Editore"s Note
Tilting at Windmills

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December 14, 2007
By: Kevin Drum

LIQUIDITY vs. SOLVENCY....Paul Krugman writes today that the Fed's latest plan to rescue the financial system probably won't work. The Fed can provide liquidity, he says, but liquidity isn't the problem. Actual bad loans are the problem:

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.

This sounds about right. There seem to be two fundamental problems at work here. First, there are huge numbers of mortgage loans out there that are genuinely hard to value. Partly that's because of lots of them were crappy no-doc-no-down-teaser-rate-two-year-reset-etc. loans to begin with, and partly because the housing bust means that even high-quality mortgage loans are tricky to value these days. Nobody knows just how far down the housing market is going to go, and that means nobody knows just how widespread the default rate is going to be on these loans.

Second, it's because the rating agencies appear to have been engaged in a massive, multi-year machination to over-rate complex financial instruments. Part of this seems to have been a genuine (if hardly excusable) mistake: the computer models they used to rate the tsunami of CDOs and SIVs coming out of Wall Street simply weren't as sophisticated as they thought they were. But it also seems to have partly been a case of the rating agencies being deliberately overoptimistic because they didn't want to lose the huge fees they were getting for rating these new financial instruments. No one wanted to piss in the punch bowl and ruin everyone's year-end bonus checks.

So: (a) lots of bad loans, (b) lots of good loans soured by the housing bust, and (c) all of them packaged up together and then given ratings that bore little relation to the actual quality of the underlying assets. And what makes it worse is that the uncertainty this causes generates even lower prices for this stuff than it deserves on its own lousy merits. CDOs and SIVs that are worth maybe 80% of their supposed value can't fetch even that much because everyone is petrified that things might be even worse than they think. Who knows what AAA really means these days? A real effort to honestly value all this stuff would cost everyone a lot of money, but it would probably be less than it's going to eventually cost them if they don't come clean. But no one wants to be first, so we are where we are: at the very beginning of a long, slow financial meltdown instead of at the midpoint of getting our arms around it all. Thanks a lot, Wall Street.

UPDATE: Steve Randy Waldman offers a counterpoint.

Kevin Drum 1:36 AM Permalink | Trackbacks | Comments (61)

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George W. Bush, meet Herbert Hoover.

(Actually, this is a bit unfair -- to Hoover. Hoover was a basically honest man whose political and economic viewpoint wouldn't let him address the catastrophe on his watch effectively. Bush is a venal psychopathic thug who doesn't give a damn about the damage he is causing.)

Posted by: jimBOB on December 14, 2007 at 1:42 AM | PERMALINK

Kevin, Do you really mean to say "meltdown"?

Perhaps S&L type hit or recession. But meltdown?

Posted by: JC on December 14, 2007 at 1:51 AM | PERMALINK

Central banks from the “Group of 10” unveiled a joint plan this week, to pump billions of dollars into the global banking system through a $24 billion currency swap and special lending facilities, aiming to cap the upward pressure on Libor deposit rates, denominated in Euros, sterling, and US dollars. Tensions have been running high in the global money markets since August, since banks are suspected to be saddled with losses of more than half-a-trillion dollars from toxic sub-prime US mortgages.

They say liquidity is not a problem yet they keep pumping in billions...

Posted by: Ya Know... on December 14, 2007 at 1:54 AM | PERMALINK

"But no one wants to be first, so we are where we are: at the very beginning of a long, slow financial meltdown instead of at the midpoint of getting our arms around it all. Thanks a lot, Wall Street."

Like I said: musical chairs.

Posted by: scarshapedstar on December 14, 2007 at 1:55 AM | PERMALINK

Ya Know comes closest.

Yes, you can blame the banks, the freed-up mortgage markets, the rating agencies. Overall there was the Fed. And it never lifted a finger or gave any warnings.

And now people talk as if the Fed's raison d'�tre is to keep everyone afloat.

In the old days, over-liberal lending would have been stamped on as an overexpansion of credit. These last few years, for sure, narry a word for over liberal lending. Not here. Not in the UK. I can't say about anywhere else.

So what we've got here is an erosion of capital against the loan book.

And you have to wonder about the political aspect. Is the Fed rosing the economic outlook?

Where did the conservative values of bank lending go? The same route as all "conservative" values. Political convenience.

So where did the "liberal" backbone go?

When all (that would be only 2 in the US) political parties seem to have no handle on a major credit crunch, you have to wonder who is engaged in a way that matters.

Posted by: notthere on December 14, 2007 at 2:28 AM | PERMALINK
"But no one wants to be first, so we are where we are: at the very beginning of a long, slow financial meltdown instead of at the midpoint of getting our arms around it all. Thanks a lot, Wall Street."

Like I said: musical chairs


More like a particularly sadistic game of musical chairs where 90% of the chairs are bombs with pressure triggers and the rest are broken. You can write off bad debt (not get a chair), buy bad debt (get a special chair), sell bad debt to a sucker (be the referee and instruct a kid to sit in a special chair), or you can be enormously lucky and have debt that's worth 80 cents on the dollar on which you can actually collect something close to that (sit down on a chair with a broken leg and fall to the floor). Posted by: R Johnston on December 14, 2007 at 2:35 AM | PERMALINK

JC: "Kevin, Do you really mean to say "meltdown"?
Perhaps S&L type hit or recession. But meltdown?"

