The realm of modern high finance with subprime mortgages and ABCP (asset based commercial paper) derivatives of all sorts is tough for most of us to grasp. Even the head of the US Federal Reserve Board needed to get an extensive briefing so that he could get a working knowledge of how these things were structured.
It's a global problem because these grossly overvalued securities were snapped up by banks worldwide. Banks in Britain, even Canada are taking a hit on their derivative holdings. Bush has tried to head off collapse by introducing a new mortgage plan designed to help some homeowners avoid default, triggering further snowball foreclosures. Now the Fed has stepped in announcing a plan to loan $40-billion to US banks to bolster their liquidity.
However, Princeton economist and New York Times columnist Paul Krugman says what American institutions are facing isn't the classic, run on banks of the old days. Things are much different now.
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.
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.
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.
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.
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