"So how did this happen, anyway?"
That's a tough question with the current crisis. It gets complicated quickly. Usually I resort to movies to step people through complicated financial news stories. On this one though, I'm stuck.
But I'll try, by re-writing my favorite explain-a-bank-run movie: "It's a Wonderful Life."
1. Cheap money. George Bailey, through his savings and loan, has access to a lot of government money at very low interest rates.
2. George Goes Mortgage Crazy. George makes money by borrowing it at a low rate and lending it out as a mortgage with a higher rate. The more mortgages, the more money he makes. So he not only does a mortgage with Mr. Martini ... who has a business and can actually afford it ... he also offers a mortgage to Nick the bartender and Violet.
3. George Passes the Risk. George realizes he can take all the mortgages he's made, pool them together in the "Bailey Mortgage Pool," and sell shares in the pool to the general financial market. Investors will get a share of the mortgage profits over time and George gets money up front to offer more mortgages.
4. Buying the Risk. Potter's bank, looking for attractive investments, buys shares in the Bailey Mortgage Pool (BMP). (So does a new outfit called Fannie Mae, which also backed Nick's mortgage).
5. Potter Gambles. Potter has a chance to buy a boatload of buggywhips. He thinks they will rise in value in the next year, but he doesn't have enough money in his bank, it's mostly tied up in the BMP shares. So he gets a loan from another bank, which thinks the loan is pretty safe. After all, Potter has all those BMP shares.
6. Uh-Oh. The war comes. Interest rates get higher and George can't get money as cheaply. New mortgage business dries up, which kills George's savings and loan. Meanwhile, Nick gets drafted. His family can't afford the mortgage payments. And Violet, who has always had problems with budgeting, is also getting behind on payments. They move into foreclosure.
7. Potter Who? The bank that loaned money to Potter hears about Nick and Violet's foreclosures. It wants immediate payments from Potter to keep the buggywhip loan going or it will call in the whole loan. Potter makes the payments, but as a result doesn't have the money to do much else. The buggywhip gamble hasn't paid off. And no one wants to buy his BMP shares.
8. Why Banks Matter. Sam Wainwright wants to refurbish his plastics factory to compete with Japan. Mr. Gauer needs to upgrade his pharmacy. And Mr. Martini needs to buy new liquor inventory. They all need a big hunk of money upfront to do these things. But Potter's bank, which usually gives them loans, can't do it. The other bank, which is also tight for money because of its loan to Potter, also declines.
9. Double Uh-Oh. Now Sam is thinking about closing his factory. Mr. Gauer is laying off delivery boys. And Mr. Martini may have to sell his house to keep his business going.
At this point, Bedford Falls is facing a recession. Unless an angel comes in buys up the BMP shares, giving Potter money to secure his loan and, perhaps, helping Nick and Violet stay in their homes by changing the mortgage terms.
They need an angel. Atta boy, Paulson.
(Okay, I couldn't work in the ratings agencies, hedge funds, credit default swaps, and a bunch of other things weedled into this mess, but hey, it's a start).