For what it's worth, JC, the Wall Street Journal isn't shy about using the term "meltdown" today. Perhaps slow-motion-train-wreck is more appropo.

"How Goldman Won Big
On Mortgage Meltdown"

Posted by: GrinningGrouse on December 14, 2007 at 2:38 AM | PERMALINK

Yes MELTDOWN. Or even better, potentially fatal HEART attack.

Most ppl do not comprehend what is happening. What is happening is not some run of the mill stock market correction/crash. What you have today is the WORSE (yes the Worse!) economic fundamentals the US/world have ever seen since 1929.

The problem is that the GLOBAL CREDIT MARKETS are BROKEN.

Due to the trust issues mentioned in the article, nobody TRUSTS each other and money is NOT flowing. Ppl are no longer worried about the rate of return , they are worried that if they lend the wont get the original capital back because overnight they are worried the other party may go insolvent !

Because of this the velocity of money is slowing to a crawl ! For confirmation see trends in LIBOR and the TED spread, shrinkages in activity the ABCP market etc.

For those not familiar, the credit markets are the lifeblood of modern commerce and money flows in the form of debt between entities that lend/borrow. Without it, money/credit, the lifeblood of economic activity, STOPS.

And I have not even mentioned mountain of unregulated OTC derivatives that have exploded in size recently, when THAT mountain of derivatives (HELLO Credit Default Swaps !) starts unwinding, you are going get the mother of all economic explosions.

Go read www.rgemonitor.com/www.minyanville and blogs like calculated risk to start to understand what the US (and the world !) is facing.

And NO, despite what CNBC says, rate cuts will NOT solve this crisis, it is NOT a liquidity problem, it is a trust/solvency/information deficiency problem ! No one trusts each other !

And NO, this is NOT a right/left issue, both parties are complicit in letting this build up. So dun go blaming Bush/Clinton, both are to blame!

Posted by: piku on December 14, 2007 at 2:44 AM | PERMALINK

It's a pity these experts can't be so rational when bubbles are being blown up. I bet their asses are covered quite nicely, offshore.

I guess it's just a coincidence that our rights are evaporating and mercenary armies proliferate. America is an asset that has been in the process of liquidation since Reagan became president.

Posted by: Michael7843853 G-O/F in 08! on December 14, 2007 at 3:19 AM | PERMALINK

Ah, Grouse, if only the train wreck were in slow motion....I have the feeling in the coming weeks, it will look more like the Shinkansen--at top speed.

Posted by: monoglot on December 14, 2007 at 4:19 AM | PERMALINK

But, hey Kevin, we had the highest rate of homeownership EVER under Bush! At least until all those foreclosures happened......

Posted by: The Conservative Deflator on December 14, 2007 at 6:44 AM | PERMALINK

Wall Street? I guess that a side effect of this debacle is that social security privatization is dead and buried.

Good.

Posted by: raj on December 14, 2007 at 8:48 AM | PERMALINK

In mathematical terms, Paul Krugman's new economic equation can be expressed as follows, where:

V = virtual
M = money
R = reality
A = Bush administration
C = corruption
G = greed
I = incompetencE
U = Underhanded deviousness
F = Ferragamo's, Condi's favorite shoe store
T = Trifecta (Rumsefeld, Rove, Gonzalez)
O = Orleans Parish, Louisiana (New Orleans)
L = Lynne Cheney's husband, Dick
Y = Media's "Yes Men and Women"
B = Baghdad

Therefore:
GU(VM + VR) + IC(T + A)(U + L) / U(Y - R)(CIA + O + B) = TOTALLY FUBAR x 2

Posted by: Donald from Hawaii on December 14, 2007 at 8:54 AM | PERMALINK

Alan Greenspan was on NPR this morning denying responsibility for the whole mess.

The interviewer didn't bring up Greenspan's pushing ARMs, of course.

Posted by: Gregory on December 14, 2007 at 8:55 AM | PERMALINK

Let me state up front that I know less than nothing about finance. My question is about the US housing market. Surely only a small proportion of the debt is actually unrecoverable. Wouldn't aggressive refinancing the problem mortgages soften the blow? Isn't it better for everybody if the lenders get back 1% rather than lose all their money? Could the tax code be temporarily adjusted to favor that approach rather than writing off "bad" debt?

Posted by: greennotGreen on December 14, 2007 at 8:58 AM | PERMALINK

For those who consider this is a problem that has reached bottom--consider this:

We are just seeing the effect of those people who just couldn't afford what they took a mortgage on.

We are now seeing the fallout of these foreclosures. Look at how many financial instituions of struggling with this.

Now, add to that the effect of falling equity extraction due to falling house prices. People can no longer re-finance their houses and spend the cash extracted it on all those things that are so tempting to buy.

Add to that the loss of jobs and spending that accompanies building houses.

Add to that the loss of income and spending that formerly was generated by real estate transactions, from the realtor on through the lending firm to the bonding firms.

