Let's parse the credit crisis and explain what really happened rather than all the silly and illogical explanations bandied about.
There are actually multiple causes, not just simply one. Actually, we'll discover seven. Each type has its own backstory.
Start with Freddie and Fannie. While widespread fables attribute this to inadequate regulation, nothing could be further from the truth, or, to be direct, a dumber explanation. Fannie and Freddie were incredibly regulated - in fact, there was a regulator OFHEO that had nothing to regulate but Fannie and Freddie. (As an aside, when you hear one of our outstaning elected officials say that this all happened because of inadequate oversight, just remember OFHEO. Your tax dollars were at work on oversight right there. Feeling better?)
Rather, F & F's demise, at enormous cost to the now-frequently-abused American taxpayer, was directly caused by a failure by the slimy gutless weasels we elected to run our government. F&F had teams of lobbyists under contract, along with a giant in-house staff of PR and lobbyists. "Pray tell", you might ask, "why would a government sponsored entity need to lobby its very sponsor?" Well, we can certainly conclude that it wasn't because they thought they were overpaid, and were attempting to convince Congress to cut their pay.
No, it was to prevent Congress from passing any legislation to rein them in or control their exploding compensation. Indeed, executives at Fannie and Freddie paid themselves at rates that would make Dennis Koslowski or Bernie Ebbers blush. Congressmen and women, being the recipients of the booty bestowed upon them by the lobbyists, weren't about to insist that F&F have auditable financial statements, or that they based incentive compensation on real performance, or only wrote mortgages to honest hardworking types who need a little help.
Sadly, the overleverage and subsequent immolation of F&F happened because the regulators and Congress aided and abetted the fraud.
Let's move on to Lehman, Bear, and the run on Morgan Stanley. This is more complicated, with five principal culprits: leverage, bad loans, business conditions, business model and shorts. First there was a confluence of changing business conditions, evolution of the business model, and leverage. The large investment banks make money a lot of ways: as stock brokers, fees from advisory work - principally from M&A, money management as fund managers,proprietary trading, fees from syndication of debt, and IPO fees. With competition introduced in the core brokerage business from the discount and online brokers, that became much less profitable. M&A fees, driven by the dramatic activity of the private equity firms, coupled with syndication fees from placing the billions of debt that the PE guys needed, more than offset the broking revenue decline. With a market eager for the higher yield of those syndicated debt offerings, the investment banks took on the syndication risk - i.e. - they guaranteed they could place the debt. Simultaneously elsewhere in the bank they were syndicating mortgage pools. Historically, this had been a nice safe product for individuals, pension funds and the like - a little higher return than CD's or Treasury bills, with the risk diversified across different regions of the U.S. and different sized mortgages. The mandarins at S&P and Moody's gave them high ratings for security.
However, it turned out that credit standards by mortgage originators and brokers had deteriorated from sloppy to fraudulent, and the housing boom had set off a speculative bubble. As it turns out, the same funds that bought the mortgage pools also bought the buyout syndication. Licking their wounds from writing down bad mortgage loans, they began to review credit standards on M&A debt, and found both the pricing and the underwriting quality lacking, i.e., they wanted much higher interest rates before they would purchase any more credit instruments.
This was the beginning of the next crack in the business model for the investment bankers; they now were stuck with debt they had guaranteed to buy at interest rates below what the market was now requiring. With buyers demanding higher interest rates, most of the other ways I-bankers make their living was effected: M&A - one of the most lucrative, ground to a halt, as did debt securitazations. With house prices declining, individuals had less net worth and changed their spending habits. The stock market began falling. That led to a complete collapse of the IPO market (when is the last time you bought an Initial Public Offering???) That, of course, is one of the other single most profitable segments for the investment banks. So, now the ways they make money have almost vanished, and the loan writedowns diminished their equity, leaving them with very high- like 30:1 in Bear's case, ratios of debt to equity. Thirty dollars of debt for every dollar of capital. At that point, a five percent decline in the value of their assets wipes out their capital, which, of course is what happened.
