A Good Nutshell Explanation of the Sub-Prime Crisis

My big "Eureka" moment on economics came when I realized for all the talk about monetary "policy" and economic "science", all financial systems are based on one thing: psychology. No economy is based on objective measures of value, but rather on the faith of every member of the economy that the things around them have worth. Take away the faith, and the economy collapses, and you may even be returned to the most basic of human economic analyses: "Can I eat that?"

But even this tool has not always been useful in analyzing the current sub-prime mess which is pushing the economy (probably has pushed it) into recession. I understand that many people borrowed money at interest rates they could not repay. What I don't understand is (1) why banks made such stupid bets that were guaranteed to work against them, and (2) why so many people took out mortgages with rates they knew they could never afford. The NYTimes does a good job of explaining some of the complexities.

And it largely explains why the mortgage mess has had such ripple effects. The American home seemed like such a sure bet that a huge portion of the global financial system ended up owning a piece of it. Last summer, many policy makers were hoping that the crisis wouldn’t spread to traditional banks, like Citibank, because they had sold off the underlying mortgages to investors. But it turned out that many banks had also sold complex insurance policies on the mortgage debt. That left them on the hook when homeowners who had taken out a wishful-thinking mortgage could no longer get out of it by flipping their house for a profit.

Many of these bets were not huge, but were so highly leveraged that any losses became magnified. If that $100 million investment I described above were to lose just $1 million of its value, the investor who put up only $1 million would lose everything. That’s why a hedge fund associated with the prestigious Carlyle Group collapsed last week.