Add to that the loss of the enormous money and incomes generated by the 25 to 1 leverage generated by the magic money making schemes and debt bundling of financial institutions.

Multiply that by some magic "money recycle" number and pretty soon you will find that the US economy is in serious, serious trouble.

If this were the Titanic, we are at the point where we have scraped the iceberg, people are poking their heads out of their cabin doors wondering "What was that?" Below decks, the crew is beginning to panic. Meanwhile, on the bridge, the captain and officers make reassuring statements.

Posted by: Neal on December 14, 2007 at 8:58 AM | PERMALINK

Neal, I would say that the titanic has been holed already and those in the know have already sprinted for the lifeboats (look at GS's shorting of the CDOs that they were selling). Now some of those who have SOME idea are starting to wake up - but most are still listening to the band (CNBC) playing.

The situation that is confronting the US/world has never been encountered b4, so there is no easy answer. I urge those who read this to go out and research this carefully for themselves, think things through and take defensive measures. And do NOT listen to what the msm/newspapers SAY, but look at what the wall street banks/movers DO.

Posted by: piku on December 14, 2007 at 9:09 AM | PERMALINK

piku,

Bubbles and bad loans have often occurred before (see Charles Mackay's ever-timely book, Extraordinary Popular Delusions and the Madness of Crowds now only 166 years old). It took Japan a decade to begin to manage a very similar problem with a real estate bubble that the central bank could not acknowledge.

As for Greenspan, he lied. He is the single person most responsible for this disaster. He was nearly sensible under Clinton, but he let his partisan cheerleading blind him to the mistakes that were happening under Bush. He turned out to be one of the worst Chairmen ever (the idiots who helped engineer the Great Depression, particularly Roy Young, but also Eugene Meyer, are still worse), because he squandered the goodwill he had properly earned in the '90s, even if some of that was a political desire to kneecap Clinton, with politically motivated bad advice and indifference to bad policy decisions while he was trying to 'help' Bush.

Posted by: freelunch on December 14, 2007 at 9:45 AM | PERMALINK

Kevin's summary of the situation is the best I have seen in the traditional media or on the blogs. It would be helpful if people such as Brad DeLong would quit trying to force the mumbo-jumbo to make sense by waving their magic wands harder and address the fundamental issues that Kevin describes.

I would just quibble with this statement:

> And what makes it worse is that the
> uncertainty this causes generates
> even lower prices for this stuff
> than it deserves on its own lousy merits.

The problem here is that trust in the knowledge and integrity of the Wall Street financial institutions has been damaged. They claimed for 10 years that while we bumpkins in flyover country might not understand the subtle complexity of their wonderful financial instruments _they_ did and we should stop worrying and get with the program. Turns out the bumpkins were right and the self-styled experts didn't understand what they were doing. That revelation destroyed trust and it turns out that trust has a value. What you are terming "the price it deserves" is the price _with_ trust - but those instruments no longer have it.

That trust has a value surprises every vendor and outsourcing manager when they break trust and it comes around to bite them, but even in modern business it does.

Cranky

Posted by: Cranky Observer on December 14, 2007 at 9:53 AM | PERMALINK

Smart comments piku (even if I'm somewhat less alarmist about the situation) and certainly far more insightful than Paul "I put the con in economist" Krugman.

What you understand (and Krugman either doesn't understand or cynically refuses to address) are the human factors involved - the trust between lenders and the perceptions of investors. Off the bat, I'm not claiming the Fed's actions have solved or will solve the problem or that we have necessarily gotten our hands around the issues. But Krugman dismisses the Fed's actions out of hand by asserting that the grounds for panic are purely rational and than, in effect, we are doomed for disaster. But, and this is how I read your remarks, there are the specific issues within the housing market and then there are the impacts those issues have on broader credit markets. Injecting liquidity into the lending market may not (well let's be frank, will not) "solve" the housing crisis but it may well stave off panic about the market. And that would ease attendant panics in wider credit markets.

As just another example of Krugman's panic-mongering, he cites the need for a 30% decline in average home prices to restore balance. Well, the recent Moody's report said that some markets may see 30% drops but the nationwide drop would be "13% from their peak through early 2009" where they see the market stabilizing. In one fell swoop, Krugman doubles the forecasted nationwide impact. Not that a 13% drop isn't a serious problem, it's just not nearly as huge as Krugman claims.

Posted by: Hacksaw on December 14, 2007 at 9:58 AM | PERMALINK

I don't mean to be rude Hacksaw, but your 9:58 is indistinguishable from the hundreds of postings that go up on Yahoo Finance the day after a scam stock starts its final plunge. The principle of conservation of energy and the GIGO concept apply applies to the financial world as with everything else in human existence. If there really isn't any there there getting a bunch of people together to pretend there is, rather than dealing with the real situation, won't help and can easily make things worse.

