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Over the last 10 years or so, Expert, Experienced and Highly Educated money people created new forms of mortgages. Alan Greenspan and Robert Rubin, two Expert, Experienced and Highly Educated money guys, thought it was a good idea for financial institutions to create these new "products."
Interest only mortgages, adjustable rate mortgages, sub-prime mortgages, balloon payment mortgages, etc, became common place. These were, by their nature, riskier than traditional mortages.
These new mortgages were included in what we've come to know as "mortgage backed securities." Securities that provided a return based on the average percentage mortgage in the bundle. Those securities are traded, bought and sold, daily on the open market.
As long as those bundles didn't lose the perceived value that their pricing was based upon....no problem. As long as more and more buyers were buying new mortgages, just like with a pyramid program, potential downsides could be basically ignored. However, because those who created the bundles didn't actually KNOW the value of those bundles, because of the variable of foreclosures on "creative" mortgages.....the risk was potentially astronomical. The reason they didn't KNOW the real value was because they didn't KNOW how many bad, and potentially bad, ARM's, interest-only, and sub-prime mortgages were in those bundles.....how many would become delinquent and eventually foreclosed upon. Why they didn't KNOW is fodder for another post.
When those same Smart Experts realized that perceived value was only that....perception....and not reality....the entire mortgage-backed securities bundles market dried up. They became too risky, too dangerous to fool with. That's what Paulson meant by calling them "toxic." Value could no longer be determined. Perception was all that was left.
Then, as those bundles deteriorated in value, institutions holding those bundles came to the government asking for bailout money to replace the losses incurred from those bundles that nobody would buy. At first, Paulson said the government would buy those "toxic" bundles from the institutions, thus, ending the bank's uncertainty of perceived value. Paulson changed his mind, primarily because if the government bought the bundles, CEO's could have their salaries and bonuses limited. Crazy stuff.
Anyway, the "new" money financial institutions received came from all the tax payers, the downline. If those institutions hadn't gotten the "new" money, they would have gone bankrupt.....as any failed pyramid program would have.
To make matters even worse, the Experts had decided to provide "insurance" to well-heeled buyers of mortgage bundles. No one actually KNEW the value of the bundles, so to "insure" they were worth something, these Experts needed to offer insurance to quell fears of investors. They didn't call it "insurance" because then the sellers would be subject to oversight. So, in their Supreme Expertness, they called that insurance, "credit default swaps." This is where AIG comes in. AIG provided the "credit default swaps."
When someone insures something, it's best to know the value of what is being insured. In the case created by all the Smartest Experts.....true value could no longer be determined. As more and more investors realized that those mortgage bundles were contaminated, because of mounting numbers of foreclosures....the "credit default swaps" insurance from AIG, and others, kicked in.....draining AIG's liquidity and creating their need of a bailout with downline tax dollars.
Because these bundles were also used as collateral, leveraged, naturally, by a multiple of anywhere from 4 to 30, it also became necessary to liquidate stocks and other paper investments to make up for the lost collateral in the bundles. Thus, the market decline. Much more selling than buying.
The financial collapse was created by borrowing against perceived value, insuring against that perception, and then investing even more with borrowed money collateralized on that perception.
Once the perception changed.....into reality....the entire house of cards came tumbling down.
Helluva way to run an economy.