Best explanation of the financial crisis origin

Here is the best explanation of the financial crisis. 

First, banks were not as worried about the credit-worthiness of borrowers because they could sell the mortgages on the secondary market. Second, unregulated mortgage brokers made loans to people who weren’t qualified. Third, many homeowners took out interest-only loans to get lower monthly payments. As home prices declined and mortgage rates reset at a higher level, these homeowners could neither pay the mortgage nor sell their homes for a profit, and so they defaulted.

Fourth, and probably most importantly, mortgages were repackaged as mortgage-backed securities (MBS). Banks had hired sophisticated “quant jocks” who wrote computer programs that could repackage these MBS into high risk and low risk product bundles. The computer programs were so complicated that no one really understood what exactly was in each product bundle or how much of the bundle had subprime mortgages. When times were good, it didn’t matter, and everyone bought the high risk bundles because they gave a higher return. As the housing market declined, however, everyone knew that these products were losing value but, since no one other than the computer programs understood them, the resale value of the products was unclear.

Last but not least, many of the purchasers of these MBS were not just other banks, but individual investors, pension funds and hedge funds. This meant that the risk was spread throughout the economy. Furthermore, since hedge funds are not regulated by the SEC, they could use derivatives to borrow money to make investments. This created higher returns in a good market, and greater losses in a bad one, thus magnifying the impact of any downturn.

 One type of derivative is the Credit Default Swap (CDS). Here is how the Credit Default Swaps caused AIG to fail:

In addition, AIG was a major seller of “credit-default swaps.” These swaps insured the assets that supported corporate debt and mortgages. If AIG went bankrupt, it would force the banks that bought these swaps to take write-downs.

How Did AIG Almost Fail?:

In fact, it was the swaps against subprime mortgages that pushed the otherwise profitable company to the brink of bankruptcy. As the mortgages ties to the swaps defaulted, AIG was forced to raise millions in capital. As stockholders got wind of the situation, they sold their shares, making it even more difficult for AIG to cover the swaps. AIG could has more than enough assets to cover the swaps, but couldn’t sell them before the swaps came due. (Source: WSJ, U.S. to take over AIG, September 17, 2008)

To summarize all of this:

Financial services companies bought mortgage-backed  securities from Fannie Mae and Freddie Mac. The worthiness of those securities were impacted by bad loans to people and a rise in interest rates that people could not afford. When people could not afford their mortgage payments they defaulted. The mortgage-backed securities began to lose value and the derivatives failed big time. When the derivatives failed, those financial services companies had to raise cash to pay them off. When they ran out of cash, they failed. 

When the financial companies fail, business cannot find enough cash fast enough to keep their business going. When business cannot find cash for their needs, they fail, too.

Economic collapse or Recession? With a Bail Out Bill, we have a recession and that is why Congress had to act. HOWEVER, was the purchasing of bad debt the right approach to bail out the economy? We may never know that answer.