We've sold debt (houses) to every demographic there is (including illegal aliens). These piles of debt were thrown into financial blenders mixing good loans with shaky loans. If you sprinkle enough good loan in with the bad, you can make the entire pool seem good (AAA bonds). As this was too tempting, the mix started having more and more bad loans, and still get AAA ratings. The high ratings, means pension funds and quality investment trusts could buy them. And they did.... in abundance. These are the CDO's (theres more to them, but this paints the rough picture).
The Risk of the shaky part is covered by paying insurance, thereby seeming to create a bullet proof investment (hey it's insured against loss!). That insurance was piled up with other insurances into more investment vehicles. You could buy the rights to the insurance which pays a premium (just like auto insurance), and you get to be the "AllState" in the deal. These were pooled and rated (more AAA grade investments) and sold.
Now, what if that insurance defaults? Well, insurance was created against the insurance, incase that insurance went belly up. And of course, those insurance contracts were pooled, divied up and sold on as more bonds (more AAA debt!).
There are now roughly 500 trillion dollars worth of this nonsense (10 times the world GDP) out there.
The entire scheme relys on the ability for "SubPrime"debt to not default en masse. In order for SubPrime to not default, housing values MUST appreciate. If they stall or go down, then the defauls begin (sound familiar?). Once that begins, then something very profound occurs.
The covenants of the Pensions funds and other quality investment funds state that they can only hold AAA grade investments. As these CDO's get their ratings changed due to defaults (thus more risk), the Pension funds and Quality investments MUST immediately sell them for whatever the going rate is, loss is unimportant. It is in the covenant. This is the "flight to quality" we are hearing about now.
But what happens if nobody wants to buy them? They continue to mark the price lower until it sells. A new price is now set for these debt pools, the loss in face value plus defaults triggers the insurance swap. If enough of these trigger, then that insurance swap triggers the insurance against it......etc.....
The real danger is in the derived investment market globally. The housing slump is the trigger and is small compared to what has been leveraged against it. The exposure to this is immense and wide spread. Not only pension funds, your 401K, bank are exposed. It is now coming to light that Money Market CD's are exposed (these have been one of the traditional safest investments). If enough subprime fails, then a chain reaction occurs on a global scale. Banks as far as Germany are now failing (one failed last week) due to exposure to subprime CDO's. Chinese banks are feeling it too now (uh oh!!!! they're the folks who lend us money to keep the lights on. We best not piss them off or they'll cut up our VISA card which is maxed).
That is a simplified overview of the leverage market and how it is starting to lurch. Once it lurches, nobody wants to lend money (the risk is too high). If nobody can take on more debt, then granite countertop sales, car sales, fancy TV's, vacations, big weddings, lawn gnomes, rider mowers, spongebob backpacks, piano lessons, laptops, nike jogging shoes, motorbikes, and everything else stops being purchased. That is the "consumer led" recession. The consumer stop consuming. In this case due to no savings and the inability to find more willing debt.
The only way to stop the inevitable is to stop the subprime slide by re-igniting the debt frenzy. But that just delays the inevitable and compounds the effect. The only people we haven't sold McMansions to are Darfur Refugees and dead people in Kosovo. Everyone else has their 6 pack of McMansions already. In other words, the gig is up.
Sorry about the long post, but that is the nutshell as I see it. Khell can probably put it in better terms (that are more accurate). What I posted here is very simplified (to avoid posting a readers digest novel).
