reply to post by Verd_Vhett
There are a number of components of this current problem that in aggregate this situation.
1. Back in the 70's under Jimmy Carter, the Community Reinvestment Act was created. This forced banks to provide loans in all neighborhoods that
that bank did busines in. The percentage was initially @45% of loans. If banks failed to meet that goal they were "red-lined" essentially
putting them out of business. Banks dealt with that by hiring a bunch of community bank officers who sought lower income folks who had a good chance
of being able to pay their loans. During the Clinton administration the percentage of loans that had to be given to low income folks was raised to
over 50% of loans. Banks were unable to find enough folks in the poorer neighborhoods to qualify for a traditional loan. To not get redlined, the
sub-prime mortage was created which provided a vehicle (no money down, interest only, ARMs, no income verification, etc) which would enable them to
satisfy the government criteria. With housing prices consistently rising, this was not that big of a problem since folks' equity in their homes was
rising and if they were getting sideways on paying their loans, they could either refinance and get into another sub-prime loan or pull equity out of
2. Banks then sold these loans to investment bankers. The bankers securitized these loans, bundling loans together to create securities. They
would package safe loans, moderately risky loans and risky loans into a security and sell them to mostly institutional investors, hedge funds, etc.
By a loophole in the methodology used by the rating agencys, only the two safest tiers of loans were rated, giving these securities AAA or AA ratings.
Therefore when folks were buying these securities, they felt they were buying quality debt when in fact they were buying crap.
3. The investment banks knew there was risk in these loans, so they bought insurance against them, a lot of it from AIG. AIG created collaterilized
debt obligations(CDO) to insure the debt securities. The banks bought $billions of CDOs to insure against the risk debt.
4. The housing market began to correct. The bubble broke. This created a model where folks who were constantly refinancing their loans against the
increased equity in their homes could no longer do so. Folk began to default on their loans.
5. The defaults increased and began to undermine the quality of the investment in the bundled debt securities. That was OK, because the investment
banks had bought the CDOs as insurance against the risky debt.
6. As the default rates accelerated, the investment banks were losing a ton of money and AIG and other folks who held CDO's were overwhelmed with
what is essentially a redemption (sale) of those instruments and began to heavily leverage counter-partys to handle these redemptions. Wall Street
is a model that is based on healthy counter-party relationships. Since no bank has enough cash on hand to handle all of the risk on their books
(think about everyone selling every dollar of Fidelity mutual funds in one day. FIDO could never satisfy those redemptions with cash on hand. They
need to borrow it from other banks). A major counterparty failed (Bear Sterns). This created a shock in the chain of counterpartys. Next came
Lehman. Now banks stopped lending to one another because they thought they might not get paid back. This created the credit crisis, because money
was not flowing through the system.
7. Folks began to belt tighten, further extracting money from the economy
Thats the best I can do. Lousey and risky investment products backed up with synthethic instruments to insure them and then a break in the chain in
counterpartys, so the banks fail. Now we're pumping money into the system to get money moving.