Cranky

Posted by: Cranky Observer on December 14, 2007 at 10:08 AM | PERMALINK

Although the subprime problem is a subset of the international big bank credit crunch, it is important to distinguish them. The subprime mess is limited (smaller than the S&L crisis) and manageable. Its not clear whether the same can be said for the larger international credit confidence problem. The biggest banks, hedge funds, sovereign funds and institutional funds were trading huge amounts of debt back and forth, each time earning commissions. Turns out that debt is not going to be paid. Each party is looking to their counter party to make good on the debt (see Citi's action today taking responsibility for $48 b of SIV debt). Its not clear who is going to be left holding the empty bag. In the interim, the big boys are holding all of their cards. That means -- remember trickle down -- that there will less money available for everyone else when they need to borrow. The big boys would like everyone to believe that this is just a mortgage problem -- don't believe it. The real problem is the complicated, opaque investment vehicles they created and sold and that now can't be traded or valued. The central banks aren't acting this way to help out the little people. Note also: our friend Mr. Greenspan blocked any efforts to try to regulate these securities and the amonut of leverage involved in their trading. He felt the markets would regulate themselves.

Posted by: steve on December 14, 2007 at 10:10 AM | PERMALINK

all of which proves that in an unregulated free market, people will simply rip each other off until there's absolutely nothing left to steal.

Posted by: sc on December 14, 2007 at 10:14 AM | PERMALINK

Krugman states that for the rent/housing price ratio to return to historical norms, housing prices must drop 30%. That is one way. Another is for rent to increase 30%. Or housing prices drop 15% and rents increase 15%.

I am a big fan of Krugman, but I do not believe that housing prices will necessarily drop 30% on average. They might, it is more likely to trend to the middle.

Of course all real estate markets are local. So some local markets might exceed even 30%.


It is still no a pretty outlook.

Posted by: Catfish on December 14, 2007 at 10:17 AM | PERMALINK

The more loans that are foreclosed, the more houses get dumped on the market and sold at bargain prices further deflating housing values making the whole problem worse. It seems to be in the best interests of the holders of these packaged loans to lean on the processors of the loan payments to just stop foreclosing on homeowners even when payments are not being made.

Posted by: Th on December 14, 2007 at 10:30 AM | PERMALINK

Cranky,

No offense taken, maybe I worded it poorly. I think Krugman made the mistake of lumping too much together, oversimplifying what it going on, and taking the very real issues in the subprime market (people getting loans they cannot afford and will default on) and drawing a straight-line projection to apply the same inevitability to global credit markets. My own sense is that, contra Krugman, what is going on in the markets is a mix of rational and irrational panic. And that while the Fed can't do much to deal with the former it can certainly help calm the latter. I think that is what Krugman missed. So I agree that happy talk will not solve real structural problems in the market (your Yahoo Finance point) but we need to bear in mind that there is a very large element of investor perception and fear out there that is affected by a crisis of confidence wish in which the proverbial Yahoo message board plays a big role.

Great comment Steve. As I was saying above, I think Krugman's mistake has been in lumping this all together without describing the various elements and how they fit together. His article dismisses the Fed's actions by claiming that overvalued house prices and bad mortgages (subprime, little money down) are the issue. But, as you note, we could ride out the subprime problem and still have a hell of a global financial program - both a real one due to the CDIs as well as the confidence/trust problems that piku noted. Managing the linkages between the two is what the Fed and others need to be focused on because that's where the far larger danger lies.

Posted by: Hacksaw on December 14, 2007 at 10:32 AM | PERMALINK

Let's not forget foreigner bank buy-ins, maybe to become full buy-outs. Singapore bought a chunk of UBS just before Abu Dhabi Investment Authority bought into Citigroup.

We'll see a lot more of this, with the new investors insisting on clearing the books. And, if Middle Eastern groups want a bigger piece of the pie ... remember what happened over the ports issue.

And, Steve, let's not forget that margin reserve backups for banks and other institutions were diluted over recent years.

Hacksaw

Posted by: SocraticGadfly on December 14, 2007 at 10:33 AM | PERMALINK

Kevin wrote: "Nobody knows just how far down the housing market is going to go, and that means nobody knows just how widespread the default rate is going to be on these loans."

I do not see the logical connection between falling house prices and the ability of people to make their house payments. Although I do see how someone who knew he could only make payments for a short time and hoped to sell out at a profit in a few months is screwed.

Posted by: Larry on December 14, 2007 at 10:40 AM | PERMALINK

Irony alert: Hack implying Krugman is dishonest.

Posted by: Gregory on December 14, 2007 at 10:41 AM | PERMALINK

i don't take anyone seriously whose description of paul krugman is that he put the "con" in "economist," so i intend to be rude to hacksaw. krugman made some very straightforward observations, not a one of which is unsupportable, and the most important of which is that markets are behaving rationally. when hacksaw has evidence that they aren't, he can bring it to our attention, but until then....

the bottom line remains as krugman wrote: this is not a problem that lower interest rates will by themselves solve, although you'd rather, in the face of this problem, have lower than higher interest rates. too bad about inflation, but that'll be tomorrow's problem.

catfish, you need to work on your algebra: rents would have to rise more than 30% to restore the historic ratio. the numbers don't work the same in both directions.

but i actually posted here to deal with a related issue: because of leverage, we've had an impression of more capital in the world than actually exists. each of the writeoffs we've seen (and we're up to somewhere beween $50 and $80 billion) represents an actual recogntion of this reality, and as more is written off (goldman thinks it could go to $300 billion), the multiplier effects of a reduction in capital will make themselves felt.

