If you follow economics and investing like I do, there’s been a lot of buzz lately all over the financial markets as a series of events have caused a major economic crisis in the United States. The story so far:

- the housing bubble, in which housing prices skyrocketed far past the average home price increase year after year, popped, meaning that prices stopped rocketing towards the moon
- the mortgages used to fund the housing bubble got increasingly sloppier and sloppier, meaning that once-tight lending standards became lax, to the point where mortgage brokers weren’t even bothering to verify income to determine whether a borrower could even repay a loan,
- the securitization market that turned mortgages into investments suddenly had large chunks of the mortgages these investments were based on go bad,
- the funds, firms, and investors who relied on securitization to transfer debt started to fail, despite having very good credit ratings (one of the Bear Stearns funds that failed a few weeks ago had a credit rating of AAA, which should have indicated outstanding economic health)

So why is this all happening? It all revolves around step 3 - securitization. As we’ve discussed on the show, securitization is the process of taking a bunch of debt, slicing it up into little pieces, and selling it on the open market. If I lend someone $100 at 10% annual interest, my money is earning money, but I can’t use it. At the end of the loan (let’s say it’s a year long loan), I’ll have $110, but until the end of the year, I have no money.

If I sell that loan to investors through a process called securitization, I can get 10 people to invest $10 in the loan, and at the end of the year, each of them will earn $1 in interest minus fees. I can request a fee of $3 for handling the loan, and so I immediately get back $103. I’ve traded off $7 in future earnings for $3 now, plus the ability to make another loan with the $100. This is securitization.

The reason everyone on Wall Street has been heavily securitizing loans of every kind but most especially mortgages is that it theoretically offloads risk. Each of my investors is only taking a share of the risk if the borrower doesn’t repay the loan. No one investor is out $100. At most, each investor stands to lose $10. Multiply this effect billions of times over billions of dollars in loans and you get a sense of just how big securitization is.

Investors love securitization because they can get very high profits. Lenders love securitization because they offload the risk to investors, and get their money back right away to lend again. Even buyers, if they knew about securitization, loved it because it meant there was a lot of money available on the markets, which meant that loans were easier to get.

Here’s the analogy of why securitization is dangerous. It works on the theory that having everyone share a little risk is safer than having a few people shoulder all the risk, and for a while, that works. It’s like having a keg of gunpowder divided up into individual grains of powder and distributing that in your neighborhood, paying neighbors $1 to hold onto that kernel of explosives. Every house has a little bit of it, and it’s harmless. Exposed to fire, it might pop and sizzle a little, but nothing bad will happen.

Human nature drives us towards greed. We figure, hey, $1 for a kernel that’s completely harmless is fine. We’re earning money at nearly no risk. So we agree to accept another kernel for another dollar. And another. And another. Everyone’s making great money in the neighborhood as investors, earning dollars for their gunpowder holdings.

Until one day you wake up and realize that while you’ve got $100,000 in the bank, you have a house full of gunpowder. And so does the house next door. And the house after that. Now, if someone lights a match in your neighborhood, instead of one house blowing up, the entire neighborhood will be destroyed.

That’s where the securitization/collateralized debt obligation market is right now. Every investment firm on Wall Street is a house full of gunpowder, and match after match is being thrown on the market.

What does this mean for you? If you have investments that are part of things like hedge funds - for example, college endowments, pension plans, retirement plans, etc. - you may be exposed to greater financial risk than you think. Check your personal finances and investments very carefully from now on.