The cause of the economic chaos – what I’ve learned

It is clear that everyone wants to blame “the other guy” for what’s happening but I see two main causes from what I’ve read and two different sides to blame.

1. Credit Default Swaps (CDS) and the bill that allowed them to bypass regulation
CDS represent a $55 trillion market (down last week from $62 trillion). To be worth that much money you’d hope that they are tangible assets right? Wrong. Credit default swaps are basically ‘insurance’ on bad debt (except that without regulation there was no one to oversee whether the purchaser actually had the capital to cover losses so no real ‘insurance’ existed, hence our problem today). They were a way that banks could get liability off their books to free up capital and now that ‘risk’ has been pushed around and re-packaged so many times that virtually all banks are in the hole for some of that $55 trillion.

Just for a little perspective, these swaps represent about four times the worth of the entire stock market and about six or seven times the failing housing market. So, to blame either Wall Street or the Housing market alone would be undercutting the real monster.

Article #1 – Newsweek
Article #2 – Mother Jones
Article #3 – Time
Article #4 - Bloomberg

2. The poor regulation of Fannie Mae and Freddie Mac
This is a secondary issue but since Fannie and Freddie are government backed it’s important because their actions put taxpayers at risk. Obviously the accounting fraud uncovered in 2002/2003 is a big deal, just like how Enron was a big deal (by the way, Enron can be traced back to #1 because in the same bill that ensured CDS would not be regulated, it also called out that energy trading would be free of government oversight). Anyway, I would argue that the accounting fraud is worth pointing out not because of the fraud itself (which is horrible but not the cause of the meltdown) but because of the emphasis on ‘affordable housing’ that it led to. The two firms went under close scrutiny and needed to justify their existence. Well, the best way to do that would be to become a champion of ‘affordable housing’. Enter a slue of sub-prime loans, artificially low interest rates and misrepresented housing values. Because of the size of Fannie and Freddie the loans they supported were the loans others wanted in on and thus a sub-prime disaster. Of course the sub-prime disaster could not have gotten nearly as out of control if banks weren’t able to package the risk of those loans in credit default swaps and sell them all over the world…

Article #1 – Center for Economic and Policy Research
Article #2 – WSJ
Article #3 - Ron Paul in 2003

So, that’s what I have learned.