How it all started

Over the past few days I've been talking at work how the financial crisis started, I gave multiple reasons for why it happened, but here is a sort of simple reason as to why the global economy is going bust.

Everyone is trying to blame the bad mortgages, and homeowners who could not pay their debts. This is not really the case bad debt from mortgages only accounted for between $200-$300 billion of debt. The problem is that banks around the world, espescially the US and Europe being completely over leveraged, and in some cases leveraged 30:1, which means that you are borrowing 30 times the amount of money you have in reserve. With that you can either make 30 times your average profit or on the downside 30 times the loss. With High Risk there is high reward, but also very high dangers. But banks have their own regulations on what they can hold right? Yup its called the Basel II accord. "The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face."

The riskier the loans a bank owns, the more capital it must keep in reserve.So when banks follow this rule they should be safe, but hello AIG, and thank you for your complete and utter disastrous methods of taking banks money. You see AIG would offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps. The bank calls AIG, and are told that historical loss rates on American mortgages is close to nothing, what drew in European investment, and AIG would sell them subprime securities for 2% of face value, and were guaranteed against default for 5 years.

"Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate. " (Porter Stansberry) Profit was written off right away by AIG, and as long as they kept their triple A credit rating they could do this as much as they wanted."The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral."

AIG never had the collateral to back up their loans, and the proft that they wrote off never actually happened. The next to nothing chance of loss on mortgages? Much worse and many times higher than they thought. Those securities in some cases were worth $0.15 to the dollar. Everyone seemed to notice this and on September 15th AIG credit score was lowered. And this is where the proverbial dominoes fell, when AIG's credit score was lowered, they needed to come up with capital to come up with an $11 billion charge, they actually managed to do this, but when they were downgraded all those swaps finally reared their ugly heads and AIG had no money to come up with the collateral they needed. Let's not forget that AIG leveraged themselves out too, and had their own debts they needed to pay. OOPS they went Bankrupt and went to cry for help.

Then "Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity."

Now it gets scary when you look at the facts:
"Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.

Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.

And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade."

SO now you know why the execs needed their $400,000 little get away, it was a stressful time when you almost destroyed the world banking system. THe pain will continue and it will get worse, much worse before it gets better, but it will get better, and hopefully the government and banking systems will enact rules to prevent any future forms of fraud that banks and their executives committed to chase a profit.