3 Quick Steps For the Economy

How we got here, and what we need to do—now—to start to turn this crisis around.

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Who could have imagined after years of prosperity that we would be in the throes of the worst financial meltdown in our history, one that has wiped out over $15 trillion of wealth from stocks, bonds, and real estate? Who could have imagined that the entire global financial system would be in distress? Or that the savants running our major financial institutions would inflict life-threatening wounds on themselves as well as on us because they didn't understand their own risks?

The symptoms so far: Brokerages fail to honor wire transfer instructions. Treasury bill transactions don't settle. The bond markets have virtually shut down such that publicly traded short-term debt instruments of high-quality companies can't be sold at almost any price. The refinancing of maturing debt is nearly impossible for non-investment-grade companies. Typically, most companies owing money to banks don't pay it off; they refinance. Now, unless equity can be raised—unlikely in most cases—they can't do that. Stock prices of outstanding companies have been falling in days by more than what is normal for entire years as investors sell long-term instruments to meet short-term cash needs.

Who could have imagined that housing prices would have dropped by 20 percent and yet are expected to drop that much again? Who could have imagined that the Big Three auto companies would all be on the verge of bankruptcy? Or that the five investment banks that survived the Great Depression would disappear within a few months?

The edge. The credit crunch is horrendous. It is the most important single issue facing the country. Only the support of the U.S. government has protected us from the complete vaporization of the financial world. How did it happen? Through the reckless bundling of debt, especially mortgages, into security packets and derivatives of those packages. Mortgage brokers, securitizers, derivative makers, and credit raters were not paid for making good loans. They were paid just for making transactions happen. Since they expected to hold the loans for no more than 45 days before the securitization took place, they ended up lending money to many who couldn't pay it back—all in order to generate fees. They acted as if there were no risk in the over-the-top lending to those seeking to buy or speculate in houses, office buildings, companies, and other financial assets. If the originators had been forced to keep these loans, they might have taken a wholly different viewpoint. But instead, they rushed to sell them to other eager investors and used the cash to make even more dubious loans.

Not only were they playing with Monopoly money, they acted like a Monopoly player on speed whose solvency depends on getting a double six on the next throw (odds against that: 35 to 1). Well, they didn't come anywhere near to beating the odds, and so they had no cash reserves when the bubbles burst in housing and finance. Hundreds of billions of dollars vanished. The government had to rush in. The Federal Reserve became not just the lender of last resort but the lender of sole resort. The Bush administration's initial plan to unclog billions of dollars of tainted mortgage-backed securities held by the banks was well intentioned but misguided. It became perhaps the most unpopular use of public money in U.S. history, seen largely as bailing out overpaid financiers and not helping the public. One result has been to undermine political support for the kind of government help now sought by the automobile industry.

Nor are we done. Saving the financial system from collapse is not the same as stopping the credit crunch. The world of finance cannot perform its role as a money multiplier, generating the liquidity that is several times the amount of reserves and deposits. Banks face new losses in credit cards, car loans, and commercial properties. Rather than lending, banks are husbanding their cash and their capital—including those billions invested by the U. S. Treasury. The problem is that many of the loans on their books made in good times are now intrinsically unprofitable and cannot be rolled over without dramatic losses. When fear of default is so high, the banks simply dare not risk lending. Instead, they have tightened credit on commercial and industrial loans, standard credit cards, and consumer loans, including home equity—restricting the supply of credit across the board. The securitization market, which provided so much of the funding for both corporations and, indirectly, for the consumer, has shut down completely. The attempt to gain liquidity has caused many funds and individuals to sell stocks, hence the volatility in the stock market. We have the first 401(k) crisis for the 50 million Americans whose retirement funds are tied up in a declining market.