They have blown up the trust on which business depends. In the financial world, once you have to prove you are worthy of credit, it's virtually gone. Creditors no longer trust borrowers, but if creditors don't roll over their short-term loans, the borrowing businesses will collapse. The problem is that the Federal Reserve's role as the lender of last resort is limited to commercial banks and doesn't cover other entities involved in banklike activities. And in this shadow world that has evaded regulation created during the 20th century, we just don't know who owes what to whom or whom to bail out.
The result is a contagion of credit exposure and a massive hoarding of liquidity as banks restrict credit to each other and to nonbank financial institutions, threatening a downward spiral. Banks are not lending because the mood is one of fear and uncertainty, aggravated by bad loans accumulating faster than the amounts the banks have reserved for the contingency. For the first time since 1993, the value of loans past due exceeds the reserves for bad debt.
Normally, the economy goes bad first, and that leads to financial problems. This time it is financial problems that are dragging down the economy. Defaults are increasing in other areas of unsecured consumer debt—credit cards, auto loans, and student loans. The risk of corporate defaults is rising from minuscule levels, under 1 percent, but in a typical recession, default rates can rise to many times that.
The risk is of a chain reaction. People rush for safety, pushing stocks and bonds lower, further weakening financial institutions by devaluating their assets, as banks pull back on their capital at risk. That, in turn, intensifies the credit crunch and aggravates the economic downturn.
The financial system is substantially frozen. It cannot channel funds from savers to those who need to borrow money. Businesses are struggling for access to funds, depressing corporate investment. Homeowners feel poorer as home prices fall, which causes them to spend less. The typical American family will cut its spending by about 7 cents for every dollar in housing wealth it loses, so the potential decline of over $4.5 trillion in home prices could lead to a nationwide reduction in consumer spending of over $300 billion this year, enough to tip the economy into recession.
The Fed's role. The good news is that federal expenditures today as a percentage of gdp are about seven times greater than in 1929, which dramatically compounds the effective automatic countercyclical forces that are in place. Furthermore, the Fed today can ease monetary policy when it deems necessary; by contrast, gold standard laws in the early 1930s forced the Fed, counterproductively, to drain reserves from the banking system when foreigners redeemed dollars for gold.
What is to be done?
Left to itself, the market will wring out trillions of dollars of debt that had artificially driven up the price of real estate and financial assets—in effect, an economy that was living beyond its means.
The Fed cannot block this process. But it is necessary for it to proceed in an orderly fashion. This will involve central bank intervention unprecedented in scale and scope to break the vicious circle of fear and forced selling. The Fed must buy time, and only the Fed can do that on the scale required.
The most compelling need is to find additional capital for the financial system. Otherwise, the adverse feedback loop could intensify. The government has also unleashed the special housing agencies—Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—to buy hundreds of billions of dollars of mortgage-backed securities, despite concerns over supporting unsustainable prices in, for example, residential real estate. Again, in order to stem panic and buy time, the Fed has no choice but to lend more money to more banks for longer periods against worse collateral.
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Krish of GA 12:24AM July 07, 2008
Me of KS 10:57AM June 10, 2008
William Bulck of WI 10:50AM June 07, 2008