until investors are reasonably sure where the bodies are buried.

Krugman: Insolvency not illiquidity...		12/16/2007 6:13:27 PM
OnWednesday, the Federal Reserve announced plans to lend $40 billion tobanks. By my count, it's the fourth high-profile attempt to rescue thefinancial system since things started falling apart about five monthsago. Maybe this one will do the trick, but I wouldn't count on it. Inpast financial crises - the stock market crash of 1987, the aftermathof Russia's default in 1998 - the Fed has been able to wave its magicwand and make market turmoil disappear. But this time the magic isn'tworking. 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. Supposethat there's a nasty rumor about the First Bank of Pottersville: peoplesay that the bank made a huge loan to the president's brother-in-law,who squandered the money on a failed business venture. Even ifthe rumor is false, it can break the bank. If everyone, believing thatthe 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-saleprices - and it may indeed go bust even though it didn't really makethat bum loan. And because loss of confidence can be aself-fulfilling prophecy, even depositors who don't believe the rumorwould join in the bank run, trying to get their money out while theycan. 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 isliquidity - the ability to raise cash on short notice. And the Fed cansolve that problem by giving the bank a temporary loan, tiding it overuntil things calm down. Matters are very different, however, ifthe rumor is true: the bank really did make a big bad loan. Then theproblem isn't how to restore confidence; it's how to deal with the factthat the bank is really, truly insolvent, that is, busted. Mystory about a basically sound bank beset by a crisis of confidence,which can be rescued with a temporary loan from the Fed, is more orless what happened to the financial system as a whole in 1998. Russia'sdefault led to the collapse of the giant hedge fund Long Term CapitalManagement, and for a few weeks there was panic in the markets. Butwhen all was said and done, not that much money had been lost; atemporary expansion of credit by the Fed gave everyone time to regaintheir nerve, and the crisis soon passed. In August, the Fedtried 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 thereason is that this time the financial system - both banks and,probably even more important, nonbank financial institutions - made alot of loans that are likely to go very, very bad. It's easy toget lost in the details of subprime mortgages, resets, collateralizeddebt obligations, and so on. But there are two important facts that maygive you a sense of just how big the problem is. First, we hadan enormous housing bubble in the middle of this decade. To restore ahistorically normal ratio of housing prices to rents or incomes,average home prices would have to fall about 30 percent from theircurrent levels. Second, there was a tremendous amount ofborrowing into the bubble, as new home buyers purchased houses withlittle or no money down, and as people who already owned housesrefinanced their mortgages as a way of converting rising home pricesinto cash. As home prices come back down to earth, many of theseborrowers will find themselves with negative equity - owing more thantheir houses are worth. Negative equity, in turn, often leads toforeclosures and big losses for lenders. And the numbers arehuge. The financial blog Calculated Risk, using data from FirstAmerican CoreLogic, estimates that if home prices fall 20 percent therewill be 13.7 million homeowners with negative equity. If prices fall 30percent, that number would rise to more than 20 million. Thattranslates into a lot of losses, and explains why liquidity has driedup. What's going on in the markets isn't an irrational panic. It's awholly rational panic, because there's a lot of bad debt out there, andyou don't know how much of that bad debt is held by the guy who wantsto borrow your money. How will it all end? Markets won't startfunctioning normally until investors are reasonably sure that they knowwhere the bodies - I mean, the bad debts - are buried. And thatprobably won't happen until house prices have finished falling andfinancial institutions have come clean about all their losses. All ofthis will probably take years. Meanwhile, anyone who expects theFed or anyone else to come up with a plan that makes this financialcrisis just go away will be sorely disappointed. Paul Krugman isProfessor of Economics at Princeton University and a regular New YorkTimes columnist. His most recent book is The Conscience of a Liberal.