Posted by: howard on December 14, 2007 at 10:47 AM | PERMALINK

Krugman states that for the rent/housing price ratio to return to historical norms, housing prices must drop 30%. That is one way. Another is for rent to increase 30%. Or housing prices drop 15% and rents increase 15%.

Rents are a major factor in the CPI, while house prices are not there at all (other than as imputed rents). If rents go up by 30% then we will essentially have 30% inflation. Homeowners will lose the same amount of buying power with their equity that they would have if prices went down. Furthermore, if wages do not keep up with this 30% inflation (which they are unlikely to do so in the face of global wage arbitrage), then this inflationary strategy will cause even more problems.

Posted by: Walker on December 14, 2007 at 11:00 AM | PERMALINK

Krugman is right about the bad debt, but it is a liquidity crisis as well, and some of the panic is irrational.

Oh, and this is not the outcome of a completely unregulated free market as some commenters claim- this entire disaster lays at the doorstep of Alan Greenspan who ran the Federal Reserve- a governmental organization.

Posted by: Yancey Ward on December 14, 2007 at 11:01 AM | PERMALINK

it is a trust/solvency/information deficiency problem ! No one trusts each other !

So much for the information age, eh?

Posted by: Doc at the Radar Station on December 14, 2007 at 11:11 AM | PERMALINK

sc,

all of which proves that in an unregulated free market, people will simply rip each other off until there's absolutely nothing left to steal.

Actually I have seen computer modeling of a fair market which demonstrated that over time the money would gradually flow to one big winner. If left alone the market would then stop, because the one big winner would have no one left to trade with.

So it may not be a flaw in people's nature, it may be inherent in the design of a market. There needs to be a certain amount of redistribution from 'rich' to 'poor' if one wants the trading game to continue.

Libertarians, obviously, would attack this idea to their dieing day.

Posted by: Tripp on December 14, 2007 at 11:18 AM | PERMALINK

Assuming everything said here is true, what can the average guy (aka "me") do?

I plan on holding onto the affordable mortgage I have. I am actively pumping money into my 401K and that is where my biggest concern is. I'm completely indexed and try not to direct things, but in this case is there something I should do besides watch from the sidelines?

Posted by: Tripp on December 14, 2007 at 11:21 AM | PERMALINK

His article dismisses the Fed's actions by claiming that overvalued house prices and bad mortgages (subprime, little money down) are the issue. But, as you note, we could ride out the subprime problem and still have a hell of a global financial program - both a real one due to the CDIs as well as the confidence/trust problems that piku noted. Managing the linkages between the two is what the Fed and others need to be focused on because that's where the far larger danger lies.
Posted by: Hacksaw on December 14, 2007 at 10:32 AM | PERMALINK

And I guess if Krugman was submitting an article to economic review a lot of these subtleties would be explained, but in the space of a NY Times column he cleared up a misconception that is criculating, the contrast between 1998 and today is a good point.

And you know maybe there is no Fed solution, other than the passage of time. That is not such a "crazy" notion. The experience of Japan and the colapse of their commercial property market comes to mind. Only time cured that in the end.

Posted by: Northern Observer on December 14, 2007 at 11:24 AM | PERMALINK

First, Krugman is an excellent trade economist. As a financial sector specialist, not so much so. His observations do see rather extended. But yes, there is a serious issue in a freeze up in the credit markets - no one knows how big or where the problems are due to complex mortgagesecuritisation products that turn out to have been, ahem, badly conceived.

Second, my dear Drum: you don't understand the mortgage issue at all. Not at all. The problem is not at the level of individual mortgages as such - even with poor documentation one can work out valuation. It's expensive, but it can be done.

The problem is at the level of portfolios of securitised mortgages (groups of say thousands of sub-Primes bundled together as a legal security - financial paper if you will). Said securities were sliced and diced into theoretical risk tranches, or segements, based on default probabilities, and sometimes further sliced and diced on other factors. So, you have a situ with pools of securities engineered supposedly for maximum finesse on risk distribution and return desire, based on assumed default probabilities (derived off of historical observations, but in prime markets largely, then 'adjusted'). Some of said securities are at 2 or 3 removes from the original loan.

There is your problem. Said securities were sold on to various investors, with supposedly solid ratings (AAA) and traded back and forth. Now the issue is no one knows where all of this is because the data was not thoroughly collected - who is holding what? Further, no one trusts the ratings on these securities (and US rating system on securities is badly tarnished, so there is a bit of a spill over into unrelated segments of the market - one reasonably asks oneself in terms of US securitised debt, well, if they fucked up so badly on mortgages - sub Prime to be sure - what on earth is lurking behind the other ratings....). Add to this that there are complex instruments built on top of these securities, and you have a toxic black hole of unknowledge.

Or in the Rumsfeld terminology, unknown unknowns. That is what the issue is in, not an individual home or individual home valuation. Rather in what the real expected default rate is AND who is holding what, because literally know one bloody knows. Further to that, no one knows what the unknown liquidity exposure is, even if you know your institution is clean - no sub-prime or US exotics exposure, do you have or do you want to take a credit exposure to an entity that may have tons of worthless US mortgage securities?

