While the Fed's blank-check, no oversight proposal is about the craziest idea possible, we are definitely at the beginning of hardship across the economy.  It's just a matter of time before — and in fact it's already beginning — before this affects most Americans.  For example, I just had to refinance my mortgage and in the process I requested $10,000 for weatherization.  Answer?  Nope.  There's another tale to tell here, but I'll save that for another diary.

To help people understand how this all started, I'll be posting a stick figure slide show that explains how mortgage-backed securities were pushed into the marketplace as soon as I can figure out how to post it.  It's called, “The Subprime Primer,” and it's been making the rounds via email for several months now but was of less interest until this meltdown.

In the meanwhile, here's a quickie rundown on subprime loans, how the dominoes were set up, and why they're falling down now.

PART ONE:  SETTING UP THE DOMINOES

Note:  All numbers are hypothetical.  The real debt in our economy right now is staggeringly higher than these demonstration figures.

The Sub-Prime Loan

First, the homeowner borrows money through a complicated sub-prime loan that begins with a really low interest rate they think they've gotten a great deal.  The mortgage broker, who is really nothing more than a glorified salesperson, gives the homeowner a really smooth pitch and probably offered little information about the risk involved.  That's all in the fine print, which the mortgage broker is supposed to review with the borrower, but in reality rarely mentions the depth of the risk at all.  The broker works on a commission and can make something like $5,000 in a single transaction, so why get the homeowner all nervous, right?  Home values are going up, up, up and everything's going to be all right, right?

Borrowing Money is called Leveraging

Imagine you're deep in debt, thinking you own more in assets but just by virtue of borrowed money.  Of course, this is how most of us buy our homes.  Let's call this process of taking on debt “leveraging.”  You put down $10,000 and then borrowed $200,000 to buy a house.  This means you've leveraged (borrowed) on a 1:20 ratio.

Ok, now forget houses and homeowners.  Instead, imagine a firm like Bear Stearns buy mortgages or mortgage-backed securities as “paper,” which is really nothing more than numbers on a computer screen and a binding agreement as with any non-cash purchase.

Let's also say that Bear Stearns borrowed $200 billion worth of mortgages or mortgage-backed securities putting down $10 billion of their own money.  Bear Stearns has leveraged on a 1:20 ratio.  Bear Sterns takes the $200 billion worth of paper and converts it into a variety of investment securities like CDOs or even high-rate CDs.  

Cutting Up Leveraged Mortgage Debt into Investment Securities

Bear Sterns sells a good chunk of the paper in the form of CDOs and CDs on the open market in order to see the value of their paper rise.  But Stearns also has to keep a good chunk of the paper for themselves in order to realize their profit after the price rises.  The formula for Stearn's profit will be equal to the amount of paper they kept times the amount of rise in value of the paper on the open market at the time they choose to sell what remains of their paper.

AIG Securities Insurance

Now when Bear Sterns chops up $200 billion worth of paper into new securities, they buy securities insurance from AIG.  Whenever you borrow more money than you have in assets, you have to insure your debt.  If a homeowner doesn't have home insurance, the lending bank requires an insurance policy to cover the amount that's borrowed.  Same thing goes for borrowed money on securities.  

So AIG is now in the game, too.  And at a much, much larger scale because AIG is insuring almost every investment bank passing along mortgage-backed securities.

Putting the Cut Up Mortgage-Backed Securities into the Open Market

Ok, now let's say Stearns put $100 billion of paper into the open market.  Then lots of players get into the game.

Mutual fund managers, pension fund managers, and retail brokerage firms (AG Edwards, Edward Jones, etc.) buy up paper thinking, hey, real estate is going through the roof, let's make some money off from this.

Now the mortgage-backed paper is spread throughout the investment economy.

And the dominoes are now set.

PART TWO:  THE DOMINOES BEGIN TO FALL

The Assumption of Increasing Value

The underlying assumption when either homeowners or investment firms borrow more money than they put down is that the thing they bought will increase in value.  The assumption is that the value of either the house or the “paper” will go up.  Of course, one should never assume such things, but if they're right this is how it works.

If the value of the home goes up to $400,000 and the homeowner sells, he or she clears the debt of $180,000, gets back the $10,000 he/she put in, plus a nifty profit of $200,000.

It's a little different for Bear Sterns in this way:  they sell a good chunk of their paper out on on the open market and keep a good chunk for themselves.  As the prices of their mortgage-backed securities rise in the open market, the value of the securities the kept rise right along with the open market rate.  The calculation for profit, as stated earlier, is equal to the amount of paper they kept times the amount of rise in value of the paper on the open market at the time they choose to sell what remains of their paper.

Underlying Assumptions are Wrong, Wrong, Wrong.

But let's say the assumption is flat out wrong.  The value of the $200,000 home plummets to $100,000 and the homeowner defaults.  The homeowner has lost $10,000 and is on the hook for $180,000.

The first round of homeowners who defaults are the millions of folks who had no idea what was in the fine print that the mortgage broker conveniently didn't tell them.  No money down and a low interest rate to start, but every year the interest rate increases dramatically, so much so they can no longer afford the payments.  It's almost like they've bought a home on a credit card, the interest rates are so high.  Imagine $180,000 on your credit card.  The second round of homeowners default because suddenly the value of homes around theirs begin to fall.  Their $200,000 home drops to a point that makes no sense to keep up their mortgage.  That's called “negative equity” and some of these folks put their house keys in the mailbox and drive away forever.

Now the dominoes begin to fall.

The homeowner defaults and home prices fall.  Seeing this, investors in the open market (pension and mutual fund managers, retail brokers, etc.) start selling the mortgage-backed securities because they suddenly recognize that they're holding bad paper.  The price of these securities plummet in the open market as everyone begins to unload.

