The financial crisis and the bailout

First were subprime mortages. Bankers and the real estate industry were making zillions selling subprime, then pacakaging them into investment vehicles. so, it behooved everyone to pump out as many mortgages as possible because, after all, prices will never fall again.

The mortgages were assembled into CDOs

A CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors.

Then, everyone bought and sold CDS on them. These are a form of insurance, but couldn’t be called insurance because that would be illegal. besides, nothing could ever go wrong, so why worry about defaults.

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the “buyer” or “fixed rate payer” pays periodic payments to the “seller” or “floating rate payer” in exchange for the right to a payoff if there is a default.

This means mortgages were packaged into bonds that were sliced and diced by risk levels into CDOs, and then everyone bought and sold pseudo-insurance on them, further fattening their cash flow. Yes, it’s all air, nothing of value that created jobs or companies (except to a tiny few) was accomplished by any of this. The robber barons of a previous era may have been pirates, but at least they created stuff, like railroads, steel companies, the oil industry, etc. These arcane financial instruments created nothing of lasting value.

Unlike stocks that can be bought on the open market, CDOs and CDSs are private, unregulated transactions. Their notational amount is in the many, many trillions. All manner of banks, pensions funds, etc. hold them.

Everyone partied for a long time of this, making enormous profits. The functioning of these markets depended primarily on two things, 1) real estate had to keep going up in value. 2) Since most these debt instruments were funded by borrowing cheap short-term money and “investing” it long-term, it was essential that the spigot of cheap short-term money continue. Alan “Greed is Good because Ayn Rand said so” made sure this was true for a long time.

However, the inevitable happened, housing prices fell and the cheap money went away. Hence the debt instruments tanked in value. But, unlike a listed stock, you can’t just sell them. In many cases, there are no buyers.

That’s when the financial markets began to lock up. Worse, everything is interlocked. Lehman goes bankrupt. How many CDSs do they have that they can no longer make good on? Will, say, a bank in Britain or a pension fund in Florida suffer big losses because of this? The point is that the shadow banking system, as it is called, is so murky and opaque, that no one knows how many icebergs are out there waiting to sink financial ships or even where they are.

Right now, credit markets are frozen. Hedge funds are facing massive redemptions and are dumping whatever they can. Lots of normal businesses that routinely borrow short-term money to make payroll then repay quickly out of A/R are finding interest rates are much higher or the money just isn’t available. So, this is having serious, real-world effects.

Jason Calacanis, who founded weblogs.com and sold it to AOL, on the current situation (via his listserv)

It’s my believe that the economic downturn will be much worse than it is today, and that 50-80% of the venture-backed startups currently operating will shut down or go on life-support (i.e. 3-4 folks working on them) within the next 18 months.

To conclude – yes, the whole system was insane, unworkable, doomed to fail, based on greed, and too many got wealthy by plundering the system and destroying companies in the process. Yup, that’s all true. And we need to fix things so greedfests like this can’t happen again.

But this isn’t some made up crisis designed to benefit the fat cats. No, it’s a real, looking into the abyss, worldwide financial crisis.