Paul Krugman: After the Money’s Gone

Paul Krugman says we shouldn't expect the financial crisis to go away anytime soon:

After the Money’s Gone, by Paul Krugman, Commentary, NY Times: 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... 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... Suppose that there’s a nasty rumor about the First Bank of Pottersville: people say that the bank made a huge loan ... on a failed business venture... 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...

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...

Matters are very different, however, if the rumor is true... 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 ... sound bank ... which can be rescued with a temporary loan from the Fed, is more or less what happened ... in 1998...

In August, the Fed tried again to do what it did in 1998, and at first it seemed to work. But ... banks and ... 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... 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... To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent...

Second... As home prices come back down to earth, many ... 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 ... 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 ... 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.

Comments

[One Salient Oversight]

Good to see that Krugman reads economics blogs.

You out there Paul? Read my blog too!!!!!

[FYI]

http://krugmanonline.com/krugman-online.htm

Krugman's Bookmarks

A Note from Paul Krugman: Blogs and Web sites I read. Actually I read a lot, and creating this list involves the same problem bloggers have in choosing who to link to on their blogroll: too many, and you aren't helpful; too few, and you've insulted people. So this list isn't a quality judgment - there are many other fine sites. It's just a list of some sites I visit often, by type.

General News

McClatchy
The news organization formerly known as Knight-Ridder. They covered themselves in glory during the run-up to Iraq, beating much more prestigious competitors and exposing the truth about the shakiness of the case, through good old-fashioned investigative reporting. And they're still the modest, unglamorous news organization that often is the first to get the truth on important stories - for example, they were in the lead on the U.S. attorneys scandal.

TalkingPointsMemo
It's a blog! It's a news organization! It's a blog and a news organization! Josh Marshall has turned his operation into a serious source of investigative reporting, as well as a place that pulls together political news from all over.

ThinkProgress
The news site of the Center for American Progress, often picking up stories you might have missed.

Political Commentary

Daily Kos
Bill O'Reilly says it's a hate site and compared the Kossacks to Nazis. What better recommendation could you ask for? Seriously, Daily Kos is a community as much as a blog and must be read to know what the Democratic base is up to. And for those who claim that it's somehow crazy or extremist, try reading the Daily Kos war diaries and compare them with what, say, the Washington Post editorial page was saying at the same time. One sounds sane and balanced, the other credulous and off the wall. Guess which is which?

Eschaton
For a while Atrios was anonymous behind his nom de blog, and there were all sorts of rumors. I even heard he was me. Anyway, he's an economics PhD named Duncan Black - actually, I could tell that he had professional training even before that was revealed; somehow it shone through the wisecracks and occasional obscenities. Yes, he sometimes uses bad words - but the observations are sharp. The minimalist style - say, a link simply titled "Oh my" with no explanation - takes some getting used to, but it's actually sort of an art form and can be addictive.

Hullabaloo
Outraged but insightful commentary on these deranged, corrupt times. And Digby herself is simply an amazingly good writer.

Economics

Economist's View
I'm biased: Mark Thoma of the University of Oregon did a yeoman job of providing summaries of my columns for those without Times Select. But his site has many other virtues: It often contains links to interesting economic research and arguments I would otherwise have missed - and the dynamic feed on the right is a good way to keep up with lots of other econ blogs.

Brad DeLong
Brad is a first-rate macroeconomist and economic historian at Berkeley, with broad interests besides. The blog is eclectic: notes for his classes, political rants, comments on history and literature, media criticism (many entries titled "why oh why can't we have a better press corps"), plus a lot of interesting economic commentary. And don't miss the Shrillblog.

Congressional Budget Office
It was great before; now that Peter Orszag runs it, it's even better. Analyses of lots of things, not just the budget.

Center on Budget and Policy Priorities
Impeccable, relevant analysis of budget and economic issues, from a progressive point of view.

Economic Policy Institute
Good economic analysis, and a treasure trove of data.

Beat The Press
Dean Baker's critique of media coverage of economics.

Ezra Klein
It's mostly political commentary, but young Ezra is one of the best sources I know on health care economics.

Calculated Risk
The best site for coverage of the housing bubble and its consequences.

[chris]

This is the point that Nouriel Roubini made a while back. But Krugman makes it clearer and simpler. The US needs to sweep all its financial rubbish into a pile and see if the Chinese will pay something for it. About the only long term solution.

[Lafayette]

Article: As home prices come back down to earth, many ... 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.

Connected vessels

Negative equity simply means that realty owners have an asset that is worth less than they had paid for. It does not mean that they can no longer make their loan payments, which cause bank illiquidity.

The efforts, first in California, to offer those (who are victims of predatory pricing) to maintain their payments at the first offered "teaser rates" can work, if the ballooning of rates is abolished. Will this save most? Nobody can really tell.

What matters, finally, is that debtors maintain payments, which directly affects lender liquidity. And it matters that liquidity is maintained by credit repayments. Otherwise banks (or credit institutions) need to go looking to the Fed for funds to maintain accounting solvency. (But, the funds will be there when/if the need arises.)

What if debtors don't (keep up the payments) and they default? That is already happening and other people are stepping up at the auctions to repurchase the properties and put them back on the market at deflated prices. What does that mean?