So, again, it ain't the bloody value of your bloody houses in Cali that is the fundamental problem - that is solvable, that is a known unknown that can be addressed. It is the unknown iceberg of credit exposure to people whose ability to pay (financial institutions I mean) is based on a huge risk they won't be liquid (have ready money) to do so.

In reality I do not expect the default rates to be that horrible - the problem is - and here one is in a real 1930s moment, can authorities take action to remove the paralyzing fear of a general solvency crisis? The competence of your government - or perceived lack thereof - is certain contributory.

Major action to prevent massive defaults - even if it causes loss of immediate value to the first tier securities holders would at least bring clarity and help reduce the massive risk overhang.

Posted by: The Lounsbury on December 14, 2007 at 11:31 AM | PERMALINK

Perhaps S&L type hit or recession. But meltdown?
Posted by: JC

Agreed.

Posted by: JeffII on December 14, 2007 at 11:32 AM | PERMALINK

"Perhaps S&L type hit or recession. But meltdown?"

The US dollar has lost nearly 1/3 of its value against other world currencies. The full impact of this has not been felt by the US consumer quite yet... but it will be.

>"Neal, I would say that the titanic has been holed already..."

Recent comment by a non-US economist. "We are on the Titanic... what is our current position relative to the scope of the impending disaster? We just left the harbor". [paraphrased somewhat]

All the above is 100% due to Bush/Neocon/Republican policies. The 'Bush recovery' was funded by a very intentional credit bubble... driving a very intentional housing bubble. This is a direct result of public policy based on fantasy.

The fatal plop will be the turkey which has yet to come home to roost... the additional impact of $1.5 trillion in unfunded war expenses.

My advice: Fasten your seat belts.

Posted by: Buford on December 14, 2007 at 11:33 AM | PERMALINK

There is a great article today in the wsj re how Goldman Sachs made $4 billion or so over the last year shorting the mortgage\structured investment markets for the firms own accounts while buying such investments for their clients accounts. Now our Sec of Treasury ran Goldman, so he must have been aware of Goldman's concerns re the market. Of course, that was private non-public information that couldn't be used to help the country anticipate and react to what has happened.

Posted by: steve on December 14, 2007 at 11:34 AM | PERMALINK

Krugman was telling us all about the coming mortgage mess long before anyone on Wallstreet was admitting there was any problem whatsoever. So while no one's estimate is likely to be completely accurate, I will go with his rather than friggin' Moody's.

"Con in economist" indeed.

Posted by: EmmaAnne on December 14, 2007 at 11:36 AM | PERMALINK

The experience of Japan and the colapse of their commercial property market comes to mind. Only time cured that in the end. Posted by: Northern Observer

Not really the same at all.

The Japanese real estate market has historically been best on land value and not on rent stream. Then there was heavy involvement by "organized" crime, which is not the same thing as major banks and mortgage brokers, though very close.

Posted by: JeffII on December 14, 2007 at 11:37 AM | PERMALINK

Liquidity on the retail end; overvalued assets/holdings on the wholesale end. Meltdown-hilarity ensues.

Posted by: scudbucket on December 14, 2007 at 11:38 AM | PERMALINK

Wouldn't aggressive refinancing the problem mortgages soften the blow?

Refinancing does not address the over-inflated prices paid for the mortgages. It is not just the interest payments that are causing the defaults, it is the realization the mortgages are not worth the price paid. No lender is going to refi a $300,000 mortgage for a house not worth $200,000.

I was bashing retail realtors and mortgage brokers about the bad advice they gave to people in 2005 and 2006, but they gave good advice in 2000 and 2001. It was the banks who approved loans for homes that had appreciated in a bubble that could not sustain its value. The banks are to blame for making loans on assets not worth the price.

I recall reading about a big business cycle bust about a hundred years ago, where JP Morgan sat down with his accountants and reviewed the books of every business that needed a bailout. The businesses that had not cooked their books and still had some reasonable expectation of continuing business were given new loans, the ones that did not look like they were going to weather the storm were set free into the markets. It looks like we need someone to review the books of every bank and let the overextended ones who played too fast and loose with questionable financial instruments to die. It will be painful, but letting the bad banks continue their bad business practices with Fed bailouts will probably be much worse in the long run.

We know a lot of banks own too many bad loans that they have used to secure loans for their business capital, but not which ones. The sooner we expose these faltering businesses and rid them from the market, the sooner we can fix the problem. It does not seem the market has a powerful player like JP Morgan, nor does it seem like the government or the Fed has a desire to assume that role. That may be why Krugman suggests it will be the home mortgage borrowers who will have to see their investments fall by 30% or more before all of the bad debts of the financial institutions are exposed.

Posted by: Brojo on December 14, 2007 at 11:39 AM | PERMALINK

The housing market will probably be soft in many parts of the country for about five years as the prices slowly decrease and rents slowly increase to bring them back in line with each other.

I suppose that's better than the decade that Japan suffered through with their commercial property bust.

