The F.A.Q.’s of Lehman and A.I.G.
By Douglas W. Diamond and Anil K. Kashyap
on the Freakonomics blog
"Why did these things happen?
The common denominator in all three cases [Fannie Mae/Freddie Mac, Lehman, AIG] was the ability of the firms to secure financing. The reasons, though, differed in each case."
"Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt."
"Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets."
"Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread."
"A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging. "
read more at: http://freakonomics.blogs.nytimes.com/2008/09/18/diamond-and-kashyap-on-the-recent-financial-upheavals/
A Slate magazine article explains some basic terms
"Central bank, reserve bank: A country's central bank maintains the stability of its national currency. In the United States, the Federal Reserve functions as the central bank and acts as a last-resort lender to failing financial institutions. The Fed was created in 1913 to provide financial stability in response to the Panic of 1907.see more definitions at http://www.slate.com/id/2200410/
Commercial bank: A commercial bank, also known as a business bank, takes deposits and gives loans, mostly to corporations. After the Great Depression, Congress required that commercial and investment banks be separate with the Glass-Steagall Act; that restriction no longer applies today. Bank of America is currently the largest commercial bank in the United States.
Investment bank: An investment bank raises money by selling securities to companies and to the government. They also provide advice to corporations about mergers and buyouts. With Lehman Bros. and Merrill Lynch out of the picture, Goldman Sachs and Morgan Stanley are the two largest investment banks in the United States."
Public radio's This American Life broadcast a special episode called "The Giant Pool of Money" which is the best and most accessible explanation I've heard.
"The thing that got me interested in all this was something called a
NINA loan. Back when the housing crisis was still a housing bubble. A guy on the
phone told me that a NINA loan stands for No Income, No Asset, as in, someone will
lend you a bunch of money without first checking if you have any income or any
assets. And it was an official, loan product. Like, you could walk into a mortgage
broker’s office and they would say, well, we can give you a 30 year fixed rate, or we
could put you in a NINA. He said there were lots of loans like this, where the bank
didn’t actually check your income, which I found confusing. It turns out even the
people who got them found them confusing. For example, a guy I met named
Clarence Nathan. He worked 3 part time, not very steady jobs, and made a total of
roughly 45 thousand dollars a year roughly. He got himself into trouble and needed
money, so he took out a loan against his house. A big one."
You can hear it (or read a transcript) at their website: http://www.thislife.org/Radio_Episode.aspx?sched=1242
