How we got here

 So how did we get to the financial mess we're in?

1. For most of the last 20 years, growth of the U.S. economy has been driven by consumer, rather than industrial, spending.
2. In the last ten years, consumer spending has been amplified by the availability of easy credit, especially for buying homes. Many of these home loans, called Adjustable Rate Mortgages, or ARMs, had a low initial interest rate for three to five years, which then adjusted to a higher rate based on prevailing interest rates at the time. Some loans even had an option called Negative Amortization, where borrowers could pay less than even the monthly interest payment for a period of time; this allowed many people to buy homes that they couldn't afford.
   
3. The easy credit caused a run on housing, which increased prices.
4. The increase in home prices allowed homeowners to take out second mortgages and lines of credit, backed by the increased value of their homes, but without commensurate increases in personal income.
5. Financial institutions packaged these home loans together into securities (Collateralized Debt Obligations, or CDOs) that hid the underlying risk of default by individual homeowners. No one knew what the true underlying risk was, but credit rating agencies gave these securities AAA ratings, the highest possible.
6. Financial institutions bought and sold Credit Default Swaps (CDSes), totally unregulated financial instruments that were intended to provide insurance in the event that the CDOs lost their value. Unlike conventional insurance, in which the insurer is required by law to keep a sufficient financial reserve to cover losses, there was no such requirement for the purchaser of CDSes. Banks could buy CDSes for pennies on the dollar. For example: A bank could purchase a million dollars of protection for a CDO for $50,000, and the seller of the CDS would have no requirement to have any capital reserve to cover losses. If the value of the insured CDO dropped to $500,000, the CDS seller would be in the hole by $450,000, potentially with no reserves to cover the loss. To minimize this risk, CDSes could be insured by other CDSes.
   
7. When marginal homeowners started to default on their mortgages and lines of credit, the value of CDOs plummeted, because no one knew how much they were truly worth. "Mark-to-Market" accounting rules required the financial institutions to value the CDOs at what others were willing to pay for them.
8. The collapse of CDO values caused the fall of Bear Stearns earlier this year, and put banks around the country under pressure. IndyMac Bank in California failed and was taken over by the Federal Government.
   
9. As the values of CDOs declined, the money in Credit Default Swaps was needed to cover these losses, so the CDSes also became all but worthless, leading to the fall of Lehman Brothers and the bailout of AIG by the U.S. Government. In an auction held on October 10th, Lehman's $400 billion worth of CDSes were valued at 8.625 cents to the dollar, meaning that investors who had agreed to insure these CDSes will have to pay out 91.375 cents to the dollar. Where will they come up with that money? Who knows?
10. The collapse of Bear Stearns and IndyMac, along with all the other problems, caused the stock market to drive down the value of shares in banks, brokerage firms and other financial institutions.
    
11. Because of the fear of not having enough value in the CDOs to cover the CDSes (and vice versa,) banks and other financial institutions began hoarding cash, placing it in short-term U.S. Treasury bills, rather than lending it out to businesses, consumers or other banks.
12. Fear of not being able to get their money caused consumers to pull their money out of the riskiest banks, including Washington Mutual and Wachovia. The Federal Government took over Washington Mutual and sold it to J.P. Morgan Chase, and yesterday, Citicorp agreed to walk away from an earlier agreement to acquire Wachovia in favor of a better deal from Wells Fargo.
13. With almost no credit available and housing prices crumbling, consumers cut back their purchases dramatically, and businesses couldn't get financing. Unemployment increased.
14. The decline in the value of shares in financial institutions spread across all sectors of the stock market, and turned into an outright panic as falling prices caused investors to pull their money out, in order to avoid additional losses.
    

And here we are.