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ringing. Central bankers are on 24/7 alert, ready to perform life
support on catatonic markets. Stock traders are panicking - the Dow's
wild ride on Wednesday, down 350 points and then almost all the way
back, is just the latest declaration of confusion and fear.

If you had been paying only casual attention to the financial markets as
summer rolled along, you could be excused for glancing at the headlines
and wondering, what the hell is going on? By many measures the global
economy is growing faster than it has for decades. But in our globalized
world, anxiety is everywhere. Soon after the markets close in New York,
Asia's traders start running for cover. By the time they're exhausted,
Europe is picking up the relay. And then back to the United States it comes.

People who devote their entire lives to studying the intricacies of high
finance are confused right now. But the basic story line isn't that
complicated once you break it down into simple building blocks. And
that's what Salon is going to do. Here are some simple questions and, we
hope, some simple answers.

How did this happen? How did we get here? What does it all mean?

There is a standard explanation included as a paragraph in almost every
story attempting to explain the current turmoil. It goes like this:
Anxious to goose the US economy out of its dot-com-bust doldrums, Alan
Greenspan and the Federal Reserve Bank lowered interest rates to rock
bottom in 2001. The resulting flood of cheap money encouraged an orgy of
borrowing at every level of the US and world economies. Whether you
wanted to buy a house or a multibillion-dollar conglomerate, lenders
were your best friends, falling over themselves to offer you whatever
amount of capital you desired - and charging low, low rates of interest.
Cheap money led to a growing complacency about risk. If you ran into
trouble, you could just refinance your house, or borrow a few billion
more dollars today to pay off the billions you might owe tomorrow.

Greenspan's policies are being blamed for inciting the greatest housing
bubble in US history. The collapse of that bubble set off a wave of
defaults by homeowners no longer able to make the payments on their
mortgages. Mortgage lenders were the next link of the chain to break,
followed by the investors who were trading in bonds and securities whose
value was tied to these loans. Suddenly, risk was back!

So that's that? It's Greenspan's fault?

Partially, but interest rate tinkering is not the whole story. It may
not even be the most important part of the story. There's another reason
so many homeowners are in trouble and stock markets are imploding: Wall
Street rigged the system so something like this was inevitable.

One could make a case that the biggest economic story of the last ten
years - bigger than the dot-com or housing booms, bigger than their
busts, perhaps even bigger than the extraordinary growth of the Chinese
and Indian economies - has been the astonishing growth of what is
obscurely referred to as "structured finance", a crazy quilt of arcane
derivatives and other "financial instruments" that have become the
lifeblood of markets everywhere.

Whoa. Stop right there. What is a derivative?

Strictly speaking, a derivative is a financial doohickey whose value
derives from some underlying asset. A mortgage loan is an asset. A pool
of mortgage loans grouped together into a security that can be traded on
markets is a derivative.

We often hear about the "real economy", that place where real people buy
and sell real things, or go to work at real jobs where they make real
stuff or deliver real services. Derivatives belong to what should be
called - but never is - the unreal economy, a place where speculators
make bets about what will happen in the real economy. Derivatives are
vehicles for making such bets. If you think the borrowers whose loans
are pooled together are going to make their payments, then buying a
share in a group of such investments might be a good idea. That would be
your bet.

A metaphor might be useful here. The real economy is like the Super
Bowl. Real men on a real field push each other around and play with a
real ball for a set period of time, and the team with the most points at
the end wins. But while all this is going on, millions of outsiders who
are not physically involved in the game bet on its outcome. Only they
don't bet just on the outcome. They also bet on the spread - how badly
one team might beat the other. Or they can get more creative and bet on
what the combined score of the teams might be, or which team's
quarterback will be the first to be injured. There's absolutely no limit
to the things that you can bet on, as long as you can find someone to
take your bet.

The betting economy is the unreal economy. All those sports bets, no
matter how kooky, are financial exercises whose value and meaning are
derived from what happens on the field. Theoretically speaking, the
betting economy exists in a separate dimension from the actual game, but
we all know that's not true. There's so much money involved in gambling
that the temptation to fix the results becomes irresistible. Players and
referees, for instance, can be bribed.

We can call a bribed NBA official an example of "spillover" from the
betting economy into the sports economy. The very same thing happens in
the real and unreal economies. So much money is riding on all the
derivative bets connected to the housing sector that Wall Street
speculators essentially rigged the housing sector to make their bets pay
off.

To understand exactly what happened, we must take a closer look at a
particular kind of derivative: the infamous "collateralized debt
obligation", or CDO.

Say what? Collateralized who which how?

Don't worry about the name. Call it an extra-special funky doohickey if
you like. It's not important. What is important is its function, which
is to make things that should be considered risky take on the appearance
of less riskiness.

After a mortgage lender makes a loan to a homebuyer, that loan is
packaged up with a bunch of other loans into a security - a financial
instrument that can be traded. Securities are rated by rating agencies
according to the chances that the underlying assets will be defaulted
upon. US Treasury bonds, for example, get stellar AAA+ ratings because
the US government is considered likely to meet its obligations.

A security based on a pool of subprime mortgage loans would normally not
deserve an AAA+ rating. Subprime, by definition, means "not so good".
Subprime loans are made to people who can't put together a down payment
or have bad credit, or can't prove they have a job. Subprime loans are
risky!

Many investors - particularly in pension funds and municipalities - are
prohibited from investing in securities that are not high-rated. Let the
hedge funds and the investment banks play around with the risky BBB
stuff, the "junk". The rest of us should be more prudent.

