How We Got Here

Over at the Frog Pond, Steven D has a pretty damn fine rundown of the financial crisis so far, and it's worth reading. An excerpt:

They (and I mean by "they" I mean traditional economists, politicians, investors, risk assessment managers, ratings agencies, bankers and insurance company executives) assumed all along that the smart guys on Wall Street and at the big insurance mega-corporations, who understood risk so well in so many other areas of finance, would understand it in this newly created market for securitized debt obligations. But of course they had no incentive to understand that risk, and no real long term market history to rely upon since the market for collateralized debt obligations was a relatively new one. It had only rally been created in the last 30 years, a drop in the bucket in economic time. Without any trend lines from past markets to guide them, and with a market that had exploded in growth exponentially over the last ten years, they were operating in uncharted waters. The assumption they all made was that the real estate bubble would continue for the indefinite future. The Federal Reserve under Alan Greenspan was keeping its rates low, pumping money into the economy, and with real estate loans (from construction lending to end user mortgages) being the easiest place to put that money to work, real estate prices continued to rise. Until, of course, they burst like all previously artificially created financial bubbles from the Tulipmania of the late 1500's in Holland, to the South Seas Scandal of 18th Century England, to the stock market bubbles of the Roaring 20's, and to a lesser extent the late 90's. Indeed, as Professor Mehrling notes, they had a hard time believing the good times would ever stop rolling even when AIG stopped issuing credit default swaps for these CDO's:

Once AIG stopped writing insurance, the game was really over, but it continued to run for quite a while. One thing that happened, and we know this from the UBS shareholder report, is that UBS started to say if AIG isn't going to sell us insurance at this cheap rate, we are going to make a plan to buy just 2% insurance and then make a plan to do "dynamic hedging" ourselves, which is a problem. That means when the price goes down, we sell, assuming that there would be a buyer on the other side.

Of course, in the end there were more sellers than buyers, and like all bubbles, this one burst as well. And all these securitized debt instruments, which had been sold as the "safest of safe" investments were exposed as the highest risks out there. Unfortunately by that time it was too late. AIG, Lehmann Bros., Merrill Lynch, etc. were in too deep. Never having anticipated that the market for their products would crash because the artificial boom in real estate they had helped to create by keeping credit cheap and ignoring the risks involved regarding (1) who was recieveing all that easy credit under the relaxed standards they helped make possible, and (2) the realistic value of the assets (homes, malls, etc.) which ultimately supported those loans, they did not have the cash reserves available to make good on their obligations.

And from there, KA-BOOM. It really was that simple: when AIG stopped writing insurance on CDOs and the music stopped, there were only a couple chairs left in the room.

Do read the whole thing.