Remember Bear Sterns?  They borrowed $180 billion to get this paper out on the market.  Now they're holding the biggest chunk of bad paper and the firms they borrowed money firm are calling in the debt.  Bear Stearns can't pay the loan and is the first firm to go bust.

Other investment banks engaged in the same practice are also in peril.  But here comes the tipping point.

AIG, the biggest insurance company in the world, has insured all of this bad paper from almost every major investment bank on in the US, and who knows, maybe even overseas.  As every player in the open market realizes that all of these mortgage-backed securities is bad paper, races to sell causing prices to fall and Bear Sterns to default on 1:20 leveraged debt it's carrying,  AIG has to pay out a staggering amount of money in order to fulfill it's obligation as a securities insurer.  Then AIG's stock value plummets and goes into a meltdown.

Because AIG is insuring a ton of other securities loans, the entire economy can't afford to let AIG go under.  If AIG goes bust, then every firm who loaned money to firms like Bear Stearns will call in the debt because the insurance on the loan has disappeared with the fall of AIG.  The lender knows that the borrower is holding a ton of bad paper and is at huge risk of defaulting on the loan.  With a debt ratio of 1:20, this means that the firm has 20 times more debt than assets, so even if the borrower sells everything down to the kitchen sink, the lender is going to suffer a huge loss, too.  Just like Bear Stearns, every firm holding bad paper are at huge risk of failure, so the lender wants to get the money owed as quickly as possible.  This is the financial definition of “exposure.”

Ok.  Wall Street is in a huge crisis.  No one is lending money because of the risk of default is so staggering.  This is what economists are talking about when they refer to a “credit freeze.”  With no lending or credit to buy, the market depends on solid assets.  

So who's got money in the bank?  What other firms are “too big to fail?”

The Cherry Picking Begins

Barclays of London has enough assets and credit to buy Lehman's.  Wachovia seeks to merge with Morgan Stanley.  Warren Buffet squeezes a no-lose deal buying up a huge stake in Goldman Sachs.  And it really is cherry picking.  The prices are lower than fire-sale.  The buyers only purchase the best assets the dying firms hold, leaving the bad paper out of the deal.  

And there's no guarantee that some of this cherry picking and mergers are going to work out.  Just yesterday with the failure of Washington Mutual, Wachovia is downgraded and may be the next to fall.  

What does this mean for the rest of us?

Do your remember the line near the end of Mary Poppins, right after the song, “Tuppins,” and the right before the run on the bank?

While stand the banks of England, England stands.  
When fall the banks of England… ENGLAND FALLS!

Wall Street is the heart that pumps the US and global economy.  If Wall Street can't borrow money and has to liquidates assets, that means you can't borrow money, and you might have to liquidate assets.  Your investment values decrease dramatically so you can't retire when you planned to.  Interest rates rise, leading to inflated prices on just about everything, including groceries and essentials.  Businesses downsize.  People lose their jobs.  Life gets hard.

What Kind of Bailout is Best?

There's no question that government has to intervene, but the trillion dollar question is, “What's the best solution?”

Should the US bailout investment banks with no oversight and no strings attached leaving taxpayers on the hook?  That was probably the assumption for the high-flying financiers who started this mess.  

Should the government demand a stake in the companies is rescues, or should we just buy up all of the bad paper and try to resell it (huh?) in a way that will reassure players in the open market?

What if the government starts at the source and helps homeowners keep from defaulting?

Maybe we can combine multiple tactics?

Ultimately, who pays?

Everybody.  

Taxpayers.  Strong firms on Wall Street.  Hopefully, other countries will hold up their own financial systems and not rely on the US to bail out every foreign bank in the world.  

Countries with surpluses, including Brazil, China, Saudi Arabia, etc., won't pay for this meltdown, but they might join in the fire-sale cherry picking and assume a huge stake in the American economy.  Then they can reap huge profits when the economy recovers.

Sovereign Wealth Funds.  These are government-owned investment funds that seek returns in the open market.  The United States doesn't have it's own Wealth Fund because first, we don't have any assets, just debt; and second, it seems like some leading anti-government capitalists espouse an extreme belief in laissez-faire economics.  

How Bad Is It?

Things are bad, real bad.  There's no question that the government has to step in and fix up this mess.  But, as I mentioned above, the real controversy is the trillion dollar question about the best way to intervene.

Sarkozy, the current president of the EU, has called for worldwide banking regulation and oversight, saying the era of self-regulation is over.  He may just well be right, even if the US doesn't affect any new legislation.

Since the US has essentially socialized investment underwriter AIG with an 80% stake in the global company, our government will ultimately be responsible for providing many new insurance policies related to investment loans.  But our role in AIG is less than certain over the next few months so this scenario is not likely.

More likely, the US government will have to create new, fairly strident oversight policies for Wall Street.  If we don't there's the chance that other governments will lose faith in our system and pull their money out of US securities and focus more trading through other financial centers like London or Hong Kong.  On the surface we will encounter political pressure, but the real driver is sheer economics and lack of confidence in the US system.

Conclusion:  The Impact on US Power

While it should be pretty clear by now that the US economy faces huge exposure to both internal and external risk, there may be significant political consequences as well.

Today, Russia has offered Venezuela $1 billion for military weapons.  Two days ago, North Korea pulled out of its agreement to stop its nuclear missile program.  US-Pakistani relations are going south.  

It's as if the world can see the vulnerable underbelly of the world's only superpower, the United State of America.

And since the Bush Administration has created more enemies than friends, it's not a good time to have our belly exposed.