Well that about sums it up:
Suppose somebody wants to make a bet with me that the San Francisco 49ers will win the next two Super Bowls. He gives me $100 today, and I have to give him $100 million in case he’s right. The chances of this happening are very small, but just in case the impossible happens I want some backup. I buy insurance from my next-door neighbor. I offer to give him a nickel every week in return for his promise to cover my bet.
My neighbor sees that he has a good thing going — getting money for nothing. After a while he takes on more and more bets until others follow in his footsteps. Soon, a market develops. In effect, people can bet on bets. Eventually, the total potential amount of money builds up into the billions and trillions of dollars.
Unexpectedly, the San Francisco 49ers win two Super Bowls in a row. My neighbor does not have $100 million on hand to cover my loss. The nickels I have been giving him have been wasted. I don’t have $100 million either.
Suddenly everybody in the market is worried about people’s ability to back up their bets. The Federal Reserve steps in and takes over the market. The free world is saved.
Ezra Klein follows it up:
Now imagine that between paragraphs two and three, everyone in the neighborhood started doing the same thing. The man and his neighbor seemed to be making so much money, so everyone got in on the action, and everyone got in on the same bet about the same game. That’s the basic shape of the river: All these folks were making the same bet: Basically, that the housing bubble could last forever. Then when it popped, damn near everyone went down at once, because damn near everyone had gotten in on the action. It’s sort of amazing to think that we’ve been paying finance CEOs incredible amounts of money to follow each other off a cliff, but there you have it.
Glenn Beck has my personal favorite explanation of what would have happened if AIG collapsed. The Great Depression. Though funny enough, Beck doesn’t believe that another Great Depression would be that much worse than where we are now. HA. That’s shock journalism for you.
Like I said in another post, the only way this problem will ever be solved is if we attack Wall Street greed at it’s core. Greedy executives with million dollar golden parachutes.