It's that time again,

for another happy-happy Monday morning post about the economy! Yay! Everyone gather around, and let Uncle Jim tell you a story...

"We're screwed."

Did you like my story? Oh, you want details? If you insist.

No, I'm not going to talk about the Dow being down below 7,000 for the first time this century (it's at 6,900 as I write). Nor about the news this morning of AIG's additional $61.7 billion loss last quarter. Those are just symptoms.

To really understand what is happening, listen to this weekend's episode of This American Life, part of which I touched on last Friday. It'll help explain how and why the fundamental problem is a political one: no one really wants to face the prospect of doing what has to be done to clean up this mess, because it would mean too many powerful interests get burned. Rather, everyone - all the bankers, all the investors, the US and European and Japanese governments - is hoping beyond hope that they can finesse their way through this, and things will skate by on the thin ice and get better sometime, somehow.

Why do I say that? Because, as they said in the "Bad Bank" episode, nationalization of banking systems has been done before. In fact, it's been done a lot of times. But usually in this or that small foreign country, and under the direction/demand of the IMF as a condition of aid. Nationalization means that the government steps in to protect the overall economy by forcing corrections in the banking system directly - that is, the government takes over (to some degree) the operation of the banks for a period of time. And this means that while the government involved usually has to assume some of the costs, that shareholders and investors take the worst hit. Oh, and the bankers who created the mess usually get tossed out if not tossed in prison. (An aside: someone commented recently that if this were happening in China, that people would be executed. I can't say that I think that would be a bad idea.)

But the current problem is so widespread, and involves so much of the business/monied classes in the US and Europe, that nationalization is generally considered a 'nuclear option', a last resort to be avoided at almost all costs.

Well, we're seeing what "all costs" means, right now. I do actually want to talk about AIG a bit here. You should read Joe Nocera's column from last Friday, titled "Propping Up a House of Cards". Here's a couple of relevant excerpts:

If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.

* * *

There’s more, believe it or not. A.I.G. sold something called 2a-7 puts, which allowed money market funds to invest in risky bonds even though they are supposed to be holding only the safest commercial paper. How could they do this? A.I.G. agreed to buy back the bonds if they went bad. (Incredibly, the Securities and Exchange Commission went along with this.) A.I.G. had a securities lending program, in which it would lend securities to investors, like short-sellers, in return for cash collateral. What did it do with the money it received? Incredibly, it bought mortgage-backed securities. When the firms wanted their collateral back, it had sunk in value, thanks to A.I.G.’s foolish investment strategy. The practice has cost A.I.G. — oops, I mean American taxpayers — billions.

Here’s what is most infuriating: Here we are now, fully aware of how these scams worked. Yet for all practical purposes, the government has to keep them going. Indeed, that may be the single most important reason it can’t let A.I.G. fail. If the company defaulted, hundreds of billions of dollars’ worth of credit-default swaps would “blow up,” and all those European banks whose toxic assets are supposedly insured by A.I.G. would suddenly be sitting on immense losses. Their already shaky capital structures would be destroyed. A.I.G. helped create the illusion of regulatory capital with its swaps, and now the government has to actually back up those contracts with taxpayer money to keep the banks from collapsing. It would be funny if it weren’t so awful.

OK, still, AIG was just a symptom, even as central a role as it plays in this fiasco. What was the cause?

It's tempting to say "greed" and just leave it at that. But the problem is bigger than that. It's "trust". Trust that housing prices would continue to rise, regardless. Trust that people would act rationally, and only buy homes that they could afford. Trust that loan officers would only loan to people who were qualified. Trust that bank managers would execute proper oversight. Trust that banking executives would exercise due judgment. Trust that credit markets would operate to offset risk with reserves. Trust that rating agencies would rate risk appropriately. Trust that the invisible hand of the marketplace would keep excess in check. And trust that failing any of these, the govermental regulatory agencies would intercede and enforce statuatory limitations.

Well, you can see where trust has gotten us. Take nothing on faith. Over the last couple of decades, regulation was relaxed and business sought to push the boundaries further, creating new financial instruments which the average person can barely understand. The experts told us it was all hunky-dory, and we believed them. But we should have noted that they were the ones to benefit from the whole scheme, and been less trusting. Or, more accurately, we should have demanded that our elected representatives in government were less trusting. But they stood to benefit as well, with the corruption of corporate donations to campaigns and lucrative Board positions once politicians left office.

I must admit to being sorely tempted to come to the conclusion that we deserve what is happening. Very sorely tempted.

Jim Downey

(Cross posted to my blog.)