That means that the "negative equity" is realized by the banks, given that many (if not most) of the defaulted properties were sold at "no down payment". (If such is not the case, then the down payment may be lost to the buyer.) That is, they recuperate their lent money by seizing the property and reselling it -- the net of which is returned to them. This too (since it is income) keeps away insolvency. But, it depends upon one fact: That consumers have faith in their own solvency (meaning their jobs) and will be able to pay the credit necessary to purchase a home. (As always, it depends upon entry-level buyers.)

What we have amongst all these relationship therefore is the water effect amongst connected vessels. In such a series, water seeks its own level -- but the quantity of water is not lost. This model is analogous to the subprime mess but is not identical. It is true, even if money is flowing from one entity to another, value IS being lost in the process.

The question is "how much"? The answer is: We don't really know, since the process is still underway. And, until we know, we (the credit institutions) are not lending anyone money for any reason whatsoever in order to protect our own solvency (which may be affected by the sub-prime mess).

This is a situation where the needed information regarding the nature of the debt is unavailable -- because our Masters of the Universe stupidly diluted the debt and then atomized it around the planet.

So, we have the "credit crunch". But, after all, what is this crunch? It is a matter of illiquidity, that is, the inability for some banks needing money to meet accounting solvency rules to find funds. Which is why Central Banks are riding to the rescue. Because it is the only way to get through the crisis if a bank does not finance the losses by means of its own reserves -- which some do.

Why does Krugman think this crisis is different and that the Central Banks cannot handle it? Good question. He should answer it -- because his article doesn't.

NB1: No, I don't buy that proposition that "negative equity" causes illiquidity. Too many defaulted assets, if they remain unsold, affect bank funds. If the economy dives, then yes, that's a problem as defaults rise (and properties are not resold). But, for as long as the economy maintains itself, and if loan payments do not balloon (and provoke more defaults) then the situation is containable. IMHO.
NB2: But, hey, I'm no finance guru. Still, I do know what happens between connected water vessels -- and money is like water, it flows.

[Dickeylee]

So the Fed is trying to stop the bleeding the only way it knows how, by throwing more liquidity at it? Sounds terminal to me. Could this all be a plan to turn the Chinese Trillions into millions? And do we think they're going to take it lying down? Hey honey, we're hundredaires!

[pt]

Lafayette, your comments are hard to understand. Paul is just saying that (a) he thinks home prices are likely to drop by a large amount, and (b) if they do, this will lead various lenders to lose a really damaging amount of money.

Which part of this do you disagree with? If prices drop below outstanding mortgages, some people will walk away, regardless of their ability to pay. In states like California, lenders can't go after borrowers for the unrecovered part of a loan what was used to buy a home. As prices drop more, more people will decide to walk away, driving prices down more. It snowballed on the way up, and it will snowball on the way down. It won't take a recession to trigger big price drops.

[calmo]

Great snowball analysis pt.
I'm done with "bubbles" now...you B so right: snowballs.

[calmo]

Laffy, I think the Fed is big on "liquidity" talk (when it doesn't use "alleviating the frozen" or "easing the freezing") to direct attention to the commercial banks that won't lend short to each other (which is the role the Fed plays with TAF --postponing the writedowns), and away from the probability that some of them would default before their year end statements (splains the timing and the tentative 'wing-it' nature of the auction proposition).
Serious consolidation in the banking industry to follow as the snowball continues down the hill.

[jim]

Yes. If banks aren't lending because they don't have enough money, then giving them more money solves the problem. If they aren't lending because they're afraid they won't get paid back, then giving them more money doesn't solve the problem.

says...

What can't the Fed inflate its way out of the housing price drop? The mortgages are for fixed amounts; if inflation starts roaring than the increasing value of the house will quickly be more than the outstanding loan.

Of course letting inflation loose would open up a whole new can of worms, but doesn't it suggest that there could be a fine line to walk balancing inflation to real-estate prices? Just a thought, I am not an economist...

[anne]

"Why can't the Fed inflate its way out of the housing price drop?"

Because that would directly contradict the legal mandate of the Federal Reserve, and because that would undermine much of the banking system by destroying assets so destroying the Fed. The problem for the Fed is how to foster the building of assets of financial instutitions. This was done from 1990 by lowering the Federal Funds rate to 3% and holding there to January 1994.

[ken melvin]

Pretend that in SF a two-bedroom bungalow in the Sunset gpt to $800k plus and that the average income for buyers is $100k.

[Twiggs]

Anne....."because that would undermine much of the banking system by destroying assets so destroying the Fed." Inflation destroys assets? Please explain.

[skeptonomist]

Calmo says 'I think the Fed is big on "liquidity" talk'.

It's not just the Fed. With all the jargon that economists and financiers use, you'd think that better and more precise ways could be found to describe the current problem. Description of the situation as a lack of "liquidity" makes it seem that it can easily (or not so easily) be solved by Fed action. Why does everything have to be framed in terms of what the Fed can do?

[anne]

Significant inflation is troublesome and reduces the value of assets for long term lenders, while the need is to increase the value of assets for financial institutions. Federal Reserve policy is and will be designed to allow a rebuilding of the asset base of financial institutions. Keeping short term interest rate low for several years was the need from 1990, and the Fed will try the same now.

[Noni Mausa]

Anne said....."because that would undermine much of the banking system by destroying assets so destroying the Fed." and then twiggs asked: "Inflation destroys assets? Please explain."

Well, maybe not solid things like houses, or Charolais breeding stock, or gold.

