This Sucker Could Go Down

Crises seem to awaken the inner poet of the commentariat, and the Crash of 2008 is no exception.

In the effort to wrap the mind around a phenomenon as expansive and convoluted as this one, literal description falls short. And so the metaphor mills have been grinding at full capacity.

'It's like living through an extended earthquake,' explained television commentator David Brancaccio, 'only we don't know yet if it's the big one or a foreshock of a big one to come.'

The New York Times offered 'a landslide changing the financial landscape'. Others likened the events to Hurricane Katrina or an eruption of Mount Vesuvius.

Even President George W. Bush reportedly chimed in at an emergency meeting with what sounded vaguely like a haiku: 'If money isn't loosened up, this sucker could go down.'

But perhaps the most popular, and most apt, comparison has been to a casino.

Commentators have identified the culprit as 'casino capitalism' or a 'casino economy', and more than one has proposed a small tax on securities transactions to slow down the betting.

The financial system, however, is an odd sort of casino. In most gambling houses, management runs the gaming so that the house always makes a profit. Card counters are thrown out by the bouncers.

In this casino, on the contrary, no one seems to be running the show. Players get to make up their own games and chain them together in ways so complicated even the creators don't always seem to understand them.

Normally, when a player loses the house takes his or her money. Here, if a player loses a large enough sum, the house intervenes and assumes the player's debts. Nobody knows exactly how much some clients have won or lost. Apparently, the house has lost control.

'What happens in Vegas stays in Vegas' is the motto of the archetypical gaming destination. In this case, however, what happened did not stay on Wall Street: it spread to banks and real economies around the world.

A big part of the problem is that this house is a disjointed collection of government and quasi-public agencies led by financial industry insiders. Many have attenuated power and little will to trim the wings of high-fliers like investment banks and hedge funds.

Nobel-laureate economist Joseph Stiglitz traced the roots of the breakdown to 'the spirit of excessive deregulation that the [George W.] Bush administration so promoted.'

In 2004, for example, the Securities and Exchange Commission, the fairy godmother of financial markets, granted a wish heavily lobbied for by the major investment banks: it loosened a key rule limiting the ratio of debt to equity for these firms.

This freed up many billions of reserves for investment, the equivalent of the casino offering unlimited free drinks to gamblers. At Bear Stearns, the first of the big five to fail, the ratio reached 33 borrowed dollars for every dollar of the firm's own money.

Some of that spirit, though, predates the Bush years.

During the previous administration, legislation demolished regulations on investment banks and the New Deal-era firewall between commercial banks and investment and insurance businesses. Senator Phil Gramm, John McCain's economic adviser, was a lead Republican protagonist, but President Bill Clinton and his Secretary of the Treasury, Robert Rubin, also supported the laws. Rubin, like current Secretary Henry Paulson, was formerly CEO of Goldman Sachs.

How does this metastasising Monte Carlo actually work?

If government regulators and Wall Street CEOs had known the answer, the crisis might have been averted. Surveying the ruins, though, it appears that the structure consisted of several floors offering a dazzling variety of games for those with enough capital and nerve.

From higher levels, players can make bets on events lower down. And, like Bear Stearns, they can borrow massive amounts of money to play with, which is known as leveraging. When their bet wins, leverage multiplies their winnings; likewise their losses when they lose.

The ground floor hosted a straightforward game played by millions of homeowners: home-equity hold 'em. Through the 1990s and into this decade, increases in U.S. home prices far outpaced overall inflation. Many families took out loans against the equity in their homes or refinanced them to pay for other needs: mainly things like medical emergencies and higher education, but in some cases less essential purchases. Pressures to tap into home equity were exacerbated by the DotCom crash and wage stagnation for many U.S. workers.

The great majority of these mortgages were sound at the time. But when home prices crashed, many homeowners were left holding loans larger than the value of their houses. The Fed and Treasury failed to warn citizens or to take action to deflate the bubble gradually before it popped.

Perched precariously on top of the bubble, the second floor offered games like refi roulette. Lenders thrust adjustable-rate mortgages and 'creative' financing schemes on overstretched home buyers, some of whom didn't understand the potential downside and borrowed beyond their means.

When low initial interest rates went up and home prices declined, mounting numbers of borrowers both prime and sub-prime began to default on their loans. Foreclosures, the U.S. procedure for dispossessing delinquent home buyers, grew rapidly.

The third floor of the casino was a Wall Street theme park where mathematicians, physicists and economists could act out their wildest fantasies.

Mortgage lenders sold their loans to intermediaries, such as Fannie Mae and Freddie Mac, who aggregated the mortgages into pools. These collections obscured the identity and value of the sub-prime loans they contained.

Based on these camouflaged values, alchemists at investment banks and hedge funds created byzantine unregulated securities like 'collateralised debt obligations'. They also marketed derivatives that placed wagers and counter-wagers on the risks lurking in the murky loan slurry.

Large volumes of these infected securities and derivatives found their way into portfolios around the globe. As the extent of sub-prime loan defaults became clear, the securities based on them began to putrefy. Widening circles of financial institutions, often unaware how much they were exposed to the contagion, began to rot from within, then suddenly bled from the orifices and collapsed.

The fourth floor of the casino was a gigantic confidence game, but also in a sense the foundation of the whole edifice: the interbank payment system.

Banks need to loan and borrow short-term money from each other constantly in order to provide credit and cash to businesses and individuals. Without liquidity -- accessible money and easily convertible assets -- to grease the gears of commerce, the machine grinds to a halt, as in the Great Depression of the 1930s.

Playing on this floor requires trust and cooperation between players. But the plague of degraded mortgage-based securities and derivatives, and lack of transparency into who owned how much of them, led to a breakdown of confidence. Nobody knew whom they could trust.

As a result, banks began to raise the rate of interest they charged each other for short-term loans. On Wednesday, Sep. 17, interbank credit seemed on the verge of freezing. Had this happened, cash machine withdrawals, credit card interactions, and short-term business loans might soon have been imperiled.

Now the high rollers have headed to Washington to try to salvage the casino. Meanwhile, the fear and greed that broke the house continue to reverberate around the world.