AIG is another situation altogether. AIG was generally an enormous, safe and prosperous insurance company. In one small office in London, however, some underwriters got too cocky. They wrote a very specialized insurance product called "credit default swaps". These can range from rather straightforward coverages to the Enronesque. At the start, these seemed rather safe policies, with nice premium income. As they wrote more, and this policy type became more popular with investors attempting to reduce downside on certain loan packages, the London office became increasingly profitable and the staff were rewarded with very nice compensation packages indeed. In fact, the average pay for all the office, secretaries, clerks, receptionists, whoever, was in excess of $1 million. They became the new Masters of the Universe, that is, until policy claims started to mount, the risks became more obvious and the losses so large that it shook investor confidence in mighty AIG. The giant fell. Don't expect those former employees in London office to give their big bonuses back to help the shareholders recover their losses.
The SEC, supposed government watchdog protecting the small investor, actually had a big hand in making sure the small investor got screwed. Some investors and speculators conclude, for whatever reason, that a stock is overvalued. If they are sufficiently convinced, they can profit (potentially) from that by selling short. That is, they sell stock that they don't have, making the assumption that it will indeed drop, at which time they can purchase the shares, lock in the price and pocket the difference. All well and good. Shorting carries powerful risk - if the stock goes up, the buyer of the stock they sold expects to get his shares, and the seller has to go buy some eventually to deliver those shares - and it could then be at a much higher price than they sold it for. Again, these are big boys and girls and they know they are playing with loaded weapons. One key point, to sell the shares, they had to borrow them from someone who actually had the shares and pay them rent.
But, along came the SEC and said - oh, don't worry about that, sell all you want. In fact, you can sell more shares than the Company you are shorting actually has. So, the smart dudes at hedge funds awakened one day and said - hey, let's all go together and pick out some companies that have some short-term debt and that depend on the trust of others to do business, and lets short the hell out of the stock and when they go bust, we'll make a gigantic profit. So they did. And, after a few companies were totally sunk (e.g. Lehman), the SEC realized that they were supposed to be looking after the little guy instead of helping hedge funds take all the little guys' money by naked shorting (that is, selling short without borrowing the stock and paying anyone any rent) and they said - oh, please stop you bad hedgies, no more naked shorting.
Another party to the shameful event was those zany accountants at the FASB. The FASB invents accounting rules, even when none are needed, because that's what they are paid to do. Recently, being practical jokers, they've invented rules that no one can understand, or designed to do maximum damage to the U.S. economy and then they hide and laugh because they know it will take months or years before anyone understands the implication of what they did.
So, this time the jokers invented "mark-to-market" accounting. This innocent sounding name cleverly disguises the insidious damage it inflicts. I mean, everyone respects the wisdom of the market, right? So, there are some complicated formulae that essentially say if you are certain types of financial institutions, and you own securities, you must price them at recent market prices, even if you don't plan to sell. As an example, suppose you buy a nice long term bond with a fixed interest rate of 6% that matures in twenty years to hold for your retirement and collect a nice interest check along the way. If that bond trades on the market, the value will go up if interest rates fall, because it pays that fixed rate, and if rates go up it will fall, again because it pays that fixed interest rate. But you don't care, because it is backed by a sound company and you are going to hold it for twenty years.
Mark-to-market makes one really, really important assumption: there is a market.
Fast forward to the mortgage market collapse: because those loan packages have hundreds, or even thousands, of mortgages, it is really difficult to figure out just how good or bad the package is. And investors, having gotten burned on the last batch they bought, decided they would buy something else. So, no market. Makes Mark-to-Market really hard math. Merrill Lynch, stuck in the position of having a bunch with no buyers, sold billions at 22 cents on the dollar. Now, no one ever said that 68% of those homeowners weren't paying their mortgages. It was just that no investor was willing, at that moment to take the risk. So, now market is 22 cents on the dollar.
Recently there have been some really lame defenses of Mark-to-Market, like "this will help us face the facts rather than limp along for a dozen year like the Japanese". No, it just means that some people who have some cash can make a lot of money buying mortgages at bargain basement prices. And it means that the FASB has played a $700 billion joke on all of us.
SO, there you have it: Congress, Fannie May, Freddie Mac, the London Branch of AIG, the SEC, the FASB, and the changing business model all combined to set the U. S. economy back probably a decade. And for the poor nebish who worked hard and sacrificed to invest his money in a 401(k) rather then splurge - well, you trusted them and they screwed you.
Worst of all, if any two of them would have done what is right for their shareholders or America, it wouldn't have happened.