Meltdown: What Happened and Where We Go From Here

Last Updated Sep 30, 2008 3:53 PM EDT

suicide.JPGAs Congress scrambles to redraft its failed $700 billion bailout plan and government agencies consider drastic measures, such as printing more money, we might take a pause to consider how we got here and what CEOs might do about it.

So, The Corner Office has talked with experts and come up with some explanations and suggestions.

The root of the crisis, of course, is the residential mortgage and subprime lending bubble that took hold earlier this decade and marched on until about 2006.

Easy, low-interest money led firms such as Countrywide Financial and New Century to offer mortgages to people who normally wouldn't qualify since they were already heavily leveraged and showed only modest prospects for income growth.

Nonetheless, these people were offered generous mortgages with no or little money down and adjustable rates. Fannie Mae and Freddie Mac underwrote many such loans with little vetting since they were under orders to make housing as affordable to as many people as possible.

Everyone wanted part of the action. The mortgages were sold off and securitized into derivative based Collateralized Debt Obligations (CDOs) and other instruments. Financial institutions such as Wachovia, Merrill Lynch, Bear Stearns, Washington Mutual and Lehman Brothers picked up and marketed such paper.

To make such investing more popular and supposedly safe, they got into other exotic securities such as Credit Default Swaps, which are essentially bets that someone promises to pay a premium-paying investor if there's a default. Since money continue to flow on so cheaply, no one worried about defaults.

As for regulation, it fell through the cracks. The Gramm-Leach Bliley Bill of 1999 which ended the separation between investment and commercial banks had the U.S. Securities & Exchange Commission regulate only the brokerage side of such dealing and not the bank holding companies. No one noticed or cared.

Eventually the bubble started to burst when ratings agencies, who had played along with the game, started to downgrade ratings of some of the banks, which in turn, reset adjustable mortgage rates to higher levels. Since the mortgage-payers were so strung out already in their finances that they couldn't pay at the higher rates since they didn't have the income.

The house of cards quickly tumbled. Insurance giant American International Group, for instance, had to scramble for cash since its ratings were downgraded and it needed to come up with more collateral for its trades. AIG was so overextended that it found, with astonishing speed, that it could not cover next financial demands from its balance sheets. It was forced to go to the lender of last resort, the U.S. government which will be buying most of its shares in a bailout scheme.

Hedge funds, those bundles of unregulated private equity managed by speculators who like to think of themselves as rocket scientists, are not all that involved in the mortgage crisis. So far, they have resisted calls for more regulation of hedge funds, but that is likely to change.

Traditional Wall Street, as it has known just two months ago, is coming apart as firms merge or go out of business. The ensuing fear could gum up the credit flows in the U.S. and global economies at large leading to wide-scale pain.

That's the logic behind the bailout which so far has failed. If the government can pump the lifeblood of capital into the racked financial sector, stability will follow, the markets may stabilize in a few months, and growth will continue. At least, that's the conventional wisdom.

If you are a CEO, what can you do in the near-term?

  • Shore up your firm's access to liquidity and secured and unsecured credit.
  • Make sure you understand your credit capabilities. Patrick Finnegan, director of the Financial Reporting Policy Group, CFA Institute Centre for Financial Markets in New York told me: "Be certain you understand clearly the terms of your current secured and unsecured credit facilities because access to new facilities with similar terms will be extremely challenging."
  • Anticipate exactly what the terms will be if you are denied your usual credit.
  • Pray
(Image by badjonni via Flickr, CC 2.0)