I have read a version of this many many times, but don’t entirely understand. There is no necessary relationship between the decline in prices and delinquency, is there? Individuals’ cash flows/incomes didn’t change because their houses’ values dropped, so theoretically they could have just kept paying their mortgage (although with great bitterness), right? So what is the relationship between falling prices and delinquency? Is it that the buyers thought they could sell the house for a good profit before their rates adjusted upward, or before their inability to pay at the current rate caught up with them? Thank you! Fantastic site!

That said, those institutions can take losses on many things other than CDS, and many of those things are not zero-sum. For example, when mortgage-backed securities fall in value, everyone holding them loses money, and may need new capital to compensate. So the real question is whether $700 billion is enough relative to the cumulative asset writedowns being taken by banks. My guess is no, but it is the right order of magnitude.

If one is to understand and prevent this in the future it must first be diagnosed properly. Certainly the collapse highlighted greed and incompetence, but the bets that collapsed were based on beliefs that US consumers would continue to pay their mounting debts (based on ever increasing housing prices). Kind of like the logic that internet firm stocks can justify stratosperic prices even if they don’t now and will not have in the forseable future any profits.

The real beginning of this mess began in the early 90’s when US consumer spending declined from a steady 8-9% of disposable income and consumer debt rose dramatically to ~130% of disposible income. For close to 20 years most American consumers have been living $100,000 lifestyles on $60,000 incomes. This was encouraged by everyone from our politicians (even the very ones now proclaiming surprise that this could happen) who consistently encourage the Fannies to loan money to those who can’t afford it, to the firms who profited from the ~20 years or deficit spending.

Without understanding fundamentals like this one can’t clearly see the path forward. Calls for lending to get back to where it was ignores the fact the average american consumer is already overburdened with debt. Hopes that a bailout of auto-industry and their union employees whose compensation is 50%+ more than the average american ignore the fundamental cost disadvantage they have vs their counterparts. Japanese companies have made cars (and money) in the US for over 25 years. Providing money to the US automakers now will only delay the inevitable and provide taxpayer support to private equity firms (who are prudent enough not to invest more in their progeny) and the unions (who democrats are beholding to). The Detroit titans will be back at the trough because they have fundamentally unsound cost structures and legacy costs. Their unions (seeing the writing on the wall) are hoping they can get the US public (who is on average paid much less well) will bail them out of their imprudent deals obtained through collusion with auto management (i.e., I’ll demand less in pay now for the promise of unrealistic riches in the future). Politicians understand this logic as they are forever ignoring fixing Social Security or other problems so as to be able to promise new goodies to constituents now (witness the promises many public sector unions have wrangled from them for future benefits. New York City won’t be the only one struggling to pay for these and basic services in the coming years.).

To some degree bailouts might be necessary to stabilize a financial system or ‘cushion the transition’ to a less materialistic US lifestyle, but unless one recognizes the US consumer debt burden and diagnoses the problem appropriately the proper plans and actions will never be taken. A focus on the financial market excesses is very appropriate, but while it might be the visible factor that precipitated our problem, it is the American consumer and their politicians desire to live beyond their means that is the fundamental trigger of all this.