Paul Krugman on the Credit Crunch

I just wonder if part of this crisis is not the result of the Bush administration animus against regulation. If there had been stricter regulations in the sub-prime mortgage market requiring genuine credit assessment before loans could be made, many of the defaults that are now happening would have been avoided. No loans would have been made.

NY Times, August 10, 2007
Op-Ed Columnist
Very Scary Things
By PAUL KRUGMAN

In September 1998, the collapse of Long Term Capital Management, a
giant
hedge fund, led to a meltdown in the financial markets similar, in some

ways, to what’s happening now. During the crisis in ’98, I attended
a
closed-door briefing given by a senior Federal Reserve official, who
laid out the grim state of the markets. “What can we do about it?”
asked
one participant. “Pray,” replied the Fed official.

Our prayers were answered. The Fed coordinated a rescue for L.T.C.M.,
while Robert Rubin, the Treasury secretary at the time, and Alan
Greenspan, who was the Fed chairman, assured investors that everything
would be all right. And the panic subsided.

Yesterday, President Bush, showing off his M.B.A. vocabulary, similarly

tried to reassure the markets. But Mr. Bush is, let’s say, a bit
lacking
in credibility. On the other hand, it’s not clear that anyone could
do
the trick: right now we’re suffering from a serious shortage of
saviors.
And that’s too bad, because we might need one.

What’s been happening in financial markets over the past few days is
something that truly scares monetary economists: liquidity has dried
up.
That is, markets in stuff that is normally traded all the time — in
particular, financial instruments backed by home mortgages — have
shut
down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst,
however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the
last few years, which in retrospect were as irrational as the dot-com
mania. The housing bubble was only part of it; across the board, people

began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans, which allowed

people without the usual financial qualifications to buy houses, and
the
eagerness with which investors bought securities backed by these loans.

But investors also snapped up high-yield corporate debt, a k a junk
bonds, driving the spread between junk bond yields and U.S. Treasuries
down to record lows.

Then reality hit — not all at once, but in a series of blows. First,
the
housing bubble popped. Then subprime melted down. Then there was a
surge
in investor nervousness about junk bonds: two months ago the yield on
corporate bonds rated B was only 2.45 percent higher than that on
government bonds; now the spread is well over 4 percent.

Investors were rattled recently when the subprime meltdown caused the
collapse of two hedge funds operated by Bear Stearns, the investment
bank. Since then, markets have been manic-depressive, with triple-digit

gains or losses in the Dow Jones industrial average — the rule rather

than the exception for the past two weeks.

But yesterday’s announcement by BNP Paribas, a large French bank,
that
it was suspending the operations of three of its own funds was, if
anything, the most ominous news yet. The suspension was necessary, the
bank said, because of “the complete evaporation of liquidity in
certain
market segments” — that is, there are no buyers.

When liquidity dries up, as I said, it can produce a chain reaction of
defaults. Financial institution A can’t sell its mortgage-backed
securities, so it can’t raise enough cash to make the payment it owes
to
institution B, which then doesn’t have the cash to pay institution C
—
and those who do have cash sit on it, because they don’t trust anyone

else to repay a loan, which makes things even worse.

And here’s the truly scary thing about liquidity crises: it’s very
hard
for policy makers to do anything about them.

The Fed normally responds to economic problems by cutting interest
rates
— and as of yesterday morning the futures markets put the probability
of
a rate cut by the Fed before the end of next month at almost 100
percent. It can also lend money to banks that are short of cash:
yesterday the European Central Bank, the Fed’s trans-Atlantic
counterpart, lent banks $130 billion, saying that it would provide
unlimited cash if necessary, and the Fed pumped in $24 billion.

But when liquidity dries up, the normal tools of policy lose much of
their effectiveness. Reducing the cost of money doesn’t do much for
borrowers if nobody is willing to make loans. Ensuring that banks have
plenty of cash doesn’t do much if the cash stays in the banks’
vaults.

There are other, more exotic things the Fed and, more important, the
executive branch of the U.S. government could do to contain the crisis
if the standard policies don’t work. But for a variety of reasons,
not
least the current administration’s record of incompetence, we’d
really
rather not go there.

Let’s hope, then, that this crisis blows over as quickly as that of
1998. But I wouldn’t count on it.