HOW WE GOT INTO THIS MESS IN 7 STEPS

1.  The Community Re-Investment Act of 1977 threw out the idea of a sound financial system in favor of affordable housing for the less well off.  

Folks who could not afford to borrow to buy a home were now the legislated target market for lenders; banks were legally forced to lend money to bad credits. Out went traditional and rational lending criteria like 20% down. Now, folks who could not afford it could buy a home for 0% down.

So the banks fulfilled their, now lawful, obligation for making the initial loan but then, as soon as possible, sold the damn things off for a packaging fee.

2.  The fundamentally corrupt regulatory process whereby the quasi government controlled wholesale lenders of Fannie and Freddie, and the large private mortgage packagers such as Countrywide, could and did buy any kind of legislature they wanted.

The Chairman of the Senate banking committee, Chris Dodd (D-CT), is and has been the largest recipient of Fannie and Freddie political contributions. In addition, Senator Dodd got two sweetheart Mortgages from Countrywide. The recent heads of Fannie and Freddie were political appointees, mainly by Democrats:  Franklin Raines, Jaime Gorelick, and Jim Johnson – all Obama advisors.

3.  No disclosure by private market participants in the Credit Default Swap and Collateralized Mortgage Obligations contracts.

Many of these transactions were simply bets regarding what these packaged mortgage securities would be worth, or not worth, as some percentage of their face value. Insurers, like AIG, were happy to collect premiums to ensure that the value of certain financial instruments would not fall below par.

Had there been full disclosure of these contracts there would have been at least a chance someone, maybe even a regulator, would have noticed that the system was on a hair trigger, one default could cause a cascade of defaults.

Markets work very well when there is adequate information, in this case there was no or inadequate information. Regulators and legislators, who had and have the power to demand disclosure showed an amazing lack of curiosity and imagination. They could have asked what was going on and gotten answers.

[What is thus needed is for the SEC to create a central clearinghouse or exchange for CDS's – credit default swaps – declare them securities, and then set standards of transparency, liquidity and collateral to be listed and traded.-JW]

4.  Since no one could see the whole picture, risks were impossible to gauge and many deals were entered into at the wrong price, or a price that did not reflect the actual risk.

5.  The aggression and intense profit motive on Wall Street overcame any caution.

6.  Only really smart people can lose this kind of money. Those considerable and mainly very young brains were put loose by their managers to speedily build giant, multi-trillion dollar complex portfolios, which they did.    

7.  Finally, the nudge at the base of the house of cards came in the form of a few more mortgage defaults than expected in some of these portfolios, which softened the real estate market, which then created more defaults, and on and on.  

What is truly breathtaking is the size and speed of the collapse. We do not know now the full implications of this mess, because it is on top of an already precarious financial situation caused by impossible government entitlement (Social Security, Medicaid and Medicare) obligations.

The only way for the government to manage this collapse in the short and medium term is to print more dollars, to ensure short term liquidity. This will accelerate inflation, reduce the value of the dollar and securities, and increase the deficit and the national debt. 

In the past, the US economy was able to grow its way out of bursting financial bubbles like the S&L failure or the dot-com stock collapse.  This time, it may be too big for that.

The long term fix, if there are any responsible adults around to champion and insist on, is to have a banking system based on rational credit analysis – lenders making loans that they intend to get repaid with interest from borrowers.

That plus limits on the leverage that banks can take on, and more disclosure.

Are those strange, novel ideas? Barney Frank, Chris Dodd, Hillary Clinton, Harry Reid, and Barack Obama would certainly think so – and would oppose them tooth and nail, for they already have.  Ergo, this mess.

TTP'er George Skakel manages a private hedge fund.