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In print | October 2, 2008

Almost 80 years later, it is still embarrassing to admit that this newspaper entirely failed to cover the most significant economic crisis that has ever faced this country: the Great Depression.

According to The Phoenix of the day, a bitter power struggle between a local chicken farm and the Arboretum, the planting of some trees on campus, and a six week feature on the debate regarding wearing blazers at meals in Sharples were all more news-worthy than the complete collapse of the American economy.

Rest assured we will not make that mistake again.

What, exactly, is going on?

In the days following the collapse of Lehman Brothers and A.I.G., Freakonomics author Steven Levitt wrote, on his New York Times blog, “To be honest, I haven’t got the foggiest idea what this all means.” Mr. Levitt was not alone. While Monday’s 700-point slide in the Dow Jones industrial average makes for frightening infographics (such as Tuesday morning’s New York Times cover, which featured a line graph seemingly pointing only downwards, there’s a lot more at work than just a stock slump.

This present fiasco went public on Sept. 8, when the federal government nationalized Fannie Mae and Freddie Mac, two long-ailing financial services companies. The problem with Fannie and Freddie was their lack of liquidity: essentially, both firms had complicated balance sheets of assets and liabilities, but no real, immediate ability to generate cash. In the same sense that a student with an empty wallet who loaned money to friends can’t use those loans to pay for groceries, Fannie and Freddie were unable to meet their short-term obligations. With combined assets of over $5 trillion, the tendrils of the two firms reached all ends of the economy, and the impact of their failure would have been of an unimaginable scale. Intending to avert disaster, the government stepped in, with their nationalization essentially making the government a guarantor of their loans.

The next phase was the Sept. 15 bankruptcy of Lehman Brothers, a massive investment bank. Clocking in at over $600 billion in assets, Lehman Brothers handily shattered the previous record for the world’s largest bankruptcy, set in 2002 by WorldCom. The very next day, insurance and financial services giant A.I.G., suffering from the same sort of liquidity problems faced by Fannie and Freddie, was thrown an $85 billion lifeline by the Fed, keeping the $1 trillion company and its 100,000 employees from going under.

In subsequent weeks, a series of other big names in banking and finance collapsed. Merril Lynch, unable to escape from $52 billion worth of bad decisions, was sold to Bank of America. Washington Mutual, the largest savings and loan association (the technical term for what we’d call a bank) in the United States, filed for Chapter 11 on Sept. 26, the day after the 119th anniversary of its founding, following a bank run of a scale not seen since 1929. Many smaller banks have also felt the pinch.

What caused Lehman Brothers, a firm which was founded in 1850, A.I.G., the 18th largest company in the world, and Washington Mutual, America’s largest thrift (again, a term which boils down to what people commonly think of as a bank) to collapse? Arguably, many of their problems can be traced back to the billions of dollars in defaulted subprime loans they had to accept as losses earlier this year. And what, exactly, is a subprime loan? That’s a longer story.

What caused all this madness?

The great villain of our story is The Subprime Loan, a spectre that has been haunting the world’s economy since the late 1990s. The general idea is: banks give out extremely risky loans to people with bad credit on terms that are very favorable to the banks, on the assumption that the money they stand to make from those loans outweighs their inherent risks. When their model works, everyone wins: individuals with poor credit histories can buy things (consumption, obviously, is good for everyone), and banks reap massive profits.

Starting in 2006, though, the spiral started to unwind. Instead of playing by the rules and repaying their loans, individuals with bad credit did what individuals with bad credit do best: they defaulted on their loans, essentially sticking banks with worthless properties (remember, the housing bubble “popped” around this time) and massive losses. Over 100 subprime lenders went under around this time.

But the subprime catastrophe didn’t end with the bankruptcy of the subprime lenders themselves. Bad loans had embedded themselves throughout the rest of the financial system, with big securities companies (such as, interestingly enough, Merril Lynch and Lehman Brothers) dressing up subprime loans to make them more appealing to other investment banks and hedge funds. Within a few months, the ripple effects of the uptick in subprime defaults was affecting even relatively distant sectors of the economy.

