And of course the agencies. The SEC is supposed to look after Moody's et al, albeit through some distant process, right? (People have been screaming for more SEC oversight of rating agencies since like, 2004: http://www.afponline.org/pub/gr/i_ratingoversig…) How could every MBS basically get a platinum rating? Huh? Clue 2. Can we imprison the raters for fraud? Meanwhile, the SEC sat on its hands. Can we imprison them for nonfeasance?

Then we have to ask about the risk managers at institutions. So these guys are incented to take on risk: Hey that nasty bottom tranche gives me 10% or whatever! Yummy! And Moodys tells me it's airtight! Yeah my boring quants say the model shows some ugly possibilities waaay out there in the tail, but hey, that's only a tiny risk for year 2 or 3. By the time the thing would explode, I'll have pocketed my FU bonus money! Screw my Famous Name White Shoe Institution, I wanna retire ASAP. But it won't happen anyway, the economy's still OK now, everybody says so. Stupid nerds.

But then the manager should have seen that NY Times piece or others like it. Clue 3.

And he should have said, By my ostentatious watch! I have 20 days to save my fricking hide! So why didn't they? Why didn't they save themselves? Was it already too late? “No way out, no way out, no way out?”

Did the manager instead say, Thank God I have a CDS on this Lehman stuff with AIG! I'm sooo golden! Really, you'd think the managers would have immediately raised the alarm for their own self-preservation.

Finally we come to AIG. Certainly they should have seen same NYTimes-type story and also acted to maintain their own lives. Did they also do nothing? (I guess we've also learned that Citadel and Pacific held this stuff too.)

So at what point exactly did all these failures collect? It seems to me that while we could bicker for a looong time about why the regulators snoozed, we should still ask ourselves why the rating agencies appeared to lie, and why neither the managers nor the swap guys acted. I mean, I guess I understand why the managers did nothing – they already had their bonuses. But AIG, why didn't AIG stop the madness?

We can regulate til the cows give homogenized milk, but if the other incentives are outta whack, what good will it do? I am haunted as to why the managers and swappers waltzed on the deck of their own personal Titanic.

And of course the agencies. The SEC is supposed to look after Moody's et al, albeit through some distant process, right? (People have been screaming for more SEC oversight of rating agencies since like, 2004: http://www.afponline.org/pub/gr/i_ratingoversig…) How could every MBS basically get a platinum rating? Huh? Clue 2. Can we imprison the raters for fraud? Meanwhile, the SEC sat on its hands. Can we imprison them for nonfeasance?

Then we have to ask about the risk managers at institutions. So these guys are incented to take on risk: Hey that nasty bottom tranche gives me 10% or whatever! Yummy! And Moodys tells me it's airtight! Yeah my boring quants say the model shows some ugly possibilities waaay out there in the tail, but hey, that's only a tiny risk for year 2 or 3. By the time the thing would explode, I'll have pocketed my FU bonus money! Screw my Famous Name White Shoe Institution, I wanna retire ASAP. But it won't happen anyway, the economy's still OK now, everybody says so. Stupid nerds.

But then the manager should have seen that NY Times piece or others like it. Clue 3.

And he should have said, By my ostentatious watch! I have 20 days to save my fricking hide! So why didn't they? Why didn't they save themselves? Was it already too late? “No way out, no way out, no way out?”

Did the manager instead say, Thank God I have a CDS on this Lehman stuff with AIG! I'm sooo golden! Really, you'd think the managers would have immediately raised the alarm for their own self-preservation.

Finally we come to AIG. Certainly they should have seen same NYTimes-type story and also acted to maintain their own lives. Did they also do nothing? (I guess we've also learned that Citadel and Pacific held this stuff too.)

So at what point exactly did all these failures collect? It seems to me that while we could bicker for a looong time about why the regulators snoozed, we should still ask ourselves why the rating agencies appeared to lie, and why neither the managers nor the swap guys acted. I mean, I guess I understand why the managers did nothing – they already had their bonuses. But AIG, why didn't AIG stop the madness?

