As I write this column, Wall Street is experiencing one of the largest and most volatile weeks of decline in its history. From this vantage point it is hard to guess how far it will go and when it will settle down, and by the time you read this, it may be on its way up. But one thing’s for certain: the events we’ve seen over the past several months will likely go down in history as the events that literally changed our financial landscape forever. 
   How did this happen? 
   It all starts with a financial instrument called a Mortgage-Backed Security. An MBS is basically a package of individual home mortgages pooled together so that it can be priced and analyzed like a bond. The pool is then usually split horizontally into several credit-quality tranches. [A “tranch,” in financial terms, generally means a piece or a portion of a deal.—Ed.] 
   These investments are very popular with institutional investors because, compared to almost any other kind of asset, a mortgage has higher credit quality. Most people, when money is tight, will pay their taxes and their mortgage and let their other bills slide. 
   To make it even more popular, investors can buy an MBS with borrowed money. All over the world there’s been a tremendous amount of MBS-buying by banks, Wall Street firms, insurance companies like AIG, hedge funds, and even small towns in Europe. And many of these players used funds borrowed from banks and from the overnight money markets to buy it. This is what caused our current financial crisis. 
   Here’s how: 
   Assume you borrow money overnight at five percent; and you use that borrowed money to buy an MBS that is expected to pay a yield of 5.75 percent over its five-year term. And the MBS has a triple-A, investment-grade credit-quality rating. 
   This is a stellar investment. You would want to make this trade as large as possible. If you’re a hedge fund with a billion dollars in capital, because of the quality of these investments, you could realistically borrow 30 to 1 to make this purchase. Your raw annual investment return would theoretically be 30 times 75 basis points. That’s HUGE. 
   Because this was such a good investment, and home prices kept climbing, there was big incentive to keep purchasing MBSs. So what happened next? 
   The housing bubble burst. In turn, the values of many MBS had to be reduced because default rates on the underlying mortgages started rising. There was an increase in the amount of risk that any given mortgage would default, and that in turn would increase the risk of the MBS that the mortgage had been packaged into. 
   Riskier investments always deserve higher yields. But if the MBS has already been cut, packaged, and sold, the income that it generates is fixed permanently. In that case, the MBS will behave just like any other fixed-income security: its value will decline, which effectively raises the yield. 
   But since you bought the MBS at a certain price to obtain a certain interest rate, you now have an unrealized capital loss, because the MBS in your portfolio is worth less than you paid for it. And remember, you borrowed the money to buy it. 
   If you borrow money to buy something, your lender will enforce your capital position at all times. He wants to be sure you have enough capital to withstand losses without passing them on to him. Simply put, if your leveraged MBS portfolio declines in value by even a small amount, your lender will demand that you add to your capital (“margin call”) in order to protect him. If you don’t the creditor can—and will—seize your assets and put you out of business. 
   That’s what happened. Currently, there is a huge amount of MBS investment out there that was purchased (with borrowed money) for more than it’s worth now. When you’ve lost that much money, you can’t buy anything new. And you’re still stuck holding the distressed assets until they mature. 
   Multiply that by thousands of institutions across the country, and you’ll see why we have a credit crisis. Any bank that’s forced to take big losses in an MBS portfolio doesn’t have enough capital to make any new loans. It’s the biggest systemic margin call in history. 
   Getting to the root of it, why would you suppose anyone would let people use 30-1 leverage, or even more, to buy risky investments like these? Basically, the leveraged purchases were not considered risky at the time. Because of their perceived safety, which nearly everyone accepted, lenders had no problem giving hedge funds and Wall Street firms the money to buy MBS on 30-1 capital ratios. 
   In fact, 30-1 would have seemed conservative, considering the assumed default rate is around 3 percent. Even today, in the middle of the mortgage meltdown, default rates haven’t gotten that high. 
   Now here’s where it gets interesting. If a hedge fund or structured investment vehicle borrows short-term money in order to buy a somewhat longer-term investment like an MBS, and makes a profit on the interest-rate differential, what exactly is it doing? It’s creating credit. That fund has made the money available for someone to get a mortgage and buy a house. The only difference between what that fund has done, and what a normal commercial bank does every day, is the source of money. 
   The bank gets the money it uses to make loans from deposits that it takes from the public. And depositary institutions are regulated heavily—it’s part of the price they pay for FDIC deposit guarantee. Among other things, they will generally avoid being leveraged any more than 10-1. 
   So a hedge fund that invests in MBS isn’t functionally different from a bank, but it escapes the banking regulations because it doesn’t take deposits from the public. It’s part of a vast system that creates credit in an unregulated way. 
   If this was the cause, what effects have we seen so far? We witnessed the seizures of financial giants like Bear Stearns, Fannie Mae and Freddie Mac. We saw the largest bankruptcy filing and bank failure in U.S. history by Lehman Brothers and Washington Mutual, respectively. We wrestled with the incredible bailout of on of the world’s largest insurers, AIG. We watched the transformation of Morgan Stanley and Goldman Sachs into traditional bank holding companies marking the end of Wall Street’s big standalone investment banks. And with the $700 billion bailout, we’ve seen the largest government intervention in the history of mankind. 
   While it’s certainly not business as usual, market turmoil is also not unprecedented. Our country has gone through difficulties like this before. We survived the collapse of the nearly 3,000 lending institutions during the S&L crisis. We survived the bailout of the airline industry and the rescue of Chrysler. We survived losses sustained from the currency devaluation in Mexico, the Russian debt crisis, and the meltdown of Long Term Capital. 
   Our economy and the stock markets survived the difficult market declines in 1929 and 1987. In fact, those same markets went on to flourish for those who were patient. While these situations are not desirable in the short run, they are manageable over the long run. Our economy and our nation will survive this one, too.