Posted by: freelunch on December 14, 2007 at 11:42 AM | PERMALINK

...the problem is - and here one is in a real 1930s moment, can authorities take action to remove the paralyzing fear of a general solvency crisis? The competence of your government - or perceived lack thereof - is certain contributory.

Well, well, it looks like an economic Katrina we get to watch on CNN over the next several months.

Posted by: Doc at the Radar Station on December 14, 2007 at 11:44 AM | PERMALINK

Ah, Kevin.

So your god Krugboy makes a declaration that we're headed for "the worst economic disaster in history because of free markets" and now all you ninies are running around with your hair on fire. Funny to watch. Meanwhile, I'm gonna sit back, relax and pop a few more of my earnings into my Merryl Lych accounts.

Let's hear what Olympia Snavely-Broadside has to say about this:

"All of Liberal La-La Land in in an uproar about a 'credit collapse' on Wall Street. Pray make no mistake, gentlemen: this is no mere Bush-bashing reflex. This hearkens back to liberal Bank-Bashing of old. This is the liberal ruffian Andy Jackson taking his hatchet to poor Mr. Biddle's Bank. This is the Specie Circular all over again. In a phrase, it is nothing less than CLASS WARFARE! Yes, you shudder at those words, gentlemen. Those words that cause you to pull your babes closer to your bosoms and draw closed your curtains. Those words that conjure bands of pitchfork and torch waving ne'er-do-wells assembling on the ramparts, hungry for your possessions, your wealth and your family's station. Just remember, in this time of amplified anxiety, that no revolution based on class envy ever goes unpunished. So did Robespierre meet his Thermidor, Lamartine his Sedan, Kossuth his Vilagos. The animal spirits of the mobs can be - MUST be - broken. Stand and fight, gentlemen. If a fight is what they want, a fight is what they shall have!" [Copied here with permision.]

Posted by: egbert on December 14, 2007 at 11:44 AM | PERMALINK

rents slowly increase

Where I live, the speculators, who bought almost 30% of the new homes over the past five years, are trying to rent their investment now. There is a glut of rentals.

Posted by: Brojo on December 14, 2007 at 11:50 AM | PERMALINK

> The problem is at the level of portfolios of
> securitised mortgages (groups of say thousands of
> sub-Primes bundled together as a legal security -
> financial paper if you will). Said securities were
> sliced and diced into theoretical risk tranches,
> or segements, based on default probabilities, and
> sometimes further sliced and diced on other
> factors. So, you have a situ with pools of
> securities engineered supposedly for maximum
> finesse on risk distribution and return desire,
> based on assumed default probabilities

This is exactly the sort of mumbo-jumbo that Kevin's analysis cut through and rendered unnecessary. In fact the use of obfuscating mumbo-jumbo (particularly the misuse and ever-shifting definitions of the word "risk") is a core piece of the problem.

Cranky

Posted by: Cranky Observer on December 14, 2007 at 11:51 AM | PERMALINK

Brojo-

Fortune had a good article about rents and pricing in major markets a couple of months ago. Their conclusion was that almost every market was overpriced for homes and that this would have to be adjusted over time. There were a few cities where the construction was vastly faster than the growth rate of the city, and those were going to see serious weakness for a long time.

Of course, there's also Detroit, where they can't even give homes away and no one is building anything, but with negative household growth, that is still too many homes.

Posted by: freelunch on December 14, 2007 at 11:57 AM | PERMALINK

Gosh, you're right, Egbert. We're not really the #1 debtor nation in the world, our currency isn't really collapsing, we haven't actually leveraged our future so we can Consume the Planet today, we're not actually seeing good-paying jobs disappear while the cost of living soars and our grandchildren will live in a Banana Republic.

No, just keep putting your fake digital money in your fake digital investments for your fake digital life and hope the whole jury-rigged system doesn't fall apart during your lifetime.

Posted by: Speed on December 14, 2007 at 12:30 PM | PERMALINK

"The animal spirits of the mobs can be - MUST be - broken."

Egbert, you would have made a fine member of the British Upper Class in the Victorian era. Your name even fits.

Posted by: THX on December 14, 2007 at 12:32 PM | PERMALINK

Let's hear what Olympia Snavely-Broadside has to say about this

Oh now come on, we know that's really Mrs. Howell.

Posted by: Doc at the Radar Station on December 14, 2007 at 12:36 PM | PERMALINK

Economics is not my forte, but I must say that I'm enjoying the comments of partisans like Hacksaw, who are attempting to discredit for political purposes - through name-calling and / or personal invective - the carefully considered observations of a well-spoken academic who holds a doctorate in the subject in question.

Posted by: Donald from Hawaii on December 14, 2007 at 12:53 PM | PERMALINK

I doubt if the sky is really falling. I look forward to seeing what Warren Buffett buys. These kafuffles are his forte.

Posted by: Bob M on December 14, 2007 at 1:06 PM | PERMALINK

"Second, my dear Drum: you don't understand the mortgage issue at all. Not at all."

LOL... My dear Lounsbury, it's clear you don't understand Kevin's point at all. Not at all. Since your restatement of his argument was laughably incorrect, all you've done is create a lovely strawman argument solely for the pleasure of hearing yourself pontificate, at length and with a great deal of unnecessary verbiage.