We can regulate til the cows give homogenized milk, but if the other incentives are outta whack, what good will it do? I am haunted as to why the managers and swappers waltzed on the deck of their own personal Titanic.

“Data on securities backed by subprime mortgages show that 8.41 percent of loans from 2005 were delinquent by 90 days or more or in foreclosure in June, up from 8.35 percent in May, according to CreditSights, a research firm with offices in New York and London. By contrast, 16.6 percent of 2007 loans were troubled in June, up from 15.8 percent.”

These are stunning rates obviously. How could this disaster not have been seen from the day this story was published in the first week of August? (Actually the danger was fully exposed in the Financial Times in April, see: http://ftalphaville.ft.com/blog/2008/04/10/1222…) But certainly it should have been clear that when the September payment came due, it was all going to be over.

As this amazing foreclosure rate starved the mortgage-backed CDOs of their monthly income stream and the banks exhausted themselves, soon becoming unable to make good on the payment, the various bank holders should have been protected by the CDSs.

These CDSs exist basically as insurance policies on the income stream. From these facts now come the questions we should ask before we get into the regulation discussion:

What seems interesting to me is that the CDSs themselves didn't seemed to be adequately “re-insured” with outside parties, parties who weren't already avenues of the trade.

Really only a few institutions seemed to do the most business in these, repackaging them on to sell to other banks across the globe. The question here is why did these few institutions, with so much capital sloshing around from the mid-aughts and apparently no place to put it, shove it all here?

Fannie & Freddie had a special group of regulators, a little bureau of about 200 people. Why didn't they have a clue?

Also, why did so much of the CDS appear to end up at AIG? Why did so much lodge in 1 place? Why didn't AIG in effect successfully “re-insure?” Insurance and re-insurance after all is something AIG certainly knew how to do.

Was this a case of a banking culture in which you have your set of close-knit partners, and you primarily do business only among yourselves? Or – considering AIG history, which caused Eliot Spitzer to go after it – was something else going on?

After Spitzer, AIG apparently had its own group of regulators, who actually sat in its Connecticut offices to watch what was going down. Why didn't they see this either?

Part of the problem here is that the business practices seem poorly understood. Journalists don't explain it well, even in financial papers.

But what I have read in some places makes it seem as if investment bank X issued mortgage-backed CDOs, sold those to normal banks – who apparently weren't making any money in their traditional business as that fell to a commodity, with everyone giving away free checking, free this, free that and so they needed the CDO income stream – and then those banks bought CDSs on investment bank X with AIG – who then may have done sold those back to X, in essence, self-insuring X with X?

Is this right? Is this a fair description of the circle? If not, could I please get a better explanation? Only when we have a clearer idea of how the circular trade developed could we hope to discover where any new regulation should be.

Yes, the industry is the most heavily regulated. I know that because I've worked in the industry for more than ten years. However, when it is unregulated derivatives and unregulated insurance contracts, bought with debt in massive quanitities because of the SEC's 2004 exemption of certain players from regulatory leverage limits that caused the problems, the obvious argument is for MORE regulation. The bottom line is that the regulated parts of the system functioned properly. The unregulated sectors took on more and more risk and leverage because no one was looking and it became so cancerous that it now threatens the entire system.

If you think that SOX caused this current mess, you are horribly ill-informed. Do you also think the CRA caused the sub-prime housing mess? Silly.

This point would be a slam dunk if the derivatives market was, in fact, ” thoroughly saturated with government regulation”. But it isn't, so, um, not so much.

And to extend the basketball metaphor, anyone who claimed that Allen Iverson is not an NBA player because NBA players are tall would be committing the same rudimentary error that you do here.

The dilemma between regulation and deregulation as some kind of crossroads of ideology is entirely false, not to mention reckless and harmful. I am reminded of the months following 9/11 when the debate was framed as a dilemma between more terrorist attacks and the immediate dismantling of civil liberty.