In my last post, I blogged about what the !@#$ has happened to our financial and economic systems. Today, we’ll explore why.

Though the problem is now much, much bigger than bad subprime loans, that’s where our story begins. Subprime loans came into vogue after global demand for investments mushroomed in the early 2000s. In just six years, the amount of money invested globally doubled to $72 trillion. In other words, people were looking for creative new investments for their money -- and lots of it.

So Wall Street got into the mortgage business. Instead of a simple relationship between a bank (the lender) and a homebuyer (the borrower), the new mortgage market was underwritten by those global financiers with tons of money to invest. Wall Street investment banks like Bear Stearns and Lehman Brothers bought mortgages from the lenders and bundled them into a new type of investment called mortgage-backed securities.

But there were two underlying problems with the mortgage-backed securities, problems that would prove disastrous: first, because there was so much demand for these kind of investments, Wall Street bankers gave lenders tacit -- or maybe explicit -- approval to lend to anyone with a pulse. We’ve all heard the stories of the guy making $40,000 a year with a 580 credit score who get a $600,000 mortgage.

The second problem was that these loans, while anyone could qualify, were by no means giveaways. Creative new forms of financing -- interest-only loans, option ARMs, and adjustable rate mortgages -- ruled the day. They came with super-low teaser rates that lasted only a brief while, after which they adjusted to much higher rates. And kept adjusting. 

Those two problems made for an environment in which rising rates of default were inevitable. And rise the default rates did.

Which wouldn’t have been too big a problem if the buyers of those Wall Street bundled mortgages actually knew the high risk involved in the underlying mortgages. But they didn’t. Wall Street bankers grossly underestimated the risk associated with subprime mortgages, often slapping prime ratings on bonds made up of risky mortgage-backed securities.

To make matters worse, investors were making bets on top of their bets. Instead of paying $1 to buy $1 worth of mortgage-backed securities, as you or I do when we invest in the stock market, for example, banks were borrowing money to buy into those investments. They would pay $1 to buy $100 worth of securities, which meant that when their investments increased in value, they saw enormous returns. It also meant that when their investments decreased in value, not only were they left holding bad investments, but they also had massive amounts of debt that they had taken on to finance those investments.

Magnifying the losses: credit-default swaps

As if that wasn’t bad enough, investors were making even more bets on top of their bets (which were already bets on bets). They bought into what Warren Buffett calls “weapons of financial mass destruction” -- credit-default swaps. To compare, the market for mortgage-backed securities themselves was $1 trillion large, but the credit-default swap market has $62 trillion floating around.

Credit-default swaps are, to put it nicely, insurance on debt holdings. To put it more realistically, they’re side bets on whether a given debt will go bad, and they’ve magnified the negative effects of the subprime crisis many times over.

Imagine a bank that owns mortgage-backed securities. When the bank bought the securities, they were worth $1000, but they’ve since decreased in value 40%. The bank hasn’t taken any actual losses -- it hasn’t sold those securities for a loss -- but U.S. accounting rule nonetheless require that the bank report the 40% decline in value as a loss against assets. When a bank “writes down” debt -- like all major U.S. banks have -- that’s what’s going on.

As banks across the U.S. (around the world, actually) took huge write-downs on their mortgage-backed securities, by now being called “toxic” debt, their assets available for use in the market decreased rapidly. That began to cause liquidity concerns. Those concerns, in some cases, drove runs on the banks, where account holders rushed to get their money before the bank’s available cash disappeared. Even banks that were financially solvent before the bank run were left cash-strapped and on the brink of bankruptcy.

But in the case of Bear Stearns, the first investment bank to fail, the government and JPMorgan Chase came to the rescue. While the company’s shareholders lost their money in Bear Stearns, bondholders were protected.

So when the government failed to do the same for Lehman Brothers on September 15, the market reacted quickly -- and violently. Bondholders and investors in other banks rumored to be in trouble -- Merrill Lynch, Morgan Stanley, Goldman Sachs, WaMu, and Wachovia -- feared that if those banks failed, the government wouldn’t bail them out and bondholders would lose their too.

Fearing bank runs like the ones Bear Stearns and Lehman Brothers faced, investment banks began to hold their money tightly. Commercial paper markets -- which provide short-term loans to businesses across the U.S. for everything from raw materials to payroll -- froze. Banks became increasingly reluctant to loan money even to each other.

It’s a crisis of confidence that the government is trying desperately to overcome, though signs are that even the $700 billion bailout package hasn’t really calmed markets, nor have the Fed’s infusions of liquidity (in the form of bank loans) helped much. Investors are scared -- they’re pulling their money out of bonds funds, and certainly not investing more (expect for Warren Buffett, that is). Banks are scared -- they’re hoarding their cash, preferring to invest in ultra-safe Treasury bills paying yields close to zero than to lend to one another. 

That’s how the real estate downturn turned into a subprime mortgage crisis turned into a credit crunch turned into a cash crunch. And, experts say, if the U.S. isn’t already in a recession, we’re headed for one for sure.

So that’s why this !@#$ happened; the question now is what to do about it. What do you think?