We are truly in the midst of historic times and the wild swings we’re seeing in the financial markets, while not necessarily fun to watch, are something to behold. Here’s a quick history of how we got here, and what it means for the future.

We really have a credit crisis that has spilled over from the Real Estate sector into the rest of the economy. From the late 90’s until mid 2007, we saw exceptionally low interest rates, combined with loosening underwriting standards for mortgages. This fueled an unprecedented housing boom and some parts of the country saw gains of 10-20% per year for multiple years.

The investment houses on Wall Street were able to package these loans up in pools and sell them to pension funds, foreign countries, other investments houses, etc. These pools all had different risk categories and interest rates associated with them. Insurance policies were written on these mortgage pools, which has also clouded the issue. Many of these loans weren’t “sub-prime”, in that they weren’t necessarily set up for people with a poor credit history. Instead, a whole new category of loans was born during this period that allowed stated income, interest only, 100% financing. When the housing market was moving in the right direction, there was no major problem and the more loans that were done, the higher the bonuses were on Wall Street.

Ultimately, though, the housing market deflated in a number of areas throughout the country, and soon these assets started to have problems. The ultimate problem is that no one really knows what the value of these securities are really worth, and buyers want pennies on the dollar. This is putting huge strains on the financial institutions and the strict “Mark to market” accounting rules are exacerbating the problem. Basically, these rules require any problem loans to be counted as a complete loss on the books, even though there is an asset (the house) that is worth something. That asset isn’t realized until it is sold.

So, we sit here today with banks unable to unload loans that are difficult to price, even though 95% of the borrowers are making their payments on time. The cash reserve accounting requirements are very stringent, and the banks need to show they have the cash reserves, and thus reducing their lending activities. This lack of lending is now affecting all sectors of the economy and has severe implications for future growth.

The Government’s plan is to buy the pools of loans that are creating the drag, collect the payments over time, get a better idea of the long term value of the securities, and then sell them back to the banks once the market recovers, which should be at a profit. This is potentially a big win for the tax payers, in that it will stabilize the credit markets and hopefully the housing market. The risk if it doesn’t work, and the housing market gets worse, is that the tax payers will lose money.