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.