Wall Street's Meltdown: An Executive Summary

10/22/2008 05:12 am ET | Updated May 25, 2011

So what happened? What caused the Wall Street melt down this past week? My friends asked me to point them to a cogent explanation, but I couldn't find one. So this is my stab at it, in a very simplified format.

Writing Down AAA Mortgage Exposure

This year, banks, insurance companies and investment houses lost several hundred billion dollars against their equity because they were forced to write down, or mark to market, bonds that two years ago were rated AAA. Until recently, the historic loss experience on AAA bonds was nominal. Today, those bonds, which represent securitized subprime mortgages, are valued at something like 50 cents on the dollar.

The writedowns are done according to an industry benchmark that is, by most accounts, highly unreliable. But nobody has a better way for measuring these bonds' fair value, because nobody knows how the mortgage defaults will play out. Why the uncertainty? First, a lot of the underlying residential mortgages involved fraud. Second, the securitization, which sliced and diced ownership of the mortgages, has turned into a legal straightjacket that prevents anyone from taking charge and renegotiating the mortgages effectively. Third, this real estate bubble was so much bigger than any other in recent U.S. history, so no one really knows how long it will take to work off the excess supply of homes.

As investors shunned subprime mortgage securities, they also avoided mortgage securities for commercial properties where the underlying economic fundamentals, and likelihood of full recovery, are much better.

No One Knows What Surprises Lurk Within the $600 Trillion (Notional Amount) Derivatives Market

Financial institutions assumed "AAA risk" in other ways as well. They obtained credit risk insurance, sometimes known as credit default swaps, from other financial institutions, such as AIG. Lehman Brothers also had credit default swaps, along with hundreds of billions of dollars in other liabilities, both on and off its balance sheet, owed to financial counterparties. When Lehman collapsed on Monday, other banks and investment houses were forced to recognize losses on their Lehman exposure. Given the complications and uncertainties of bankruptcy law, it would be very hard for anyone to get a quick handle on the magnitude of the loss.

Uncertainty Leads to a Crisis In Confidence

The uncertainty surrounding the losses from Lehman, and potential losses from AIG, on top of the losses from mortgage backed securities, made everyone anxious about whether banks and brokerage houses would have sufficient equity capital by September 30, the end of the fiscal quarter. To preserve their capital, banks cut back on extensions of uncommitted credit, including inter-bank loans.

As a result, financial institutions suffered a crisis in confidence from which they could not easily recover. If you were a corporate treasurer, you might reconsider keeping your company's payroll account with Washington Mutual. Goldman Sachs might cut back on trading securities with Morgan Stanley. Citibank might stop trading foreign currencies with Bank of America.

The specter of everything grinding to a halt was what prompted Paulson to seek extraordinary powers to provide a credit backstop for the financial system.

Lehman Failed Because It Ran Out of Time

Lehman's demise was driven by timing. Its fiscal quarter ended on August 31, so it was compelled to report $7 billion in losses on mortgage backed securities on September 10, sooner than other banks. And Lehman's negotiations to sell itself to Barclays extended into the eleventh hour.

My hunch is that Lehman was the victim of hardball bait-and-switch tactics. On Friday afternoon September 12, Hank Paulson told Wall Street that the government would not step in to save Lehman. (If Paulson doesn't regret that statement, many others certainly do.)

By the time Barclays walked away from the negotiating table on September 13th or 14th, there was physically not enough time, before the opening of the markets on Monday September 15th, for Lehman to negotiate anything with anyone else. Lehman was forced to file for Chapter 11 on Monday September 15th, and a few days later Barclays was able to cherry pick Lehman's best assets and business units and buy them for a reduced price. Barclays had a competitive advantage over other bidders because of its earlier due diligence. Again, it's just a hunch. I wasn't in the negotiating room. But the tactic -- run up the clock to the last minute so the other side must decide when his back is against the wall -- is well known in the financial services industry. It's also a well known tactic on Capitol Hill, where it's being used right now.