Understanding Lehman and AIG

This is probably the clearest, most concise explanation I’ve read explaining the cause of our current financial crisis:

The decision to allow Lehman Brothers to go belly up has been criticized by many people as a mistake that cost AIG dearly. That turns out to be an incorrect conclusion, a classic correlation and causation error.

It is much more accurate to observe that the same factors that drove Lehman into bankruptcy also drove AIG to the brink.

It began with rates so low that everyone in the nation decided they wanted a home. This included people who could not afford one. These folk applied for mortgages from a new kind of lender that operated with little regulation and even less supervision. These lenders were willing to give loans to these people – bad credit risks, too little income, not enough equity in their homes – due to their unique business model.

They were able to ignore traditional lending standards because they had no plans on holding onto these mortgages like most banks do. They could specialize in sub-prime loans because they were a “lend–to-securitize” originator. They made loans and then sold them to Wall Street firms, who repackaged them into complex securities.

These same investment banks used too much leverage and had too little capital to buy much of this paper from each other, but since it was rated triple AAA rated by S&P and Moody’s, there wasn’t anything to worry about.

Underlying these transactions was the assumption that home prices never went down. Oh, and, this entire series of events took place at a time when the dominant political philosophy was that it was impossible for this to go wrong. The self-regulating markets, you understand, would see to that.

What bad could possibly come of that?

From The Big Picture blog – an excerpt from the new book Bailout Nation.

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