The Wall Street Meltdown, As Explained to an Idiot (Me!)

Despite yesterday's 936 point Wall Street rally, many of us remain deeply worried about our economy. Some of us believe the $700 bailout is the only thing standing between us and another Great Depression. Others, like a blogger named Ryan, condemn Congressman Charlie Dent for finally agreeing to an infusion of public money. "I am seriously considering voting for a "write-in" rather than yourself. Sam Bennet is an idiot but you have stabbed me in the back... what really can I do here? Please contact me and tell me I still have some reason to vote for you."

This American Life, hosted by Ira Glass, is one of my favorite radio programs. But it's the last place I'd look for an explanation of our current financial crisis. But Lehigh County Commissioner Dean Browning, who himself is something of a financial maven, has recommended the program because it explains high finance in terms I can understand. We're all aware that there's simply too much debt. We're all aware that subprime lending and a runaway housing market helped create this mess. But few of us, myself included, know a damn thing about the commercial paper market or credit default swaps. Yet those seemingly obscure concepts have played a major role in our meltdown. Here's a summary of this very interesting program.

Commercial Paper Market

This commercial paper market are business IOUs, short-term loans, valued at hundreds of billions of dollars every day. A major business might need $50 million today that it can pay back tomorrow. It's relatively boring business.

It stopped being boring when the most liquid market in the world suddenly froze up.

How did this happen?

That's because of money market mutual funds, which are like savings accounts, traditionally one of the safest places to store money. Money market managers are the folks who often make these short-term corporate loans. Money market managers always seek a stable $1.00 net asset value (NAV): they aim never to lose money. If a fund's NAV drops below $1.00, one says that the fund "broke the buck". For the first time ever, one of the biggest and oldest funds, The Reserve Fund, "broke the buck." Its share dropped from $1.00 to 97 cents. It actually lost depositors' money.

How did this happen?

The Reserve Fund did so with when it gave Lehman Brothers a short-term loan in exchange for commercial paper. Lehman suddenly went bankrupt. All the money lent was gone, and The Reserve Fund was in trouble. Then another mutual fund broke the buck. Money market managers freaked out, and refused to lend any more money, preferring instead to invest their money in the U.S. government. As the panic spreads, no one will lend any money at all, which pretty much destroys capitalism.

Because businesses can't get money, they have to cancel or delay plans. McDonalds, for example, had to delay the installation of latte machines. General Electric, the second largest US company, saw its stock prices fall because it was unable to borrow the money needed to function.

There's another financial product making our financial crisis even worse.

Credit Default Swaps

Credit default swaps, called "financial weapons of mass destruction" by Warren Buffet, classically apply to bond owners who want to transfer the risk of default to someone else. You enter into an agreement paying a third party a percentage every year, and he agrees to pay you if the bond defaults.

What happened is that people who don't even hold the bonds began basically to bet on them. It's like buying insurance for a house you don't own. There are $5 trillion in bonds, but $60 trillion in credit default swap protection worldwide. AIG had to be rescued because it had promised over $400 billion to people holding credit swap default agreements with them, $400 billion it did not have.

The same groups often both buy and sell credit default swap agreements, and there is no way of knowing who in that chain has and does not have the money to pay in the event of a default. After Lehman Brothers, it became apparent that many guarantors simply lacked the capital to pay. Default credit swaps, unlike options and other financial arrangements, are unregulated.

Would it have helped to have swap cops?

That idea was first rejected in 1998, during the Clinton administration, because these products are exchanged by sophisticated financial institutions. Government would just get in the way. In 2000, Congress actually decided (95 to 0) against regulating credit default swap agreements, right around Christmas.

It was a bipartisan failure.

Will the bailout help?

It is a severe and scary crisis, but spending $700 billion will help. Under the Paulson plan, we are about to become the proud owners of a big load of bullshit burgers, i.e. toxic assets. (I give you $1,000, but take all the crap out of your garage). A clear majority of economists prefer a stock injection plan. (I still give you $1,000, but now I own part of your house, and I can evict you if you have not measured up). We still give the bank money, but become a part owner. Conservative Republicans and banks themselves really hate this idea.

Under the bill that passed, the stock injection plan is a possibility.

The majority of economists believe this plan is probably the best we can get, and we have to do something sooner than later.