You might not notice from looking at the local news, but not only is the country in the midst of the largest financial disaster since the Great Depression, your national government is about to take the most significant political action of the decade, arguably more important than the AUMF that got us into the Iraq War, to avert a total meltdown. If you don’t know anything about it, now’s a good time to catch up, since the current plan proposed by the Bush administration will put us all on the hook for $700 billion in bad debt . . . and all controlled by Henry Paulson with no judicial or legislative oversight allowed (a “clean” bill, to borrow the current euphemism).

Update: Indeed (via).

1. What happened?

Today’s word is “credit default swap.” Basically we’re well past the point where mere mortgage fraud and default is the problem. Over the past decade, lenders made it possible for people to take on home loans they never should have gotten into, either because the borrowers were too poor to buy a house at all, or because the excessively generous initial terms (low initial rates, “liar loans,” etc.) tempted people to buy homes that were too expensive, or to buy too many homes.

All that started blowing up, as you probably know. What you may not fully understand is that investment banks turned those initial loans into increasingly complicated meta-investments, which were then repackaged into meta-meta investments, for the purpose of spreading risk. Devilstower at DailyKos puts it clearly (emphasis his):

“Credit default swaps did allow the banks to share risks. So much so, that banks raced each other in an effort to find more risks. They made it possible for the down payment on homes to become 3%, 1%, 0%.”

Let’s say, for example, that I take out a mortgage. All that means is that the bank gives me a bunch of money, and I have to pay it back with interest. I’ve made a legally-binding promise, and that promise is worth money. So the bank will try to loan as much money as it can, since it stands to make money from each promise.

But it’s still just a promise. The bank is betting that I will pay off my mortgage; it’s taking a risk. The balance that has to be struck is between taking as many risks as possible, since that is how they make more money, and ensuring that in the event of disaster the failed risks won’t overrun the successful ones.

Normally a bank would strike this balance by making loans on safe terms. But by limiting risk in that manner, they limit their potential market.

So let’s say I want to take out a second mortgage on a second home. I probably shouldn’t do this, and the bank probably shouldn’t loan me the money. But I think I can either get a better job, or inherit money, or flip the house at a profit. And the bank wants to take on more risk. So what do they do?

Basically, they buy insurance on my promises–that’s a credit default swap. They pay someone else a premium for another promise: the promise that, if I default on those two mortgages, the insurer will give them the money I couldn’t pay. The bank will make less money on those risks, but more than if I and the bank didn’t take on a second risk.

Hopefully you’re starting to see the problem. At the very bottom level of this mess is merely an agreement, that I will pay off two mortgages. That’s it. It’s not an actual thing or real money: the “product” is a promise that I will give them actual money. Then, on much higher levels, those promises of money get bundled into promises, which really aren’t all that different in principle.

Here’s where the housing market comes in. It adds another level of speculation–maybe I took out a second mortgage to buy a house in an up-and-coming area because I thought I could then sell it for more money because housing prices were going up. In other words, I promised to pay back money based on what I speculated another person would promise in the near future. There are a lot of tools to guess that, but it’s still just a guess.

When I can’t pay my mortgages, the bank goes to the CDS issuer and says, hey, he defaulted, so you have to pay out from the insurance we bought. The issuer takes the money that it made from the CDS premiums or other investments and gives it to the bank. But then a second bank wants its money. And a third, and so forth. That’s what happened to AIG: “In the scramble to make good on the C.D.S.’s, A.I.G.’s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world. . . .”

And it turns out that banks seeking more risk, and thus more profit, made too many loans to people who couldn’t or didn’t keep those promises. And then the CDS issuers can’t fulfill their promises to follow through as insurers.

And that’s a gross simplification. Banks figured out all sorts of opaque ways to make promises to each other, but no one makes those promises for free, so each promise added to the amount of money that was supposed to change hands.

2. What do we have now?

Basically, a bunch of promises that cannot be fulfilled. Homeowners can’t pay banks; CDS issuers can’t pay the banks; and so forth. As Devilstower puts it: “The unregulated and poorly reported credit default swaps may have actually passed $70 trillion last year, or about $5 trillion more than the GDP of the entire world.”

And when those promises can’t be fulfilled, we don’t know what they’re worth. They exist, but no one has any idea if those promises have any value, and if so, how much.

Update: Bonddad: “Everyone is acting as though factors that correctly determine the value of assets in the market for some reason shouldn’t apply to this situation. The bottom line is some of these assets (CDOs, CLOs, CMOSs etc…) are crap. The market should value them as crap. Simple.”

3. What the fuck are we going to do about it?

Good question! That’s what’s happening at a feverish pace right now.

On Friday the Treasury asked for $700 billion dollars. That money would be controlled by Secretary of the Treasury Hank Paulson. He would buy “troubled assets,” mostly mortgage-backed securities, i.e. promises, with that money. He would have absolute discretion to buy whatever troubled assets he wanted with no effective oversight: “it would place no restrictions on the administration other than requiring semiannual reports to Congress, granting the Treasury secretary unprecedented power to buy and resell mortgage debt.”

Paul Krugman argues that Paulson would have to buy those troubled assets at far more than “fair price” because otherwise the bailout would mean fuck-all. And for kindly bailing their ass out we, the tax payers, would have no ownership over the companies: “Mr. Paulson insists that he wants a ‘clean’ plan. ‘Clean,’ in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out.”

Honestly, I’m still trying to figure out how that part works, but I think it means: Paulson buys the assets with our money at inflated rates, because the rates have to be inflated, otherwise the bailout doesn’t work. He then sells them at a loss because no one will actually buy the assets at well above market price unless they have to.

And that’s not the whole of it. Calculated Risk sees it working this way: “every time the Treasury sells some securities, they will probably plow the net proceeds back into more troubled assets until the entire $700 billion is gone.”

Fortunately, Christopher Dodd is less inclined to just give all our money to failing investment banks for the purpose of just being really nice to them, and is working on a plan that would give taxpayers equity stakes in any company that sells us its crap through the bailout plan. Paulson seems to have agreed to that but it’s all moving very, very fast right now.

And, in case you weren’t feeling bad enough, here’s how it’s currently being framed: “The challenge facing Paulson, Dodd, Frank and the party leaders in Congress: How do you strike a deal with one another while simultaneously persuading rank-and-file members not to give in to the hue and cry they’re hearing from back home?” 

If you want to make a hue and cry, time’s running out.

Update: Ezra Klein makes an important point: “If your business has $20 in the bank, and your creditor is demanding you pay back your full $100 loan next week, you’re going to collapse. If you then restructure the debt so you pay back $10 a week, and you pay $120 in total, you may have lost more money, but you didn’t collapse. The problem with the bailout plan is that we’re supposed to be buttressing Wall Street against the possibility of collapse, but Paulson went a step further and constructed the government’s approach to help protect against loss.