Wall Street wasn’t quite done digging its own grave, though. A whole collection of diabolical new ways to make money emerged in the late 1990s and early 2000s: just one example is the fiendish credit-default swap, or CDS. Considering that The Economist valued the market for CDSs at $62 trillion on Sept. 18, one might expect that most people would have at least a vague understanding of what a credit-default swap actually is.

As best we’ve been able to divine, a CDS resembles an insurance policy on loans, in that lenders can use them to insure against defaults. But unlike every other insurance policy on the planet, a CDS doesn’t actually have to refer to any loan in particular: brokerages can trade in “debt” as an abstract idea, with the value of such trades increasing or decreasing in value as the riskiness of the “debt” changes. Practically, when loan defaults increase, banks involved in CDSs lose massively. The fact that there is $62 trillion worth of this nonsense in the economy is rightfully horrifying.

And CDSs aren’t the only factors leading to the recent demise of banks. Wall Street has created, over a period of decades, an impenetrable web of arcane policies, procedures, and ways to make exorbitant amounts of money. In short, the present financial crisis is the product of years of poor choices finally returning home to Wall Street.

What’s the deal with this bailout, anyway?

Enter the supposed savior of our economy, The Bailout. Attempting to address criticisms of the government’s seemingly inconsistent handling of Fannie and Freddie (save), Lehman Brothers (allow to fail), and A.I.G. (save), Ben Bernanke (the chairman of the Federal Reserve), Hank Paulson (the treasury secretary), and leaders of Congress have worked on hammering out a more systematic way to give the economy a life preserver.

The plan, fleshed out this weekend, would create the Troubled Asset Relief Program, designed to relieve banks of their most problematic investments. Here’s the basic idea: the government would be able to purchase up to $700 billion worth of risky mortgages and mortgage-related assets (remember those CDSs?), sticking taxpayers with the burden of what The Economist calls “toxic debt.” The end result, Messrs. Paulson and Bernan­­ke contend, would be the restoration of a more normal lending market in the United States: consumers would still be able to obtain home, car, and student loans, albeit at higher interest rates, and a depression caused by an abrupt decline in consumer spending would be averted. The details of the plan, of course, are more complicated and ill-understood, a problem in and of itself, but economists have, largely, found the Troubled Asset Relief Program to be a sound solution.

But the bailout package, passed by the Senate, failed in the House on Monday, triggering the aforementioned 700-point drop in the Dow Jones. Whatever its economic merits, it gained a reputation amongst a befuddled public as a “taxpayer-financed parachute for high-flying Wall Street tycoons,” as The New York Times colorfully described it on Tuesday. But the rhetoric of the Times is disingenuous: voters miss the point of the legislation (ensuring that they are still able to borrow money, thereby keeping the economy afloat) and only get the secondary point that, as a consequence of keeping the economy running, the government is also keeping risk-taking banks solvent.

With a new vote scheduled in the Senate for Wednesday night, hope remains that a more comprehensive solution will still emerge before the end of the week.

Okay, I get it. But what should the government actually be doing?

The government, or more specifically, the House of Representatives, should be passing whatever form of the Troubled Asset Relief Program next comes up for a vote. The confluence of electoral politics, misguided populism, and ignorance about economics led to the proposal failing the first time. The House cannot allow this to happen again. If a successful vote comes by attaching popular riders, such as tax breaks for companies implementing green policies or an increase in the FDIC guarantee of bank deposits to $250,000 (a measure both Barack Obama and John McCain have endorsed), so be it.

In the longer term, extensive regulatory changes need to take place so that such a problem can never emerge again. The Kiplinger Business Resource Center suggests two such categories of changes: oversight and simplification. The first is a refraction of the strategy implemented with the Sarbanes-Oxley Act after Enron collapsed in 2001: when companies misbehave, make the government party to more of their intimate details. Increased disclosure of balance sheets only serves to make companies more accountable to their shareholders, and to the American public.
The second, simplification, means changing how financial markets operate on a very basic level.

The reason subprime loans became so problematic was because banks spread them throughout the economy in an attempt to diffuse their risk, a practice which is only moderately dangerous and unlikely to go away. Rather, regulators need to crack down on the exotic ways in which banks go about diffusing that risk. (Herein, the CDS once more rears its ugly head.) It can’t be expected that every American understand everything about how financial markets work, but making things a little less opaque is certainly a step in the right direction.

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