The Depression of 2008

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Posted By: Richard Masson

I am not sure a public chat room for baseball cards is the proper venue for this discussion, but I will say that in my experience, things are never as bad (or as good) as they appear. Financial institutions are highly leveraged (banks, investment banks, etc.) and there is not one of them that can withstand a "run on the bank" like what faced Bear, Stearns this past week. Remember there are two kinds if insolvency: balance sheet insolvency where liabilities exceed assets (the entire banking system in the early 90s, for example) and cash flow insolvency (what do you mean my money isn't in the safe? I want my money now!). As best I can tell, Bear is facing the latter. It's assets will be liquidated or its business units sold, liabilites will be settled, and that will be that. Perhaps the same fate awaits Lehman or others. We'll see.

The mechanism by which problems with subprime home loans translate into bigger problems is through a relatively new invention called collateralized debt obligations, or CDOs. There are many places where you can find out how these work, but to cut to the bottom line, the very riskiest pieces of CDOs (which will probably collect nothing) were pooled together and debt was issued against them which was erroneously rated AAA, but which will probably also collect nothing. Ownership of this debt is pervasive because AAA rated paper historically never defaults, let alone incurs losses. When the music stopped, many large institutions were left holding the bag. This translates into issues in the broader economy because those with losses are reluctant to lend more money to anyone else, even creditworthy borrowers; instead, they become focused on shrinking their loan base.

Do not despair. The beauty of our financial system is that we recognize losses pretty quickly and move on (unlike, say, Japan). What emerges is a stronger and more competitive system.