Before I get into the more detailed points, I want to do a brief, and admittedly incomplete, history of how we got here, b/c the issues have been going on for longer than some people think.

After this, I'll get into the original intent of the post, to explain how our financial system worked before it fell apart. It's difficult to do this without some context.


A bull market in credit:

according to richard russell, a bull market has three phases: a skeptical phase, an acceptance phase, then a bubble phase where it becomes a non-sensical mania. these periods pan out over decades, which is why we are going to be dealing with the ramifications of this for some time.


1) fed chairman paul volcker raises interest rates to insane levels in the early 80's (rememeber, high interest rates cause bonds to fall in value). after stagflation ended, interest rates peaked & began to fall. the bull market begins.

2) volcker fights special interests in congress and the at fed that want to deregulate the banking sector; he wins some battles, but deregulation still takes place in various ways.

3) when volcker's term ended, ronald reagan did not reappoint the democrat fed chairman b/c he caused 2 horrible recessions by raising interest rates. instead, he chose a fellow republican to replace him: alan greenspan, who battled volcker on deregulation. months later, the 1987 crash occurs due to new financial products, and greenspan responds w/ a long career of deregulation, bailouts, and interest rate slashing. the same year, AIG's infamous financial products division is set up in london. also in 1987, now defunct investment bank Drexel Burnham Lambert issues the first CDO.

4) reagan begins huge budget deficits and borrows heavily in the treasury market to build up a huge defense program against the USSR, and to finance tax cuts, flooding the capital markets with highly liquid treasuries for decades to come. at the time, US bonds frequently had yields of 8% or more.

5) loose credit standards led to the S&L crisis, after which home prices recovered, & began a steady ascent upward. consumer credit began to take over the US

6) behind the scenes, glass-steagall was being steadily dismantled piece by piece by the bank lobby and the greenspan fed.

7) greenspan coins the term "irrational exuberance" in 1996 regarding the stock market

8) JPMorgan invents the credit default swap in 1997

9) 1998 - LTCM collapses & is bailed out due to leverage & derivatives; AIG begins selling CDOs and CDSs

10) greenspan begins flooding the markets with money & credit due to Y2K fears. the increased leverage, LTCM bailout & rate cuts contribute to the NASDAQ bubble

11) in 1999, clinton & congress officially repeal glass-steagall, though the meat of it was effectively eroded over time years before; goldman sachs, the last major private broker/dealer on wall street, issues their IPO at the top of the market: all of the major broker dealers have now dumped the risk from the owners to the public shareholders.

12) the CFMA is passed by congress in 2000, making over the counter derivatives exempt from regulation

13) the leverage shifts from .com stocks to credit instruments. the collateral for many of these instruments was real estate, dragging the burgeoning credit mania into the housing market.

14) in 2000, the CEO of goldman sachs, hank paulson, lobbies congress to reduce leverage limits on investment banks; the SEC complies 4 years later. (http://www.youtube.com/watch?v=m8VYVUMuB6U)

15) enron collapses in 2001 due to derivative bets hidden in highly leveraged accounting vehicles. these vehicles are later adopted by banks across the globe to hide their own bets in the credit markets

16) in 2004, greenspan cuts interest rates to 1%. the SEC removes the “net capital” rule, eliminating leverage caps for the 5 major broker dealers (http://www.nytimes.com/interactive/2008/09/28/business/20080928-SEC-multimedia/index.html) After this, leverage in the system goes ballistic, taking home prices with it. the growth of credit derivatives begins to go parabolic.



17) Feb 2007: "All five of the big brokers are being run by management teams that are to die for, that are seasoned, that have seen everything there is to throw at us...It's the best group of managers that I've ever seen in any industry... Goldman Sachs (GS), Bear Stearns (BSC), Lehman Brothers (LEH), Merrill Lynch (MER), and Morgan Stanley (MS)... All of them, right now, are being run by great men. For the first time in my memory - for the first time in anyone's memory - all five major brokerages have great management..." (Jim Cramer on Mad Money: http://www.madmoneyrecap.com/ARCHIVES/daily_recap_openingsegment_022707.htm) in the same month, the entire sub-prime mortgage brokerage industry went bust.


18) July, 2007: 2 bear stearns hedge funds collapse


19) August, 2007: "THEY KNOW NOTHING. THEY KNOW NOTHING." (c) cramer