So what does a lack of regulation and oversight lead to? Securities rated safe packaged with safe and subprime mortgages. These mortgage-backed securities allow subprime loans too be bundled together and then further insured with Credit Default Swaps (CDS). If I’m a lender at a traditional bank and instead of selling a loan that my bank will have on the books for 30 years, I’m selling a loan that we will resell “risk-free” in a few weeks — I don’t have to worry about doing my homework. And that lack of regulation for all of this allowed interest-only and ARMs to be given to subprime borrowers with the justification that the ever-increasing housing market (read Irrational Exuberance, 2nd edition which correctly predicts the housing bubble) will allow these borrowers to “grow” into their mortgages. A system was built that allowed people that couldn’t afford loans to get them, and made it in banks’ interests to sell them no matter what. The fact that people took out these loans and banks loaned this money means that each were acting in their own self-interest, a fundamental assumption of how unregulated free markets are supposed to work. But it is up to the government to set the stage for these interactions and make sure that when everyone acts in their own self-interest we all don’t end up with a prisoner’s dilemma in which we are all worse off.

Fundamentally the real problem wasn’t only a lack of regulation for subprime loans but the shadow market of credit default swaps. Put simply, credit default swaps are unregulated “insurance” contracts between large investment houses that allow the insurer to ignore any capital requirements to cover the condition where the “default” occurs. Okay, maybe “put simply” is an overstatement. What happened was a large number of very big firms realized they could make an amazing amount of money selling these CDS “insurance” contracts. Many of the very same firms would buy these same CDS derivatives to hedge risky investments. When they hedge on a large and risky investment, it becomes “risk free” — unless the seller of the CDS can’t end up paying. Warren Buffet in early 2003 called derivatives, like CDSs, “financial weapons of mass destruction.”

AIG specifically was not both selling and buying CDSs like many firms, but only selling. They are an insurance company and had a small 400 person office (they have a international workforce of more than 100,000) working on CDSs. That small office brought down the company because they made huge amounts of money selling CDS insurance policies with NOWHERE near the amount of capital to cover the condition that they needed to cover another group defaulting. And because there was no market or regulation for these contracts, there were no capital requirements ensuring that they could actually cover them. They were using actuarial tables similar to personal injury tables; these tables calculated each contract as independent of all other contracts. This meant that in the unlikely event of having to payout on a CDS, it was not any more likely they would have to payout on others. As Jon Stewart would say, “funny thing,” turns out that they are all connected.”

So the CDS market is completely unregulated. There is no oversight, no exchange, and so no one actually knows what the total of CDSs are — the estimate is around 60 trillion dollars. This means that if everyone defaulted, these companies would owe $60 trillion. And 700 billion is 1.1% of that. The good news is not everyone will default.

Mix these new mortgage-backed securities with the fragile international market that the credit default swaps lead to in backing them. And add to that agencies rating the risk of mortgage-backed securities who are paid by the investment banks packaging and selling them. And add the irrational assumption that house prices will go up double digits each year (only health insurance costs do that).

So when the real estate bubble bursts, it hurts. But it really hurts mortgage-backed securities that are supposed to be fairly risk-free. And the companies that have insured many of those securities via CDSs now owe money. Because they don’t have the liquid capital (ie cash flow) to pay on these defaults, they must sell assets. When everyone sells assets to pay this off, they start losing their value. This loss of value triggers more default conditions to be triggered and selling from the many companies that don’t have the capital that a well-regulated market would have required. Back to AIG. AIG was a seller of CDSs. Their traditional insurance pool didn’t come close to cover what they had gotten themselves into. A well-regulated market would have required that they had enough capital reserves to cover all these CDSs just like the banking industry after the Great Depression were required to keep certain amounts of cash on hand.

So there’s the problem. And there’s a temporary and there’s a longterm solution. The temporary solution is capital to the banks, injections of liquidity, etc. The longterm solution is oversight, regulation, and willingness to admit that the answer is not breaking government but fixing it. Fully free markets will lead to huge corporate mergers, ownership of the political process, corporate demand for as few regulations as possible, no attention to externalities, and a search for short-term profits that trump any societal risk. Well-regulated markets means breaking up large companies so they can be competitive. It means oversight and setting rules of how markets, contracts, and business operates.