From Electoral Vote.com: Wall Street in Turmoil

The financial industry is reeling. The venerable Lehman Brothers investment bank has filed for bankruptcy. Insurance giant A.I.G. is close to bankruptcy, and Merrill Lynch only avoided bankruptcy by selling itself to Bank of America for $50 billion in BoA stock. Other financial firms are in the bullseye. This week has been the worst week for Wall St. since 1929.

For people who don't understand what is going on, here is the story in a nutshell. Decades ago, when you wanted to buy a house you went to local bank and applied for a mortgage. If the mortgage was less than three times your annual income and you had a good credit history, the bank would loan you the money and you would pay them interest and some principal every month for 30 years. Then Wall St. got a bright idea: buy up all the mortgages from the banks, collect a few thousand into a pool called a CDO (Collateralized Debt Obligation) and sell shares in it. The owner of each share would get a pro-rata share of the incoming monthly mortgage payments, analogous to what a bond owner gets.

What happened? It sounded like a great idea and soon all mortgages were sold and repackaged into shares. It didn't take long before the banks realized that they could issue mortgages of five, six, even eight times the buyer's annual income or sell them to people with terrible credit histories. After all, the shaky mortgages would soon be somebody else's headache. That's what happened. Lehman, Merrill, and others bought billions of dollars of mortgages that the homeowners had no hope of ever repaying on schedule and nobody wanted to buy shares in these worthless CDOs, so the brokers got stuck holding the bag with billions in worthless loans.

What are the political consequences of this meltdown? It is a bit early, but here's the expected pattern. Republicans will say that bankruptcies, however unfortunate, are an absolutely essential part of free markets. When managers make stupid decisions, the market punishes them by driving them into bankruptcy. This warns other managers not to be so greedy. Democrats will say that millions of innocent homeowners and small investors are going to lose their homes and life savings due to misbehavior on the part of rapacious and unscrupulous bankers and that it is the job of the government to regulate the entire financial sector to protect ordinary people who don't know the difference between a CD and a CDO.

One thing that is crystal clear already is that reporters are going to be asking the candidates how they plan to deal with this. John McCain might call for more regulation and when other Republicans scream at him use this to prove his "maverick" credentials. Of course he will be accused of locking the barn door after the prize horse (with or without lipstick) has escaped since he has never been much of a fan of government regulation before. For Obama it will be easier to call for more government oversight. Democrats believe government is supposed to protect people.