After The Money's Gone
Waiting for the Fed after the money's gone
- Paul Krugman
Disappointment ahead for those expecting central bank's plan to solve debt mess
On Wed, the Fed announced plans to lend US$40b to banks.
In past financial crises, 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 isnt just a lack of liquidity - there's also a fundamental problem of solvency.
Suppose there's a nasty rumour 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 rumour 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 didnt really make that bum loan.
And because loss of confidence can be a self-fulfilling prophecy, even depositors who don't believe the rumour 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 rumour 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 rumour is true: the bank really did make a big bad loan. Then the problem isnt 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 (aftermath of Russia's default). 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 more importantly, nonbank financial institutions - made a lot of loans that are likely to go very, very bad.
There are two important facts that may give you a sense of just how big the problem is.
Bubble bursts
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 per cent from 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 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. If prices fall 20-30 per cent, there will be 13.7- 20 million homeowners with negative equity.
That translates into a lot of losses and explains why liquidity has dried up. It's a wholly rational panic, because there's a lot of bad debt out there, and you dont know how much of that is held by the guy who wants to borrow your money.
How will it 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 wont 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.
- Paul Krugman
Disappointment ahead for those expecting central bank's plan to solve debt mess
On Wed, the Fed announced plans to lend US$40b to banks.
In past financial crises, 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 isnt just a lack of liquidity - there's also a fundamental problem of solvency.
Suppose there's a nasty rumour 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 rumour 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 didnt really make that bum loan.
And because loss of confidence can be a self-fulfilling prophecy, even depositors who don't believe the rumour 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 rumour 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 rumour is true: the bank really did make a big bad loan. Then the problem isnt 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 (aftermath of Russia's default). 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 more importantly, nonbank financial institutions - made a lot of loans that are likely to go very, very bad.
There are two important facts that may give you a sense of just how big the problem is.
Bubble bursts
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 per cent from 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 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. If prices fall 20-30 per cent, there will be 13.7- 20 million homeowners with negative equity.
That translates into a lot of losses and explains why liquidity has dried up. It's a wholly rational panic, because there's a lot of bad debt out there, and you dont know how much of that is held by the guy who wants to borrow your money.
How will it 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 wont 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.
posted by Ming at 1:24 AM
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