Every news program has some half-wit finance expert with their own theory of how this all happened (CNBC being one of the most egregious offenders). Most of these theories are only vaguely based in fact and look for someone outside of the financial industry to blame.  Well, I plan on providing a simple explanation of the major factors behind this crisis.

First, I will start with the favorite excuse of the financial pundits…short selling.  This is a very poor reason for the current financial crisis.  Short selling has been around forever and if done legally, a short seller has to find someone who already owns the shares to lend them the shares for the short sale.  The mechanics of this process makes it almost impossible for someone to sink a company with a solid balance sheet.

The one exception is naked short selling, which has been occurring.  This essentially means the short seller is shorting shares he/she has not borrowed from a current owner.  This allows a short seller to build up a short position that is much larger than normal, over a shorter period of time, which can put extra pressure on the company’s stock price.  This pressure by itself is still not enough to sink a quality company, but it might be enough to push a bad company over the edge.

The second and more important reason for this financial calamity is the quality of the financial products owned by these institutions.  This has been covered ad nauseam, so I will just say they (Wall Street) had a lot of really bad loans on their books.

Now we come to the final and most important reason by far, which is excessive leverage (poor management).  All banks/financial institutions are required to have a certain ratio of debt-to-net capital.  This keeps risk in check and prevents a major economic catastrophe, like bad mortgages, from destroying our financial institutions. 

Here is an excerpt from the Big Picture (Barry Ritholtz), who is also quoting Julie Satow from the NY Sun:

As we learn this morning from Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage — and the current massive unwind.

Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms. The SEC allowed these firms to legally violate existing net capital rules that require broker dealers limit their debt-to-net capital ratio to 12-to-1.

Instead, they levered up 30 and even 40 to 1.

Almost 3 times more leverage than what is considered safe.  This is not surprising at all given the extreme profitability of these firms over the past few years.  They used this extra leverage to make enormous sums of money, but in the end it appears to have been too risky. 

Now let’s take a look at who was given this special exemption (quoted from the Big Picture):

1. Bear Stearns (failed and bought) - Big surprise here.  Who would have thought the first major financial house to go under was doing something foolish.
2. Merrill Lynch (failed and bought) - Wow!  Another surprise.
3. Lehman Brothers (bankrupt) - This is just the most unlucky industry on the face of the planet!
4. Morgan Stanley - How shaky is Morgan?
5. Goldman Sachs - Is it possible the New England Patriots of Wall Street have a flaw?

Ignore most of the talking heads and all the fools from congress, and focus on what actually happened, which was the DESTRUCTION of REASON on Wall Street by the financial firms and the SEC/Fed/Treasury.  However, they cannot shoulder all the blame, as this DESTRUCTION of REASON was carried over from Main Street.  We have to carry some of the blame as we allowed reason to be destroyed in the public sphere way before it was destroyed on Wall Street. 

Platoon

Chris Taylor: Somebody once wrote: “Hell is the impossibility of reason.” That’s what this place feels like. Hell.