Remember, a loan has to be backed by equity capital to take a loss if the loan goes bad. the reason this crisis is so bad was because banks borrowed money to buy securitized debt, which already had embedded leverage.

so rather than having equity behind the loan, you have debt. so in effect, you have borrowed money backing borrowed money: it's like the difference between looking at your self in a single mirror, vs. looking at your reflection with 2 mirrors: with one mirror you see yourself once; with two mirrors you see yourself an infinite number of times, not just twice.

this is what happens when you back debt with debt, rather than equity: it magnifies the losses, rather than capping them. the result is negative equity, which is magnitudes worse than going to 0. (negative equity is far worse than "0 times any number")


remember, only commercial banks were allowed to extend credit. they were required by banking regulations to have some form of capital behind their loans; usually a liquid, highly rated, AAA US treasury that could be sold on demand for cash.

But also remember the new daisy chain created by intricate relationships between counterparties:

1) commercial banks used toxic waste credit derivatives with embedded leverage as collateral to borrow & lend money, and the risk is securitized and sold to hedge funds.
2) the credit is lent to investment banks.
3) ibanks re-lend the money to hedge funds, and this new debt is securitized and sold off to other hedge funds.
4) hedgies, now levered 60:1, go into the world bond market and buy securitized debt, auction rate securities, commercial paper, student loan debt, credit card debt, and ABCP, so banks can issue more securities for them to buy.
5) these securities are insured by more under capitalized hedge funds issuing credit default swaps.
6) and because of dynamic hedging, all of these people will be forced to short each other into the ground if something goes wrong, or loses their credit rating.


the bottom line is that all of these people are broke.

and there is no equity cushion or backstop to absorb the potential losses: just another shitty hedge fund.

before, the loans stopped at the bank, which was backstopped by savings deposits, the fed, and FDIC. now, the securitized loan stops at the hedge fund; but the hedge fund has no reserves. it has no backstop. plus, it can't liquidate a credit derivative like a T-Bill for cash, b/c credit derivatives are illiquid. in order to get more capital, it needs to borrow money from a bank.


but what happens when that bank is also insolvent?