However, reduced interest rates at one end of the hot dog, and increased prices at the other end, nibble the hell out of my pension. There are a lot of us looking with trepidation to both nibbles on a fixed income.

Is that part of what you meant, Anne?

Noni

~ "eee! that tickles! ~

[kharris]

Twiggs,

This is not a direct answer to your question, but it may help. Imagine that mortgage borrowers are prone to default because their homes are worth less than the outstanding mortgage debt. Those holding mortgage paper are at risk of losing money. If the Fed induces inflation, nominal housing values will fall less, and perhaps rise, which reduces the incentive to default (on fixed rate mortgages). However, the real value of the cash flow to holders of the (fixed rate) mortgage paper is reduced because the real value of nominal cash flow is reduced at the rate of inflation. Either way, holders of mortgage paper lose value. In the second case, though, the Fed has intentionally intervened to transfer wealth from lenders to borrowers. It is one thing to lose money. It is quite another to have somebody create a policy aimed at making you lose money.

[lonesome moderate]

"What can't the Fed inflate its way out of the housing price drop?"

Well, once the word got out that the fed is pursuing a policy of high inflation, we would have a dollar meltdown in the financial markets overnight. I don't know what the consequences would be, exactly, of having the dollar instantly go from the world's reserve currency to just another unstable piece of paper, but I can't imagine that it would be good.

[btgraff]

"Inflation destroys assets? Please explain."

Interest paying assets moreso than equity or physical assets.... namely, bondholders suffer because as interest rates increase, the current value of the bond goes down.

[btgraff]

funny thing is that since so much US government bonds (and other US debt) is owned by China, Japan etc., inflation would mostly harm foreign governments! Because there is a trade-off with mortgages (inflation would reduce the present value of any mortgage debt, yet make the underlying assets worth more, since real estate prices would increase or at least not decrease any further), I don't see financial institutions as being the biggest losers.

Also, Paul Krugman reads this website! Hi Paul!

[anne]

For an individual who depends on what is truly a fixed income, any inflation lessens the income. However if fixed income means bond holdings, there are inflation protected bonds with which interest payments vary directly as inflation varies. Also, lower interest rates can bring capital gains to bond holders and there are assets beyond bonds to hold. So, for an individual the problem takes thought.

[calmo]

I like this bit from kharris:It is one thing to lose money. It is quite another to have somebody create a policy aimed at making you lose moneyIt's not often one (Ok, it could only B me) hears this political explication of the phrase "lose money" or "lost money" wrt some financial decision or public policy.
Exceptions include 'Greenspan (whoever) lowered (raised) interest rates again and my ARM reset means I'm going to lose money'.
More commonly "I lost money on my HB shorts." Rarely, "I lost money to HFs squeezing shorts."
The impression is that you have a hole in your pocket, --not that someone is drilling away extracting it...which might lead you to believe that 'making money' is just extracting this burden from someone else.
So much depends on this half-blind attitude, yes?

[Alan]

Regarding negative equity, Krugman explained on his blog why he considers it important. "In today’s column I emphasized the importance of what looks like a coming avalanche of negative equity — homeowners who owe more than their homes are worth. Why is this so important?
Well, I was strongly influenced by recent Boston Fed research, which finds a crucial role for negative equity in causing foreclosure.
We attribute most of the dramatic rise in foreclosures in 2006 and 2007 in Massachusetts to the decline in house prices that began in the summer of 2005. Subprime lending played a role but that role was in creating a class of homeowners who were particularly sensitive to declining house price appreciation, rather than, as is commonly believed, by placing people in inherently problematic mortgages.
…
negative equity is a necessary but not sufficient condition for default, because selling dominates defaulting if a borrower has positive equity.

[save_the_rustbelt]

Krugman's timing was really good on this one.....

Citigroup reveals $49 billion subprime blow amid ratings downgrade
Dec 14 04:39 AM US/Eastern

The world's biggest bank Citigroup is taking on board 49 billion dollars' (34 billion euros) worth of hugely devalued subprime loans to reassure markets amid a credit downgrading on concern about its capital base.

The announcement by Citigroup late Thursday insisted that the bank was dealing with the damage done by the US home-loan crisis, just as financial markets showed renewed alarm about the fallout and scepticism over central bank measures to shore up confidence.

Saying that the assets concerned had fallen from 87 billion dollars in August to 49 billion dollars, the bank insisted it was "maintaining the overall high credit quality of the portfolio." .........................

[Bruce Wilder]

Snowball Earth!

There's a wonderful paleoclimatology theory about what triggered an episode in earth's history, when the planet became a frozen snowball. (And, no, as far as anyone knows, Exxon was not involved.)

The financial snowball certainly seems to be rolling downhill, at a pretty good clip.

I like the way the Fed grabs attention with an offer of $40 billion in free money -- a staggering amount -- and then has that amount dwarfed by an announcement from Citigroup about "maintaining the overall high credit quality of the portfolio." (str -- that was truly priceless -- ranks up there with "your call is important to us" and "we're here to help").

Krugman made a good distinction between liquidity and solvency, and suggested why the solvency problem will prolong the crisis.

Efficient markets theory usually posits an immediate market adjustment to reflect changed expectations, and not the drip-drip-drip of Chinese water torture (or the niagra-niagra-niagra of the present crisis). My own experience in the financial markets is that information is often revealed gradually, and a consensus about factual reality emerges in a strip tease, where gradually Bayesian probability estimates are modified as a sequence of events confirms an initial guess or insight, which is not, initially, universally shared.

