, an unwillingness to loan another financial institution money because you don't know if the borrower's Jenga Pile o'Crap will come tumbling down:
...AIG's collapse in a matter of days resulted from the collateral requirements under the terms of contracts that are opaque, unregulated and difficult to track on corporate financial statements...
The problem seems straightforward. After the AIG collapse, how does one institution trust its exposure to another? If CitiBank seeks a loan from JPMorgan, how does JPMorgan know whether some event might be looming that will result in a collateral call under some of the myriad derivatives contracts to which CitiBank is a party, a collateral call that in a matter of hours could bring Citibank to its knees.
The US has now signed on to the British plan to make direct investments in banks, but simply injecting liquidity and capital will not address this concern. But US officials appear to be resisting the second British proposal -- which provides for direct central bank guarantees of inter-bank loans. Like guaranteeing deposits, guaranteeing inter-bank loans would transfer the risk of the unknown from the banks to the central banks.
Paulson and Bernanke may view this last British proposal as one step too far in the socialization of the financial system. But until the CDS market is brought into an effective regulatory framework and the legal rights of creditors are clearly established, do we really have any choice but to take this next step?
With complex financial instruments, if there's no regulation, nobody knows if someone is facing incredible risk. Among the other steps that need to be taken, credit default swaps need to be regulated. A first good step would be requiring full, transparent reporting of the liabilities incurred by CDS's.
NPR's This American Life had two fantastic episodes on this topic. The first was on the sub-prime crisis, and the second one was all about the credit crisis/credit default swaps. Clear, concise, interesting, and told in that TAL human-interest kind of way. Really really fantastic, I highly recommend them.
The people who helped with the research on that are also doing a daily podcast with updates on the crisis. It's called Planet Money (http://www.npr.org/blogs/money/, also on iTunes). They fully admit they didn't understand a thing about banking when this started, and the whole podcast is several smart people figuring things out and explaining them to you. (Actual reporting! Crazy.)
Since it's not meant for broadcast, they can play longer interviews with economists and other interesting people. They also have traders they call up every day and ask how things look in the real world. It's great, great stuff.
Layman's observation: one of the basic assumptions for perfect markets is perfect (zero cost) information. Any physicist working in statistical mechanics or computer scientist working in algorithms would find this absurd; however, it makes for a sometimes useful approximation. The less perfect the information, the less perfect the market. The basic role of regulation is to reduce overall information costs for buyers and sellers.
Insufficient regulation yields insufficient information; inferior or defective goods sneak into the market, and the market is vulnerable to re-assessment on an influx of information.
The less perfect the information, the less perfect the market. The basic role of regulation is to reduce overall information costs for buyers and sellers...
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