Warning: if financial shenanigans make your head ache, go right down to the last post and read about Osama Bin Laden, because this is going to be pretty specialized.
The sub prime mortgage mess has now expanded to restrict the whole credit market, not just credit to people with poor FICO scores. You can't get a jumbo loan even with good credit, which effectively means you can't buy a house in the San Francisco Bay Area. I've actually been waiting for something like this to happen. For the last dunnamany years, the investment banking community has been trading a class of financial instruments they call "credit derivatives" - whose purpose was to "manage risk", by spreading it around among multiple parties so no single party was exposed to all the risk of any one transaction.
The mortgage backed securities, which are collapsing like card houses as subprime mortgage holders default, are only one example. The general class is an investment where a group of normal, understandable transactions - A borrows money from B - is munged up into a big pot, which is then given a name, divided up into pieces and resold, with the pieces priced based on the amount of risk associated with them. In other words, instead of B just booking the fact that A owes him a million dollars, B creates derivative instruments which he sells to C and D, based on their appetite for risk. If C buys the highly rated piece of the pie (or "tranche"), then C gets a relatively low percentage of the interest, but doesn't expect to have to pay out much if the underlying loan (or loans) goes Tango Uniform; D, however, buys the bottom or junk "tranche", which carries the highest risk of default, so D gets the highest percentage of the interest. B passes on some of the income from the loans to C and D in exchange for also passing on some of the risk. This process is called securitization.
I am simplifying wildly here.
The point I'm getting to, though, is that these arrangements are enormously complicated. Further, under current accounting rules, firms that have bought these things have to "mark them to market" daily - that is, their value on the company books has to be what the holder thinks it can sell them for. (I say "it" because human beings don't own these things; financial institutions own them.) And there's where the shoe pinches, because when all the irrational sub prime mortgages started to reset their interest rates to the "real" amount, and the owners suddenly realized they couldn't pay, refinance or even sell because the housing market had slumped, the holders of these investments found themselves getting margin calls (not only do they buy this crap, they buy it on credit - they call it "gearing" or "leveraging") on investments they thought were rated AAA.
What everyone forgot was that if you have securitized a bunch of mortgage loans, and sold the pieces, they are only worth something if the mortgage holders are still paying on the underlying loans. If the mortgage holders default, the securities become worthless.
So while the mortgage firms that made the original loans were going bankrupt, the financial firms that bought the mortgage-backed securities realized suddenly that the assets they held weren't worth what they thought they were. Worse, they realized that they didn't actually know what the assets they held were worth. And worst of all, they realized that they had loaned money out to other firms, and they now couldn't judge whether those other firms were capable of repaying them or not, because the other firms didn't know what their assets were worth, either. This is called counterparty risk - the risk that the counterparty you trusted will fail you. If you have been reading in the newspaper that banks are afraid to borrow from each other, this is why.
The problem isn't that these firms are going bankrupt; it's that they don't know whether they're going bankrupt or not. And this is all happening because some very bright people invented these credit derivatives, and sold them to the financial community as a clever way to "manage risk", when in fact only about 8 people anywhere actually understand them. It all worked fine as long as there was another fool standing in line ready to buy the next one. But the fool has stepped out of line and put his money under the mattress.
Peter Lynch of 1980s investing fame used to say that you shouldn't invest in anything you couldn't explain to your mother. He was talking about buying stocks, but it applies here too.
So are they going to take the whole economy down with them?? I don't know, but I doubt it; I'm afraid I think they'll get bailed out. They've already had a kind of bail-out, when the Fed lowered its "discount rate" (what it charges banks to borrow short term to true up cash for the day) back in August. I hate to see them get off scot-free from this stupidity, but they'd take too many other people down with them.