Long, and almost certainly wrong, the only question is how wrong, explanation of the CRISIS ON WALL STREET, Part 1

So, G. (no, wait, it's g.) posted an hour long YouTube video that took me about 8 hours to get through, because I stopped, looked stuff up on wikipedia, rewound and listended to again, etc. I wrote as I went along, too, and here's what I wrote.

My understanding of “Crisis on Wall Street” : Princeton economists review recent events on Wall Street and assess the implications for the economy and public policy – September 23rd, 2008
posted on Impolite Company: http://morisey.typepad.com/my_weblog/ and available on YouTube at http://www.youtube.com/watch?v=Wj_JNwNbETA


The “guys” referred to are Princeton professors. They have names, but since their names mean less to me than their order of appearance, I’m just referring to them as Guys 1-3.

Guy 1
Guy 1 in one Sentence:
"It's like the depression - panic feeds on panic and things spiral out of control."

Guy 1 in detail:
So, these companies that are making money for themselves and their clients (broker-dealers) are too into the short-term loan business (repo-market) and the market loses confidence. Suddenly it costs a whole lot more to get a loan (the haircut), and they have to scramble to get back into real money instead of taking out loans and re-loaning the money at a higher interest rate (delever). Chaos ensues.

The problem, he says, is that the existing regulations are all about how much real money (assets) you have divided by how much perceived money you have (capital) (the capital ratio), without taking into account how much of that capital could disappear literally overnight (because it's in the repo market) - and also that risk is assessed intra-bank and not inter-bank (VaR vs. CoVaR).

And ALSO, since none of the banks really knows how screwed the other banks are, they all start getting nervous and taking out insurance against each other so if the bank they've loaned to goes down, they're still ok. Except that the credit rating companies use the insurance (the Credit Default Swaps) to gauge how screwed the banks are (because they don't know either), and start saying they have bad credit, and everyone's like "I knew it! I need more insurance!", insurance rates go up, and then the cycle repeats. [So, why did AIG go under? Seems like the Credit Default Swaps should have the insurance entities in good shape, as their rates go up and up….oh, but I guess it’s like when the hurricane hits. Suddenly everyone needs the money because everybody’s fucked – but the fucking in part was created by the buying of the insurance. Nasty!]. He says if the US allowed CFD's (Contract for Differences), either bank-to-bank ("over the counter") or on the stock market (a clearinghouse model), that would allow a more informed notion of how screwed the other banks were (the Counterparty Credit Risk).

And THEN, he starts talking about the TED Spread, which is again about measuring risk (it's got to do with treasuries vs. everything else). And the banks look a lot riskier at the end of each quarter, I guess because they're all "omg, we need money to tell our stockholders about!" and start doing riskier things or whatever - so he says, if the TED spread is going to be greater at the end of the quarter, let's let banks report on the average instead of the snapshot.

Guy 1 Definitions:
Broker-dealers: http://en.wikipedia.org/wiki/Broker-dealer

Repo Markets: http://en.wikipedia.org/wiki/Repurchase_agreement

Market liquidity: http://en.wikipedia.org/wiki/Market_liquidity

Haircuts: http://en.wikipedia.org/wiki/Haircut_(finance)

Deleveraging: http://en.wikipedia.org/wiki/Deleveraging

Capital Requirement: http://en.wikipedia.org/wiki/Capital_requirement

Capital: http://en.wikipedia.org/wiki/Capital_(economics)

Assets: http://en.wikipedia.org/wiki/Asset

VaR (value at risk): http://en.wikipedia.org/wiki/Value_at_risk

CoVaR: the only reference I could find is here:
http://www.newyorkfed.org/research/staff_reports/sr348.html - basically, the value at
risk (VaR) of financial institutions conditional on other institutions being in
distress. (I notice that Markus K. Brunnermeier is a co-author. In other words, he
made it up).

Contract for Difference: http://en.wikipedia.org/wiki/Contract_for_difference

Counterparties: http://en.wikipedia.org/wiki/Counterparties

CDS (Credit Default Swap): http://en.wikipedia.org/wiki/Credit_default_swap

Credit derivative: http://en.wikipedia.org/wiki/Credit_derivative

Treasuries: http://en.wikipedia.org/wiki/Treasuries

TED Spread: http://en.wikipedia.org/wiki/TED_spread