What's happening here?

A repost from another venue...

The immediate problem was liquidity.

Commercial paper is used by banks and corporations to finance the day to day business, to purchase inventory or to manage working capital. [wiki]

The size of the commercial paper market has collapsed 20% over the last 15 months. In addition, CP rates (30d A2/P2 nonfin) which had been stable near 3% spiked to 5%. The system froze up. Access to working capital for non-financial businesses became nearly impossible and very expensive. The whole economy was threatening to grind to a halt. This is what panicked the FED

The capital provided to offset the current liquidity crisis in non-inflationary. It is short-term capital used to finance the day to day operation of businesses, like paying the employees every Friday. Since the economy is contracting, it is not stimulating demand to the point where it can cause prices to rise.

..........

... the still overvalued assets that are now going to be propped up the feds instead of having the transparency of marked to market assets.

Curiously, if in fact, the mark to the market provision was correctly applied we would have less of a problem.

The problem is extremely complicated, but I will venture to say that the majority of the loans held by the Fannies are good (performing), that they will be paid off over the life of the loan.

The problem lies with the non performing loans, both for the Fannies and for those held within CDO's (mortgage bundles). When loans become non-performing, they reduce the value of the CDO's (bundle, or portfolio) and the ratings firms (Moodys, S&P etc) downgrade the instruments making borrowing money on them more expensive. (higher risk => higher rates). When the real estate market drops further, the ratings agencies again downgrade these instruments.

The problem is that the downgrades are made based on the initial collateral value of the instruments at 100%. Initially this is correct because the risk adjusted returns are based on the collateral being valued at 100%. At this point the holder may take the paper loss by marking it to the market, carrying it on the books as only 70% of the original value.

However, assuming another non-performing event occurs or the collateral value again declines, the instrument is again downgraded by the ratings agencies. This calculation is based upon the original face value (100%) of the instrument because at the present there is no easy way to evaluate bundled securities. As a result the security which actually will have a positive return when its collateral value is calculated at 70% is incorrectly downgraded making it again harder to finance the loan.

Of course, at the root of the problem is leverage, the continuing need to borrow short term money to finance the longer term loans, and somewhere within this web of finance, a downward spiral occurred making it impossible for the lenders to raise enough capital to either reduce leverage or finance the loans, Poof.

Over the last year, all the parties have been trying to unwind this mess. My hunch is that even if real estate prices are only half way to their nadir, that most of the fire sale discounted CDO's are going to produce fabulous returns for those who scooped them up. This should include the US government.

Without a doubt the lack of oversight by the government regulators has contributed to this crisis. It points to Greenspan's philosophical failure to realize that greed and fear distort the functioning of a free market.

So we find ourselves gripped in fear, the capital markets have frozen up and without intervention, a problem which is primarily one of a small sector of the economy would have spiraled into a severe recession. People and businesses who had nothing to do with the housing industry would be dragged into the abyss of a financial collapse.