Crisis and bailout a la Krugman

[hay rick]

Paul Krugman gives an excellent, concise explanation of the current housing bust/credit crunch financial crisis and then adds his misgivings on the proposed bailout. Read the full article here:http://www.nytimes.com/2008/09/22/opinion/22krugman.html?_r=1&hp&oref=slogin

Here is the summary of the "how it happened" part:
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I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”
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He then characterizes the Paulson plan as a step 4 intervention- injecting new money into the market for distressed assets to stop the downward spiral of prices- and expresses his skepticism about such action resolving the crisis. Krugman continues:

<snip>
The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

That’s what happened in the savings and loan crisis: the feds took over ownership of the bad banks, not just their bad assets. It’s also what happened with Fannie and Freddie. (And by the way, that rescue has done what it was supposed to. Mortgage interest rates have come down sharply since the federal takeover.)

But Mr. Paulson insists that he wants a “clean” plan. “Clean,” in this context, means a taxpayer-financed bailout with no strings attached — no quid pro quo on the part of those being bailed out. Why is that a good thing? Add to this the fact that Mr. Paulson is also demanding dictatorial authority, plus immunity from review “by any court of law or any administrative agency,” and this adds up to an unacceptable proposal.
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Krugman is great at making complex economic matters more accessible. One further point of my own:

This crisis originated in the explosion of mortgage-lending to people who had insufficient income to pay for the properties they were buying, at the prices they were paying, on a conventional fixed loan basis. This crisis will not be truly resolved until housing prices come down to meet buyers' incomes and/or incomes increase to meet the increased price of housing. Declining family incomes over the last several years have played a part in creating this mess, but nobody wants to talk about it in the context of the current financial crisis. A sustainable recovery will also need to address the issue of how to support and increase family incomes.

[KittyWampus]

1. The crisis originated in Lenders turning mortgages into investment vehicles- securities that bundled

various mortgage debts together.

[hay rick]

2. Many moving parts.

Fannie and Freddie did the same thing earlier, but the underlying mortgages were sound, so the securities were less speculative.

Some of the factors that led to the current crisis:
1. The emergence of mortgage lenders who originated mortgages for a fee and then immediately sold them. Their stake was in collecting origination fees and it didn't matter to them that the buyer might default down the road. Indeed, their incentive was to expand the pool of would-be buyers as that would increase the number of mortgages they could sell. Better yet, the same people would have to come back to refinance before their teaser rates reset resulting in still more fees. As long as home prices continued to appreciate, buyers could refinance and take out home "equity" loans. Buyers entered into this arrangement willingly because it put them in a house they otherwise couldn't afford. They didn't necessarily read the fine print- they knew it had worked before. But everyone also knew this couldn't go on forever...

2. The firms that did the securitization hired the ratings agencies to rate their securities... a massive conflict of interest. Sub-prime loans ended up in bundles that were rated AAA.

3. Our current account deficit. Foreign holders of dollars needed a place to park their money. This created a capital infusion that helped prop up the system as the bubble expanded.

4. Feds turning a blind eye to all this.

Feel free to add to this list. The point is that, like a perfect storm, many factors came together to intensify the bubble and its aftermath.

[applegrove]

3. Thanks for posting.