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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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‘Bomb’ went off, and we’re feeling the fallout

ANYBODY who expects a quick and easy explanation for the forces that have felled numerous Wall Street institutions will be greatly disappointed.

Before these past few months, many people probably knew little to nothing about Lehman Brothers, American International Group, Bear Stearns, Fannie Mae or Freddie Mac. Now they’re Page 1 news, and people expect simple answers as to how they could have failed and in some cases potentially cost taxpayers billions of dollars.

It’s fairly easy to come up with a general answer that explains some of the reasons for the seemingly overnight events that have felled century-old institutions.

As the housing market soared earlier this decade, people stretched to buy more house than they could afford. Many were helped along with subprime mortgages offering no money down and teaser interest rates. As long as the value of the house kept rising, these people could just borrow against the equity or flip the homes.

But when prices started dropping and mortgage rates reset, these folks could no longer afford their homes. That was tragic for the individual family, but it also reverberated up the financial chain to Wall Street.

The defaulted mortgage had been sliced and diced and packaged into securities that investors purchased. Once the mortgages declined in value, there was no market left for these securities, and financial institutions were unable to sell them at a time when they needed cash. Bankruptcy ensued for some, federal bailout for others.

That’s the basic version. To understand it further takes way more complex studying, and perhaps only those in the institutions that have failed really get it.

This week I came across a letter that Warren Buffett wrote to the shareholders of Berkshire Hathaway in 2002. Anybody seeking to understand the domino effect that has destroyed many financial firms and continues to threaten others would do well to read it.

In a section labeled "Derivatives," Buffett writes about how the Wall Street firms were all interconnected via the complex financial contracts they had written with each other on mortgages and more. Here is what Buffett wrote about these derivatives contracts:

"We view them as time bombs, both for the parties that deal in them and the economic system. [D]erivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

He goes on to explain that even the firms that are fundamentally solid can be brought down by the struggles of others due to these connections. He writes about the type of "chain reaction" disaster that has now occurred. Much of the intervention of the Federal Reserve has attempted to prevent this domino effect from felling the global financial system.

All the way back in 2002, Buffett and partner Charlie Munger were warning people that things were dangerous and only getting worse:

"Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event. Linkage, when it suddenly surfaces, can trigger serious systemic problems."

Sound familiar?

The good news is that not all financial companies are created equal. Many commercial banks, including Bank of America, Wells Fargo, J.P. Morgan, U.S. Bancorp, BB&T and more, seem to have sidestepped the worst of the financial meltdown.

These and other conservatively run banks seem poised to take a leadership role going into an environment where financial dealings will perhaps become more transparent and understandable.