THE CLAIRE FOSS JOURNAL

After the Moneyís Gone
By PAUL KRUGMAN

Published: December 14, 2007

On Wednesday, the Federal Reserve announced plans to lend $40 billion to banks. 
By my count, itís the fourth high-profile attempt to rescue the financial 
system since things started falling apart about five months ago. Maybe this one 
will do the trick, but I wouldnít count on it.

Reactions From Around the Web In past financial crises ó the stock market crash 
of 1987, the aftermath of Russiaís default in 1998 ó the Fed has been able to 
wave its magic wand and make market turmoil disappear. But this time the magic 
isnít working.

Why not? Because the problem with the markets isnít just a lack of liquidity ó 
thereís also a fundamental problem of solvency.

Let me explain the difference with a hypothetical example.

Suppose that thereís a nasty rumor about the First Bank of Pottersville: people 
say that the bank made a huge loan to the presidentís brother-in-law, who 
squandered the money on a failed business venture.

Even if the rumor is false, it can break the bank. If everyone, believing that 
the bank is about to go bust, demands their money out at the same time, the 
bank would have to raise cash by selling off assets at fire-sale prices ó and 
it may indeed go bust even though it didnít really make that bum loan.

And because loss of confidence can be a self-fulfilling prophecy, even 
depositors who donít believe the rumor would join in the bank run, trying to 
get their money out while they can. 

But the Fed can come to the rescue. If the rumor is false, the bank has enough 
assets to cover its debts; all it lacks is liquidity ó the ability to raise 
cash on short notice. And the Fed can solve that problem by giving the bank a 
temporary loan, tiding it over until things calm down.

Matters are very different, however, if the rumor is true: the bank really did 
make a big bad loan. Then the problem isnít how to restore confidence; itís how 
to deal with the fact that the bank is really, truly insolvent, that is, busted.

My story about a basically sound bank beset by a crisis of confidence, which 
can be rescued with a temporary loan from the Fed, is more or less what 
happened to the financial system as a whole in 1998. Russiaís default led to 
the collapse of the giant hedge fund Long Term Capital Management, and for a 
few weeks there was panic in the markets.

But when all was said and done, not that much money had been lost; a temporary 
expansion of credit by the Fed gave everyone time to regain their nerve, and 
the crisis soon passed.

In August, the Fed tried again to do what it did in 1998, and at first it 
seemed to work. But then the crisis of confidence came back, worse than ever. 
And the reason is that this time the financial system ó both banks and, 
probably even more important, nonbank financial institutions ó made a lot of 
loans that are likely to go very, very bad.

Itís easy to get lost in the details of subprime mortgages, resets, 
collateralized debt obligations, and so on. But there are two important facts 
that may give you a sense of just how big the problem is.

First, we had an enormous housing bubble in the middle of this decade. To 
restore a historically normal ratio of housing prices to rents or incomes, 
average home prices would have to fall about 30 percent from their current 
levels. 

Second, there was a tremendous amount of borrowing into the bubble, as new home 
buyers purchased houses with little or no money down, and as people who already 
owned houses refinanced their mortgages as a way of converting rising home 
prices into cash.

As home prices come back down to earth, many of these borrowers will find 
themselves with negative equity ó owing more than their houses are worth. 
Negative equity, in turn, often leads to foreclosures and big losses for 
lenders.

And the numbers are huge. The financial blog Calculated Risk, using data from 
First American CoreLogic, estimates that if home prices fall 20 percent there 
will be 13.7 million homeowners with negative equity. If prices fall 30 
percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. 
Whatís going on in the markets isnít an irrational panic. Itís a wholly 
rational panic, because thereís a lot of bad debt out there, and you donít know 
how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets wonít start functioning normally until investors 
are reasonably sure that they know where the bodies ó I mean, the bad debts ó 
are buried. And that probably wonít happen until house prices have finished 
falling and financial institutions have come clean about all their losses. All 
of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan 
that makes this financial crisis just go away will be sorely disappointed. 

 

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