The present crisis seems to have built into it, a regular schedule of shocks to the system. And, just as important, it seems to have its own fog-generators in place. So, even as the snowball gathers speed, though we know there is a slope, no one will be able to see the slope clearly.

The liquidity crisis, reflected in sharply elevated rates for commercial paper, have done in the SIVs. The SIVs, I expect, are mostly solvent, but, by their nature, cannot survive a prolonged liquidity crunch. The collapse of the SIVs will radically alter the balance sheets of the Big Banks. A lot of the information content of financial statements is derived from comparing year-to-year -- the usual methods of financial accounting analysis will be useless, because, without SIVs to carry these things off the books, bank financial statements will look completely different from how they looked in the past.

The collapse of underwriters will have the same effect. The point of insuring bonds, thru credit default swap agreements and the like, has been the ability to take stuff off the financial statements. Without insurance, the banks will have to add potentially massive amounts to their balance sheets. All of this is fog-generation: assets are moving around, being re-valued, and there's no good way from "outside" (or really, "inside" in many cases) to discern what's "really going on", to discriminate intelligently between the effects of liquidity crisis and solvency crisis, between sound assets and worthless excretions.

Ironically, the financial statements of Big Banks will more fully disclose their true financial position, and at the same time, because of the novelty of the disclosures, even as the information content goes up, uncertainty and doubt among investors about what it all "means" will also escalate.

Meanwhile, of course, the housing market will be snowballing downward -- 10%, 20%, 30% over the course of the next two or three years, at least. So, for the next three years, even after the liquidity crisis has altered the financial structure and financial reporting of banks, bad news will continue to emerge.

[Bruce Wilder]

str: "maintaining the overall high credit quality of the portfolio."

That's priceless. Right up there with, "your call is important to us."

[Patricia Shannon]

It seems to me that negative equity, and a slow housing market, are important in the U.S. because of lack of job stability. A bunch of us are being laid off at Equifax, as it outsources as much as possible to India. Some of my co-workers whose jobs are ending would have a hard time relocating for the sake of a job because they have a house, and won't be able to sell it right now for what they owe on it.
Lest someone jump on me and make untrue accusations, I will waste room on the blog by pointing out that I like Indians, I have nothing against them, I just don't want U.S. jobs outsourced to them when it results in qualified U.S. workers not being able to get jobs.

Since I know some people will be interested, as of yesterday, I have a job that will start when this one ends. I still feel concern for my co-workers who will be laid off by the end of the year. One was laid off already, today is the last day for a couple more.

[Patricia Shannon]

There is an ancient Chinese curse that I thought everyone knew, but I found my co-workers have never heard of :
May you live in interesting times!

[Cynthia]

So the first moment Krugman's coyote looks down, he'll see a sea of water (liquidity)...

On second look, though, his coyote will see this sea of water suddenly turn into a huge block of ice (insolvency)...

Just hope (and pray) on the third and final Wile E. Coyote moment, the ice will turn back into water---or at least something between water and ice such as a soft cushion of snow...

[Robinia]

Yes, indeed, "maintaining the overall high credit quality of the portfolio." Might be a tad late on that job, I'd say.

Those mulling the posts below regarding the stability of the dollar as the "world currency" might also note the language that Citigroup uses here: "insisted that the bank was dealing with the damage done by the US home-loan crisis." Not the damage of a world-wide liquidity crisis. The words "US" and "crisis" (and/or "recession") are appearing much more frequently in the same sentence in the news these days. (Remember when you mostly only read that in Paul Krugman's columns?)

So-- this explanation in Wachtel's commentary below was very succinct in capsulizing a danger associated with potential drift (or worse, sudden drop) away from the holding of dollars as a "world currency":

"For the country whose currency achieves this status, there are considerable advantages. The United States can run large trade deficits, buying more than it sells in the world, because the selling countries are eager to acquire dollars as reserves. Such trade deficits are in reality debts whose reconciliation can be postponed as long as countries seek dollars as reserves."

So, help me here professors, but, I'm seeing that there is a possible follow-on bubble-bursting effect (or "day of reckoning or reconciliation") if the falling dollar results in some of these effective debts suddenly becoming due-- deepening a US recession caused by the housing market bubble bursting and the subprime lending crisis. Are aforementioned Masters of the Universe all planning to move overseas? I would think that the best approach would be to quantiy the insolvency/overvaluation of assets ASAP (expediate the process in Krugman's last paragraph). That is, actually, why I thought that perhaps the TAF idea would have some utility-- in that it would, through the auction mechanism, have a price-discovery aspect, and so start pointing to where the bodies are buried?

[calmo]

Well mulled (over), Robinia, and good points about the shifts in language (I miss those good old days when it was so sophisticated to announce "The subprime mortgage cisis is well-contained." and the like, you?) [For a short period, there were chronological collections of these statements showing these language shifts (spill over from the inter Fed meeting notes (which are surely cutanpastes with few edits from previous notes)?)...which put the current missives in historical context...thereby imparting meaning, significance, (and confidence) to the statements...which were no longer stand alone self-sufficient in this respect...the collecting of previous statements had to go. Our trashing of the historical perspective, such an important part of the general irresponsibility.]

