I’m no expert but I thought this might be useful to someone. Edits encouraged.
“Lehman and AIG have a lot of money tied up with bad assets (that were poorly priced subprime mortgage bundles or a security tied to those bad mortgages) that had to be written down (when something turns out to be worth less than it had been).
What happens is that when an asset is written down, investors get nervous and call on their debt – as they are worried you might be unable to pay it back later (classic run on the bank) and so the company loses the liquidity offered by that debt. You need a certain amount of liquidity to function, and if you cannot get it then the run on the bank continues until your business is paralyzed.
So a vicious cycle ensues.
No one wanted to buy lehman because it would mean guaranteeing against default all of those incredibly risky (read: worthless) assets. Lehman should have acted on this months ago (as Merril is doing now) and today may have been avoided.
In the Bear Sterns case, paulson promised to back those bad assets on behalf of JP Morgan, so a deal was done. In this case he refused to, likely due to moral hazard considerations. Commerical banks backing pure investment banks (JP buying Bear, BofA buying Merril Lynch) seems to provide a solution, as they have a massive cash base to fund potential writedowns. Hopefully MS and GS can avoid having to resort to that.
So I guess this isn’t really an issue of fundamentals – the wheels, it’s an issue of the financial markets – grease on the wheels. Unemployment and gdp growth have nothing to do with this, but they will surely be effected. When companies require capital they come to investment banks. But the question is who will finance the financers? If investment banks themselves require capital then their ability to finance others will be compromised. This will have broad implications.
It’s a result of some incredibly bad decisions across the financial system mixed with greed and short sightedness. Couple that with a seemingly unquenchable thirst for credit from the American people and the world met by an enormous amount of cash around the world waiting to be invested anywhere for the highest returns no questions asked, and this is the result.”