Currently, we find ourselves in a mess that many are calling the most serious economic crisis since the Great Depression. If not worse. A mile-high mountain of paper profits has been set ablaze and reduced to ashes, choking investors who put their faith in houses, stocks, or commodities, or… or… just about anything else you can name.

The bad news is that no one completely understands what’s going on; the good news is that, yes, a measure of sense can be made of the madness. Being armed with that bit of understanding should enable us to survive the tsunami… even prosper.

The road to perdition
Until recently, average Americans were only dimly aware that there were two types of banks – the commercial banks nearby and the major investment banks located in faraway New York. Understanding the bank where they conducted business, with people they knew, was enough. The big, impersonal Wall Street banks – which dealt in higher-risk investments with potentially higher rewards – were for companies and the very rich.

While ordinary citizens thought little about the distinctions among banks, the government did not. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read: looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud linked to the mixing of commercial and investment banking.

Congress decided to erect a “wall” between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act. Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it forbade commercial banks to underwrite securities or act as stockbrokers or dealers.

Glass-Steagall remained in force for six and a half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base. 

Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of Glass-Steagall and, in 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry. 

With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) And Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.

Bubble, bubble...
We’re not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. It functions as it should only in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won’t do much about the latter, since both market traders and the regulation itself may be boneheaded.

The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings. 

The Commodities Futures Modernization Act of 2000 transformed the new mortgage-backed securities into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.

Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies – Goldman Sachs (NYSE: GS, Stock Forum), Merrill Lynch (NYSE: MER, Stock Forum), Lehman Brothers, Bear Stearns, and Morgan Stanley (NYSE: MS, Stock Forum) – were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.

Just as Congress was repealing Glass-Steagall, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.

Well, how about housing?
Back in 1977, Congress passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of “fairness in lending” combined to weaken bank standards of who did or didn’t qualify for a loan.

But that was just the beginning. In an effort to end a recession in the new century’s first years, the Greenspan Fed reduced interest rates to near nothing and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action.

The commercial banks – and independent mortgagors like Countrywide Credit – were awash in cash. They started lending it, and every borrower’s credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.

The perfect storm was building. But at first, boy, did things ever look rosy. The country’s homeownership rate – 62.1% in 1960, rising to only 64.1% in 1994 – shot up to 68.9% by 2006.

As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. Why not, when there’s no risk? Housing prices only head in one direction, up, up, up, right?

It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, despite recessions in the early ’80s and early ’00s, there wasn’t a single down year for housing in all that time.

However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.

Why do rational people do irrational things?
Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.

With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.

So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.

The investment banks did not set out, of course, to become landlords. They just wanted some product to sell for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created; the mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, like structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.

The extent of the slicing and dicing into different levels, what financial chefs refer to as “tranches,” was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we're being charitable here), and buyers had no idea what their purchase was really worth.

And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.

CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.

There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now “protected” by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.

And here’s the really big rub. Suppose the party providing the initial insurance protection – having already collected its upfront payment and premiums – doesn’t have the money to pay the insured buyer when a default occurs. Or suppose the “insurer” goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.

However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.

Except, of course, things didn’t work out that way.

When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse. 

Tomorrow: Who’s responsible for fixing this mess? Will it work? What can you do about it? Part two of “Hell, meet Handbasket” concludes the two-part series. Stay tuned.

Read more Stockhouse articles by Doug Hornig.