This:That is, actually, why I thought that perhaps the TAF idea would have some utility-- in that it would, through the auction mechanism, have a price-discovery aspect, is what needs splainin now or we wait (like Chamberlain?) and see how(if?) the crud is priced (behind closed doors by parties identified only as "commercial banks"). Total loan (possibly partially recoverable) amounts @ $40B/month...cheap compared to Iraq, yes?

[barry payne - economist]

Bruce Wilder

Excellent expansion of Krugman's comments, and I recall that some curious scientists finally figured out that the frozen snowball was punched through from the bottom by volcanoes to set the melting cycle in motion.

I was curious if you or anyone may have comments on one old school theory of asymmetric expectations which asserts rising prices can induce dramatically more spending and aquisition of assets than falling prices.

If prices are falling, one tends to hold off, waiting for an even better price and shunning the asset as an investment, while rising prices can result in a bubble.

Another way to pose the question is to ask why bubbles don't deflate themselves in the same manner they do when expanding.

Even going from a "non-bubble" stable situation to a substantial drop in prices, doesn't this explain why the substantial distortions created by financing real assets going up in price don't repeat themselves in reverse when prices go down? (assuming equivalent fed enabling policy in both directions).

And doesn't much of the fraud disappear as the players look each over closely on the downside?

Also was curious on any comments about how Goldman Sachs managed to jump ship before it sank, particular on the subject of the "expensive insurance" purchased at the time - did the insurers get burned?

[hari]

If FED had not seen the abyss of R - word in its last meeting papers, it's unlikely it'd have agreed to inject such a huge amount of banking liquidity - in joint action with five other central banks.

The reading of their policy decision is NOT what Paul is concerned about - he's interested in the priority Bernake & Co are giving to their assessment of coming moral hazard.

Recession is inevitable now; but will it be prolonged and severe, is the more difficult question!

[Robinia]

Never could sound sophisticated hard as I might try, Calmo. Maybe because I'm actually thinking (messy and error-filled work) and not just repeating what others think sounds cool. But, yeah, I miss the days when I had some doubt in my own gut feeling that all these sophisticates trying to scam one another into buying over-rated assets would sink the whole she-bang eventually.

Sigh. If only somebody out there in the US would produce something, instead of just selling it in 57 varieties using 384 business plans and 1,596 financing options...

[calmo]

Hey, we do produce, we do.
Just don't get paid for it...not like the investors, not like those RE "producers" either.
And isn't that the thing: we abandoned our skills to become RE "producers" because that's where the money was?
A bit like being in a room full of lawyers all looking for clients...no counter parties worth talking to.
Trouble is, not all of us have the cushion to wait it out, until the normal clients return.
No, I wonder about the stability of a society with a projected (CR's site) 10M homeowners having no equity in their house by the end of 2008.
I don't trust the media to give us the real picture of this adjustment, you?

[vinnie vegas]

vinnie vegas says...

Once again, Wall Street brainiacs have bent middle-class Americans over and f*!#ed us in the ass. Next time I hear a blowhard rightwing/free market capitalist talk about personal responsibility that's directed at those stuck on the lower rungs of society I'm gonna go all second amendment on 'em.

[Robinia]

Naw, we'll get the real story from the blogs.

Bloggers are the free press of our times-- as above, even NYTimes columnists/international economics experts go there to hear the real deal. You're right-- we produce, we just don't get such a good return as either the RE flippers or the ad-copy guys working CNN and Faux News. But, chin up, neither did Ben Franklin and Tom Jefferson, and THEY kept writing.

[Dickeylee]

Does Citicorp now get the entire $40B? Inquiring minds want to know that this call is indeed important to you...

[calmo]

I don't think of this as work (hear those mice rampagin through my kitchen? there lies the work)[You think that's only a chore?...it used to be...] I don't think this is play either, but if you come onto me deadly serious, I'll retreat to that position in a flash...I'm not ascared of havin some fun, you know?
So, Robinia, I just wanted to defend workers (esp dish washers at the moment) here, ["we do produce, we do"] especially those who might have some inkling that they held the jobs the President was referring to when he said "There are jobs Americans just do not like to do. (the illegal alien jobs)"
It's not as glamorous now to derive your income solely from your work. This has come to mean that you are a servant to others who are investing and financing on your lesser activities. The tradesman who spends 4years learning his craft, earns a fraction of what he could make as a RE agent with 6 wks of training. [The RE agent teaches him that he is a dummy...lookit the size of his house an see if it ain't so.]
House prices made so many bad long term career decisions, no? [In econospeak: the allocation of human resources has been badly skewed by the magnitude of the housing boom...the recovery will be from the efforts of a singularly undistinguished labor pool...not short and sweet, but long and bitter.]
If the government could tie its own shoelaces, this debacle might never have been.
I'm hoping that the economic conditions just ahead are not severe enough to incubate an escalation in military adventures.

[BJ Feng]

A decent RE agent does do a lot of work, but people nowadays don't understand what a RE agent should do and most seem afraid to ask agents to do work. The agent works for you, but needs orders and specific guidelines. Unfortunately, most people are so ignorant of financial matters that they depend on agents for financial advice or other advice that agents have no expertise in. An agent can't tell you if your purchase will be profitable, or if you can really afford that house. An agent can only tell you if your house is at market price, not if the market is overpriced. That being said, I know of an acquaintance of mine who has been an agent for over 3 years now and hasn't sold, or been involved in one transaction! And now with the housing slump, it's hard to make it as an agent unless you actually have the skills.