Do feel free to come back when you have a point, won't you?

Posted by: PaulB on December 14, 2007 at 1:11 PM | PERMALINK

I disagree that this situation has been faced before.

The issue here is that this is not just an asset bubble - this is a systematic problem that has been spread much further/wider courtesy of securitization/unregulated OTC derivatives.

As for a precedent, basically there are 2 sides or bets being made here, inflation or deflation (or a combination of both, in varying timeframes). Depending on your view the outcome (and the precedent and hence the correct action to take) can be very different.

And blaming repub/dems is honestly just silly - both parties are identical on this stuff (look at their donors, they are the same) and would have acted the same way.

I am also a bit more alarmist because it is better to be safe then sorry.

And Cranky - what mumbo jumbo - Lonsbury's description is correct, he isnt doing it deliberately to bs you.

Posted by: piku on December 14, 2007 at 1:19 PM | PERMALINK

First, quite right Paul B in part, I misread Drum's commentary (other than his opening which is wrong in the details). My humble mea culpa for which my only excuse is it is quite late at night here at the end of a long week. Honest misreading.

The "bad loans" issue is questionable, it is, however, the lack of visibility on disentangling a decent number of acceptable loans and risk from pure rubbish.

Regardless, my apologies for misreading Drum and my apologies to him directly.

Posted by: The Lounsbury on December 14, 2007 at 1:21 PM | PERMALINK

Yancey Ward: Krugman is right about the bad debt, but it is a liquidity crisis as well, and some of the panic is irrational.

I'm sorry Yancey, but I'm going to have to agree with you.

Irrational panic can exist by itself, or it can be icing on the cake of real problems. Alas, this is the latter. The Fed's actions can't make everything better, but they can make things less painful and destructive. I think that's what they're doing now, and there's nothing more they can do now.

Oh, and this is not the outcome of a completely unregulated free market as some commenters claim- this entire disaster lays at the doorstep of Alan Greenspan who ran the Federal Reserve- a governmental organization.

Ok, now we can (partly) disagree. Much blame goes to Greenspan for keeping rates too low, but not all.

The financial three card monte of CDO's and their risk rating is exactly the sort of problem that occurs in unregulated markets. I partly blame Greenspan here too, but for opposing tighter regulation and oversight of these practices. The problem wasn't just government intervention of the wrong type (too low interest rates for too long) but also lack of government intervention of the right type - ensuring honesty and transparency in financial markets. Preventing fraud, or its close cousins, is exactly the type of intervention that government should do, lest the markets become a Wild West. Preventing fraud is one reason why properly regulated markets are more free in many ways than completely unregulated ones.

If you think that a complete lack of government intervention would have prevented this nonsense, the please review the history of the wildcat banking era.

Posted by: alex on December 14, 2007 at 2:34 PM | PERMALINK

"
"Like I said: musical chairs"

More like a particularly sadistic game of musical chairs where 90% of the chairs are bombs with pressure triggers and the rest are broken. You can write off bad debt (not get a chair), buy bad debt (get a special chair), sell bad debt to a sucker (be the referee and instruct a kid to sit in a special chair), or you can be enormously lucky and have debt that's worth 80 cents on the dollar on which you can actually collect something close to that (sit down on a chair with a broken leg and fall to the floor)."
Posted by: R Johnston on December 14, 2007

---------

Fantastic explanation for the layman.

What we have to do to govern is not to pick winners and losers, but to try and ameliorate the damage to private individuals who aren't speculators and to help smooth out the crash, so that as many of the corporate entities as possible can be kept solvent. This protects as much of the asset as possible while recognizing the situation isn't going to let us all walk away unscathed.

However, there will be some who try to use lobbying to get more for themselves. That's typical Washington behavior.

How to smooth out the crash? Legislation to let and perhaps force lenders and borrowers to refinance while accepting higher prices for borrowers and lower profits for lenders.

How to help the weakest? Loans or grants to the weakest and the legislation mentioned above to help everybody get through the bubble/burst without going belly up.

How to help the corpos? Legislation to smooth out the bubble/burst and Fed liquidity and perhaps help in getting larger entities to buy-out smaller ones which were closest to bankruptcy.

These aren't radical or even new ideas. They just need to be implemented in a non-partisan way for the good of the national economy.

Posted by: MarkH on December 14, 2007 at 2:39 PM | PERMALINK

Translation: Leveraged Funds bought crap assets
and no one stepped in to adjust the obvious growing relative risk in CMOs and the ARMs' component because the free market mantra and political totalitarianism of BushCo has silenced sound economic policy.

"Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction." (Greenspan euphemism for 'funds bought crap assets')

2006 Wall St bonuses $25 bill.

2007 Wall St. capital writedowns $25bill+.

Goldman Sachs ( Paulson..Fed..etc) has short position, cha chinging as they sold crap assets while the markets hemorrhaged.

Bravo Krugman for taking good shot at explaining this mess.

Posted by: cognitorex on December 14, 2007 at 4:33 PM | PERMALINK




 

 

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