Uh-oh! Wall Street Meltdown for Dummies

There was alotta finanical FAIL going on this weekend. Lehman Brothers is expected to file for bankruptcy tomorrow. Bank of America just bought out Merrill Lynch at $44 billion (a paltry $29.35 a share). AIG appears to be next...

"A.I.G. became one of the focuses at an emergency gathering of Wall Street executives over the weekend, and was trying to arrange a capital infusion in the face of possible credit downgrades."

What do we learn after dozens of Wall Street’s finest cram into a single room to discuss the meltdown of the financial system? With a Category 5 disaster brewing, the Masters of the Universe can still agree to act out of their own self-interest.

Two of the biggest dogs on Wall Street went down over the weekend, how'd this happen? From the blog Self-evident...

Lehman Brothers: $640 billion in assets, $613B in liabilities, counter party to $729 billion in derivatives trades.
Merrill Lynch: $996B assets, $972B liabilities, $4.2 trillion in derivative trades
AIG: $1T in assets, $972B liabilities, $447B in CDO swaps.
Bear Stearns: $339B assets, $387B liabilities, $2.7T derivative trades.

It's all in these numbers... but what do these numbers mean? In order understand this mess, we need an understanding of the sub-prime crisis and its repercussions. NPR has a great primer on what the sub-prime crisis is all about. We also need to understand the more complex topic of derivatives and that they are BAD, ... from Business 2.0's Web Guide

Derivatives is a generic term for a variety of financial instruments. Unlike financial instruments such as stocks and bonds, a derivative is usually a contract rather than an asset. Essentially, this means you buy a promise to convey ownership of the asset, rather than the asset itself. The legal terms of a contract are much more varied and flexible than the terms of property ownership. In fact, it's this flexibility that appeals to investors. "A good toolbox of derivatives allows the modern investor the full range of investment strategy" and "the sophisticated management of risk," according to the derivatives specialists at NumaWeb.

Futures and options are two commonly traded types of derivatives. An options contract gives the owner the right to buy or sell an asset at a set price on or before a given date. On the other hand, the owner of a futures contract is obligated to buy or sell the asset. The option-shunning experts at the Motley Fool pointed us to their Options FAQ, complete with warnings and reminders that 80% of all options traders lose money.

Okay, so how are derivatives bad? Understanding how derivatives are bad is too complex and boring to tackle in one post, so simply take it from the Wall Street guru who predicted this insanity SIX years ago. Way back in 2002, the man Warren Buffet warned us...

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear....[They] are financial weapon of mass destruction carrying dangers that, while now latent, are potentially lethal."

Despite Buffett's compelling warnings, a massive derivatives bubble arose, and in parallel with the subprime bubble helped to drive the domestic and global economies. In other words, there is boatloads of crap on everyones' books. The banks that are lending LB and ML money have lost confidence in LB and ML's balance sheet or liquidity and are no longer lending banks the money they need need to finance their toxic $hit.

Still don't get it? Well, if you're a pessimist, consider this the beginning of a complete meltdown of the financial system. If you're an optimist with a bunch of cash on hand, happy hunting :)