The whole housing boom started due to low interest rates and an easy money policy by the FED. Now the FED is supposed to continue to accommodate? What other bubbles will pop up? Eventually these bubbles will have to deflate and that will be painful, but people don't seem to want to take the medicine they have to take in order for things to get back to "normal". Yes, thousands of foreclosures is the medicine. As someone mentioned before, negative home equity values don't matter unless that person can't afford the monthly mortgage payments, or that house was purchased for investment purposes instead of living purposes. I wish there were more information out there, but my guess is that the huge increase in foreclosures are with people who were "investing" or flipping, and had very little of their own money put at risk. They lose the home they paid nothing to get (zero down). Since rents are cheaper than mortgage payments in most cases, they can easily just move to an apartment.

[Ken]

economists dont grasp how people see their homes. Its a place to live and raise their families and not an investment. The banks and originators knew this when they "innovated" the mortgage market.

I think we have to look at what caused the bubble. First of all it was intentional. If it wasnt we have some really stupid people at the Fed. At the close of the last credit crisis (early 90's) Greenspan classified treasury debt as risk free. As if loaning out 9 of 10 dollars wasnt enought. That freed up 10's of billions. That coupled with the debt reduction policies of Clinton expanded MS. Then sweeps expanded it further. The additional leverage allowed for Glass Seag. to have its full effect. LTCM should have told us something. if they were too big to fail what did the Fed think would happen when consumer and investment banks consolidated?

The banks have had the SIV option to keep assets off the books and the commercial paper markets were flush with cash. With all this liquidity "we dont need no stinkin savings rate". Damn the capital requirements full leveage ahead.

Well here we are 15 years later wondering what happened.

The right thing is to allow citi, wahovia and morgan to put the assets on the books and get their capital requirements in order. That means selling those assets. If there is no market that means selling other assets that are worth something. A visit from banking regualtors isnt a bad idea either.

The next thing is to regulate and get confidence into the commercial paper market. At this point the fed is just replacing that missing liquidity.

[Robinia]

Gee, BJ Feng, wish that I could believe that were true-- actually, suspect that it is true in some markets/locations, but is very geographically uneven. Take a look at Detroit, for an example. There, we have a cadre of individuals very different from your honest, hard-working RE agent (I have friends in this category of honest RE broker, and I think they work for their pay). They preyed on whole neighborhoods of near-poor, elderly, mostly-black, innumerate people who had significant equity built up in their houses, convincing them to refinance using mortgages that were in no way appropriate or safe for their situations. That is, of course, why they call such lending predatory. Because it preys on the innocent. Once in a bundle, it is very hard to see this kind of loan as separate from the more ethical kind. And then, the ubermenschen play their alphabet-soup high-finance card games with the blended "products."

Still think that too many smart people in the US are involved in various arbitrage activities, and too few are producing tangible product. All cheifs, no indians (not to dis the Native peoples, who I deeply respect, and whose societies never had such imbalances). Agree with Calmo that the skilled and smart are simply being duped into thinking that the Wall St. high-fliers are smarter than them-- this from somebody whose income over 30 years has been primarily derived from her own tangible-product labor and the labor of her carpenter husband. Our little bit of money is invested mostly in our solar-heated house and a forest full of firewood. Which we think, actually, is not so dumb as some of the Wall St. wiz types might think.

[ken melvin]

We mourn our losses. For those jobs that we were proud of doing and doing very well, and for what might have been and will be again some day but probably not here. A moment please for all those automated plants that would have been here making everything now made in China by hand for nothing an hour. A mere setback I'm sure; no more than twenty years or so and the very best.

[ken melvin]

Strange indeed that the bed of real estate agents is so hot with Randism given that they produce nothing at all, work both sides, and, as any honest broker will tell you behind his/her hand, there's nary an honest one in the lot. When I told the old bastard that I was a graduate of Berkeley, he feigned a thoughtful look and said, "Ah. I know them well, nothing but a bunch of goddamned communist".

[calmo]

So comrad melvin...so glad to know ya. (Before another parenthetical takes me away, iz "After the money's gone" a Talking Heads line?)[Lately, do you find this "communist" charge just so unsupportable so desperate so hootable strikable that you want to take out your thick felt pen and put a big X right across the speaker's face?] I do appreciate your remarks about work, and automation displacing much of that human muscle and now human thought/calculation...that dimension that characterizes human behavior (not other animals (like mice) so much, no) is undergoing some radical transformations. Seriously, there is more to those bumper stickers ('Boys with the most toys win') than just the toy stickers.

Ken, does this sound funny to you:The next thing is to regulate and get confidence into the commercial paper market. At this point the fed is just replacing that missing liquidity. Wazit the unusual phrase "get confidence into" that tickles my ear (like get gasoline into the tank and I'm sure the car will start) or the triumphal march of those phrases around it: "The next thing is to...", & "At this point..." undaunted by the problem which for everyone else is snowballing out of control (the gas you put in the tank? well, the engine compartment is now on fire...the fire extinguisher you grabbed to put it out? it reacted badly with the upholstery and the fumes asphyxiated the occupants...the curious onlookers that came to gawk? not only cats are killed, no...)
But that's us: somewhat curious, somewhat killed.

comrad BJ, thank you for defending hard working RE agents against my insensitive charges that they don't earn their keep. (Such a phrase if I don't say so myself, keeper of mice.) [Do you earn your money or just make it? Make it or 'do well with your investments'?]
You B right: there is nobody quite so hustling as a hustling RE agent...trying to make payments on his McMansion too there are lawyers with RE licenses chasing ambulances. There are electricians with RE licenses, plumbers, mechanics, nurses, garbage collectors (who are so well placed to do this multi-tasking, no?)
You figure the RE industry should recognize their members in a different fashion from this "producer" thingie?

