A good explanation of the "mortgage crisis," but it fails to point out
that it is all but certain that this problem will be aggravated by a
recession, falling incomes and joblessness. Moreover, all of these
influences will likely act to reenforce each other. It is rare to see
such a conjunction of negative factors, a "perfect storm".
Peter Hollings
PS: An additional factor is that most of the mortgages were packaged
into complex derivative securities ("Collateralized Debt Obligations")
and sold off. Given the now questionable values of these securities,
they can no longer be readily traded and financial institutions have
become wary of trading with counterparties holding large portfolios of
them. The FED's liquidity injections may help banks needing liquidity
but unable to sell these CDO securities. Having the liquidity available
would be vital if a run were made on an institution. But, it does not
repair the problem of actual losses on the securities. During the S&L
crisis 30 years ago, banks were able to compensate over time for losses
on part of their portfolio by earnings on other parts and thus gradually
repair their balance sheets. Those which were not able to do this were
merged into still-strong institutions. This time around, a lot will
depend on the magnitude of the losses in relation to the remaining
earning assets.
-----Original Message-----
From: PEN-L list [mailto:[EMAIL PROTECTED] On Behalf Of Jim Devine
Sent: Friday, December 14, 2007 8:43 PM
To: [email protected]
Subject: [PEN-L] PK's lucid column
I am amazed the pen-l has ignored PK's column:
December 14, 2007 / New York TIMES
Op-Ed Columnist
After the Money's Gone
By PAUL KRUGMAN
On Wednesday, the Federal Reserve announced plans to lend $40 billion
to banks. By my count, it's 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 wouldn't count on
it.
In past financial crises - the stock market crash of 1987, the
aftermath of Russia's default in 1998 - the Fed has been able to wave
its magic wand and make market turmoil disappear. But this time the
magic isn't working.
Why not? Because the problem with the markets isn't just a lack of
liquidity - there's also a fundamental problem of solvency.
Let me explain the difference with a hypothetical example.
Suppose that there's a nasty rumor about the First Bank of
Pottersville: people say that the bank made a huge loan to the
president's 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 - and it may indeed go bust even though it
didn't really make that bum loan.
And because loss of confidence can be a self-fulfilling prophecy, even
depositors who don't 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 - 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 isn't how to restore
confidence; it's 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.
Russia's 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 -
both banks and, probably even more important, nonbank financial
institutions - made a lot of loans that are likely to go very, very
bad.
It's 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 - 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. What's going on in the markets isn't an irrational panic.
It's a wholly rational panic, because there's a lot of bad debt out
there, and you don't know how much of that bad debt is held by the guy
who wants to borrow your money.
How will it all end? Markets won't start functioning normally until
investors are reasonably sure that they know where the bodies - I
mean, the bad debts - are buried. And that probably won't 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.
David Brooks is off today.
--
Jim Devine / "The conventional view serves to protect us from the
painful job of thinking." -- John Kenneth Galbraith