But investment bankers are clever fellows. In cahoots with the ratings
agencies, they came up with a way to magically transform a low-rated
security to a high-rated security. (The culpability of the ratings
agencies - Fitch, Standard & Poor's, Moody's - should be not
underestimated. It might be helpful to think of them as the bribed
referees in this game.)

Enter the collateralized debt obligation. The CDO takes a pool of risky
mortgage loans and divides it into slices. (Wall Street calls these
slices "tranches", but that seems to be a word that makes the brains of
normal people freeze up, so we'll ignore it.) For simplicity's sake,
let's say that a mortgage-backed security gets divided into two slices
when it is transformed into a CDO - a senior slice and a junior slice.
Let's say that the senior slice gets rated AAA+ and the junior slice
gets rated BBB-. But if anything goes wrong - if the homeowners whose
loans are part of this security start missing their payments - the
investors in the junior slice have to lose all of their money before the
investors in the senior slice start feeling any pain. That's the beauty
of the scheme. You take a bunch of bad loans and turn some of them into
high-rated gold and some into lower-rated bronze. You sell the gold to
the cautious and the bronze to the bold. If a few loans go kaput, the
bronze investors suffer. If all the loans go kaput, everybody gets hurt.
Unless there's a total financial meltdown, everyone is happily making money.

We keep hearing in the financial news about risk being "sliced and
diced". Is that what you're talking about?

Yes. After the transformation, we now have an instrument that satisfies
the desires of both conservative investors, who can just buy the AAA+
rated slice, and investors who have a taste for risk, who can buy the
BBB- slice. It's a brilliant work of alchemy.

And very popular. CDOs tied to subprime mortgages became hot
commodities, snapped up with gusto by traders all over the world - even
the riskiest, most likely to self-immolate, lowest-rated slices of those
CDOs. Especially those slices.

Why? Why was there such an appetite for risk?

No risk, no reward. In the securities world, financial vehicles whose
underlying assets are risky yield higher rates of return. Subprime loans
ultimately charge higher rates of interest than prime loans. That means
that as long as homeowners don't take advantage of introductory low
rates and pay off their loans early, pools of such loans will throw off
a higher stream of income than pools of less risky loans. Traders who
want to get a piece of that higher stream of income will take the chance
of default.

This is where we approach the crucial turning point. Many different
parties have been blamed for the housing mess. Homeowners are told that
they should have read the fine print on their loans and should have
avoided taking on financial obligations that they couldn't meet.
Mortgage lenders are blamed for pushing the risky loans in the first
place. And of course, there's the maestro, Alan Greenspan. But these
attributions of guilt all miss the mark. The incentive for everyone to
behave this way came from Wall Street, where the demand for subprime
CDOs simply couldn't be satisfied. Wall Street was begging the mortgage
industry to reach out to the riskiest borrowers it could find, because
it thought it had figured out a way to make any level of risk palatable.

So Wall Street wanted mortgage lenders to make bad loans?

Let's return to our Super Bowl metaphor. The gamblers aren't satisfied
with their odds of winning, so they bribe a player to fumble at the
one-yard line and alter their bets accordingly. Wall Street traders,
hungry for more risk, fixed the real economy to deliver more risk, by
essentially bribing the mortgage originators and ratings agencies to
fumble the ball or make bad loans on purpose. That supplied CDO
speculators the raw material they needed for their bets, but as a
consequence threw the integrity of the whole housing sector into question.

But hang on. Isn't the total amount of subprime loans outstanding just a
fraction of the overall home-lending market? And isn't the US economy
still growing? Why has just one small sector of one country's economy
caused so much trouble?

Two main reasons: a lack of transparency and an overabundance of leverage.

What's been described here so far is just the simplest possible model of
how things work. The truth of what is really going is far more complex.
So complex that no one has a good handle on exactly what will happen if
things go awry. Not regulators, not traders, not even pessimistic
journalists. Try reading an SEC filing from a New York investment bank -
it is one of the most difficult-to-comprehend documents ever created by
the human mind.

It is not, in a word, transparent. It serves the opposite purpose: It is
an instrument of obfuscation. Because of failures of regulatory
oversight, we have very little idea who owns what, or what risks hedge
funds and pension funds and municipalities and mutual funds are really
exposed to. This is all fine and dandy if your goal is to prevent your
competitors from understanding what kinds of bets you are making. But it
becomes a much more severe problem when you're trying to figure what is
going wrong when the trains start derailing.

(By the way, if you're looking for something that government could do
that might address this problem, calling for greater transparency
carries the double whammy of being both the right thing to do and,
rhetorically speaking, something that free markets are supposed to
depend on for their proper functioning.)

Next up: leverage. Archimedes told us that if he had a lever long enough
and a place to put it, he could move the world. Speculators in the
world's financial markets also like leverage; but they don't use
crowbars to move objects - they use borrowed money to make bigger bets.
This is fine as long as your bets pay off. But when your bets go bad,
the people whose money you borrowed want it back.

Right now, a great many people want their money back.

The people who say that subprime is just a small part of the economy are
correct. What they fail to note, however, is that the same games that
Wall Street played with subprime are likely being played in every sector
of the economy. It's not just a Super Bowl whose results can be fixed.
The NBA, and Major League Baseball, and the Tour de France and the
Olympics are all under the same pressures.

Subprime ripped a window open into the way business as usual is being
conducted.

Now everyone wonders, what's next?


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http://www.salon.com/tech/feature/2007/08/17/wall_street_panic/print.html


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