[cm]

Robinia: "Smarts" are not a one-dimensional thing. Gaming the rules instead of playing by them is arguably a dimension of (street) smarts.

Conversely, the line between honesty/straight-dealing and being (made) a sucker is unfortunately rather thin. The only saving grace for the scrupulous appears to be learning to recognize and avoid, or effectively retaliate against crooks (often difficult when bound by scruples).

[calmo]

cm, straight-dealin, straighter-talkin and straightest honestest poster in the universe (I'm such a distant second, obviously)[You try harder when you're 2nd, people.] this bit:Conversely, the line between honesty/straight-dealing and being (made) a sucker is unfortunately rather thin. brought to mind Reb presidential candidate, former Governor, current Baptist Minister Huckabee who I heard speak on NPR lately and about whom I read a disturbing "nervous" Krugman assessment.
No "Ums", "Ahs", or "Well"s with this guy. A person who sees the forest and is deaf to those poor little trees in front of him who have the audacity to think he knows where he's going. [You ministers out there know what I'm sayin?]
Filling the Black Hole of Republican Candidates is not wrinkly old Fred, but a real seasoned actor: Huckabee.

[ken melvin]

Huckabee a good real estate, refrigerator, used car, ... salesman.

[mrrunangun]

Prof. Krugman is so right on. As usual, the American government finds itself unable to face and deal effectively with unpleasant and threatening facts and prefers to implement a solution to a problem {liquidity} which is only a secondary effect of the primary problem {solvency}. The primary problem can thus be ignored for awhile longer as we have "done something" and the public and its government can feel satisfied for a time. Meanwhile the fire burns on hidden in a place we don't have to look for it.

[yamada]

I think people in the U.S. are now realizing their economic fundmentals, which Japan has experienced in the past.
Stil I think the numbers may get worsened than what has mentioned by Mr.Krugman, because the price of real estate in the U.S. has in averege tripled compared to the price 10 years before.
Nobody has invented the remedy to cope with the extreme asset depreciation.
But I hope the blog below may be the one, and be of use.

http://reversewealtheffect.blogspot.com/

[calmo]

Greetings Yamada and welcome to economisty...I visited your site and wish I could say I understand your view (me eyes not so good, ok, possibly the stuff behind the eyes not much better...). Are you coming from Japanese deflationary experience and are your formulations recognized in the Economics Literature?
Can you expand for us economics weaklings?

[Winslow R.]

PK wrote: "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."

Is this a statment on the current condition of the economics or politics? I expect better from Mr. Krugman, leader of the 'free world' in economics.

[Lafayette]

pt: Paul is just saying that (a) he thinks home prices are likely to drop by a large amount, and (b) if they do, this will lead various lenders to lose a really damaging amount of money. Which part of this do you disagree with?

I took pains to explain precisely what was happening. Read the comment posted above, again.

Krugman ties "negative equity" with credit institution "illiquidity". I have understood his explanation in that manner. And, it just isn't so.

The only illiquidity that is occurring is that of the home owner, who will not resell his/her house to make a profit. Therefore their "asset" is "illiquid".

In the past, people profited from "positive equity value" by selling their homes and spending part of the profit (whilst also buying another property, perhaps smaller). This fueled the economy, which is not about to happen again any time soon, given present housing prices.

So, the economy cannot expect any boost from "realty asset appreciation".

That's all that is being said ...

[Vigneswar]

Lafayette : In the past, people profited from "positive equity value" by selling their homes and spending part of the profit (whilst also buying another property, perhaps smaller). This fueled the economy, which is not about to happen again any time soon, given present housing prices.

This is what is happening in India these days or I should say for the past 2-3 years. Because of the current economic boom in India there is excess liquidity in the market and the House/Land prices have gone up by 10 times(20-30 times in some places).

Even though the Indian Government is trying its best to contain the prices by increasing the lending rates to 12-15%, people(Non Resident Indians - NRI's) dump money into India which is in turn diverted into the Realty sector, which further hikes the House prices. And now with even lesser interest rates in the US, NRI's would take the advantage of investing more into the realty in India.

And the Realtors in India capitalize on the NRI's by quoting exceptionally high prices and the NRI's blindly accept what the Realtors quote, and the prices go North in no time. Now this becomes a vicious circle.

So the main problem is - even though there is no market for New Houses, people are enticed in investing as they foresee
a huge profit by selling them off in a short period of time. And as more people join to cash in on the virtual opportunity, more is going to be the bubble size.

What they don't foresee is one day the bubble is going to burst.

[anne]

Vigneswar, please set down references when possible. And do add to you comment; I would like to read more about the Indian real estate market.

[Lafayette]

vw: What they don't foresee is one day the bubble is going to burst.

Speculative frenzies are almost always blind. Anyone in India would be wise to stay away from this one. (I recommend also the Economist's article this week on some doubts that are settling in as regards India's IT boom.)

