Stock markets rallied today after the president announced a new deal under which mortgage lenders would ease the pain experienced by subprime borrowers by lowering and freezing rates. The move is designed as a last ditch effort to avoid another run of foreclosures that could cripple the economy even further by putting increased pressure on a market that is already well-classified as a seller’s market. Unfortunately, the problem isn’t quite contained yet as new economic reports surfaced indicating that the subprime mess may be a side-effect rather than the reason for the economic decline we’ve seen.

So, what’s the major issue? Bad debt. Banks that traditionally made money through the difference in lending and savings have recently made money by packaging securities and selling them off to the secondary markets. This shifted the focus to profitable loan origination to simply as much loan origination as possible regardless of the rate. To that end, we’ve seen significantly lower interest rates as banks worked to give access to credit to everyone regardless of their income or existing debts.

The hedges worked out in a computer program as investors thought they could reduce their risk in this market by simply buying derivatives in another. Unfortunately, investors tend to constantly forget about one thing: liquidity. That is, there is no market if nobody is willing to buy and sell the securities. We saw this in the credit market after people started realizing that a lot of these loans were about to default. While they are hedged properly according to a model, there was simply nobody on the other end to take the trade regardless of intrinsic value.

The underlying reasoning, of course, is the simple fact that the median household income has not budged since 1999 while the amount of debt taken on has only increased exponentially. The predictable outcome is a lot of people that are unable to keep current on their bills. And that is why we are in the subprime mess as we see it now.

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