Remember, once first-time buyers refuse to enter the market (typically due to an increase in borrowing and therefore repayment costs), then the bubble either bursts or let's out considerable air. First-time buyers trigger the cascade upward of housing transactions, as everybody seeks to move up a notch, thereby monetizing residual realty value to feed their consumption propensity.

The speculative bubble will inevitably burst, as you say. What seems too good to be true ... usually is. Particularly, in real estate. (Any fool can make money in an upmarket. It's a down market that separates the wheat from the chaff.)

[Richard Weller]

Krugman says:
"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."

True, this fire cannot be extinguished by an edict from the Fed. There is no one solution. We need a series of coordinated measures, first to gain time, then to deal with the solvency and liquidity issues.

A point to keep in mind is that as more foreclosures happen in a neighborhood, all property values there will fall, and more owners will find themselves in a negative equity situation. This then risks to shrink equity even more. Eventually this rebounds on the institutions holding the debt, provoking further writedowns of capital. Then we can get to a situation where insolvency might be suspected.

It makes sense therefore to put a moratorium on foreclosures while a package of measures is worked out. The current move by the Fed and other central banks to push funds out the door is a good temporary measure.

Here are two ideas:
For the SIV and CMO problem, a entity (under the Fed?) should link the databases of the mortgage servicers, originators, and various financial operators who have purchased and packaged and repackaged mortgages so that updated information could immediately pass from the the servicer to the ultimate debt holders. Then MLS data should be integrated with borrower data such as payment history, credit updates, mortgage terms, and employment status (if available), to model a measure of default risk. The MLS data could presumably give a rough estimate of the current value of the mortgaged property. This default risk would be consolidated with the risk figures for every loan that has been consolidated in a CMO. The weighted risk factor then would be applied to value the various tranches of the CMO. The purpose of this exercise would be to make public the real-time asset value of any given CMO.

I realize that people are hesitant to grab a falling knife, but at least the "safer" tranches should maintain their value. It should probably only be a question of the riskiest tranche being written down. This is a way to reduce the "unknown" to a normal businesslike level. If the SIVs have not all been bought in, then they could again be funded by short-term borrowing. If not, then anyway their assets already taken on the balance sheets of HSBC, Citi et al could be discounted in a normal manner, thus reducing uncertainty about the capital adequacy of these institutions.

To stabilize the mortgage market, lower interest rates is too generalized a solution, rather like the "trickle-down" concept. Rather than trying to increase financial liquidity, perhaps we could increase options for distressed real estate owners. Certainly we shouldn't completely ignore "moral hazard", but let's not shoot ourselves in the foot by thinking with blinders on.

A previous comment by Patricia Shannon (12/14 10:22 AM) explains one of the many consequences of negative equity - being unable to sell and move to take a new job. There are no doubt many situations where a "work-out", even if available, would not fit, either. The following is intended for those who cannot qualify for Congressional or Bush solutions:
I suggest an alternative market for trading down to function for the 3-4 years it will take the normal market to stabilize. My thought is that this will help avoid excessive overshoot to a bottom. Several previous remarks mention the risk to the Imperial Dollar. Perhaps that is the ultimate risk to our lifestyle.

What is the point of having an alternative market?
1. To sell and purchase new housing incurs a lot of expenses. The law for this market would suspend transfer taxes, mortgage fees, and commissions. The Federal government would fund its function.
2. The buyer would assume the seller's mortgage, but any terms extending into predatory territory would be invalid. So this "moral hazard" of purchasing a predatory loan would be realized by the debt owners and/or the originator. Further, any abusive over-valuation of the property at origination could result in a writedown of the principal. This might be flagged through modeling historic MLS data and grouping loans by problem originators.
3. While this is generally intended for homeowners, investor-owned properties in small markets could be included to increase buyer options ("moral hazard" not withstanding) or to meet excess demand for market efficiency. One could transfer out of a home in one market to move elsewhere.
4. If a consortium of lenders could work out a grid to convert loans to fixed-rate, that would help stabilize the market. The idea is to avoid too much case-by-case niggling which would interfere with market efficiency. Anyway, borrower quality could be reasonably known through the reform of the mortgage information system (above).
5. To get through this process faster, any mortgage terms concerning prepayment penalty would be inapplicable in that these "sales" would be treated as a privileged transfer. Besides, the revised mortgage would be assumed by another rather than being paid off. This would thus be more flexible than the Fed proposal (60-day window before rate reset).
6. The taxpayers in these transactions would have the option of carrying over their equity from the "sold" property, i.e. no taxable transaction.
7. In the case of servicers and originators in difficulty/bankruptcy, there must be an orderly transfer, if only temporary, of their data and functions to another servicer, perhaps the (Fed) entity proposed above.

One rationale for this alternative market is to create incentives for people to trade down, which is otherwise difficult to accept. This plan would not generally penalize mortgage holders although some of their rights to disallow loan changes should be overridden to allow the market responsiveness. Hopefully the volume of foreclosures and bankruptcies would be minimal compared to what has happened so far, not to mention the coming snowball (avalanche?) mentioned by other bloggers.

As many have observed, finding alternatives to foreclosure is ultimately less costly to the mortgage holder. In fact, we should recognize that ending this spiral is central to preventing major damage to our economy. Therefore, this solution would be a matter of public interest over-riding private contracts.

I would welcome any help to get these ideas a hearing.