August 10, 2007, 5:17 pm

A Dark Financial Forecast

Paul Krugman responds to readers comments on his Aug. 10 column, Very Scary Things. Terri Arnold, San Diego: Ive been puzzled by the reaction to the defaults in the subprime mortgage market? Arent financial institutions fairly savvy about the percentage of defaults on the loans it issues? Wouldnt the lenders involved in issuing subprime loans have had a pretty good idea of the risks involved? Am I being too cynical when I think this is another case of take the money and run? Paul Krugman: I think there are a couple of things. One is that as long as housing prices kept rising, the default rate was low, because people could refinance. And there was a lot of denial about the housing bubble. The other is securitization: these loans were chopped up, and the pieces marketed to investors who really had little idea what the real risks were. Michael M. Ross, Boston: Fixing the liquidity crisis should begin at the bottom of the pyramid, not the top. Any bailout should begin with individual subprime borrowers by starting a program of government-backed zero-percent mortgages. This would do more to restore confidence in the financial markets than all the free money loaned by central banks to big banks and would probably be cheaper too. Paul Krugman: Well, Id go for an active effort to restructure loans. Zero interest is not going to happen hey, our leader wont even raise gas taxes to keep the bridges from falling down. Sherri, Rochester, Mich.: Our assets are in stocks and bonds, most managed by Fidelity. We are senior citizens who have always saved and been conservative with our money. Is there anything we can do to protect our assets? Paul Krugman: If the bonds are AAA or better yet, government no problem. Stocks are risky, though I would say that right now their value isnt out of line with profits, which are very high. Len Cassamas, Atlanta: Given the weak dollar and the huge amount of debt the nation has accumulated, I have two questions. First, is there really any difference between a T-bill and a junk bond? Second, is this, in economic terms, the perfect storm brewing? In other words, in your view, how bad could this get?

Paul Krugman: Oh, yes, theres a huge difference. For all that Bush has done, the US government still has vast potential revenue compared with its debts. Also, T-bills are the safest asset even if youre worried what are you gonna hold instead, canned food in the basement. I dont think this is the perfect storm theres only one crisis, which is largely driven by housing. Now, if we add in something crazy like, say, Dick Cheney bombing Iran then youve got your perfect storm. Ray Copson, Reston, Va.: Heres my question: could this be the beginning of a crisis that forces the United States to balance the federal budget and rein in the trade deficit? Imagine the implications of that! Paul Krugman: So far that shoe hasnt dropped. If the Chinese start cashing out, then it gets interesting. George Peng, New York: I agree I think this has a ways to go. I suspect were seeing a classic unwinding. Im surprised we havent seen more about how the sudden disappearance of subprime loans effectively takes out a large part of the first-time homebuyers base, which then makes it difficult for second-time homebuyers to move up, and so on. If you consider the A.R.M. resets coming up soon, doesnt this mean that, at least in housing, were going to see some recursive effects for awhile? This slowing of the housing market has widespread impacts on the overall economy, so when analysts and pundit say the economy is healthy, I have to think that they seem to only be looking backwards, not forwards, which the stock market seems to be doing slightly more effectively. And the debt instruments backed by these loans trade in illiquid markets, so there can be wide spreads between fundamental and market prices. However, if youre levered up, then your margin lender may not care what fundamental value is and issue a margin call based on this putative market price. I think thats what were seeing lenders pick a price, issue the call, which then leads to more panic selling and margin calls as others notice. Of course, the other problem is that nobody knows what fundamental value is because default models are clearly wrong by significant margins. I guess the question is, how much of what were seeing is an issue of confidence or is it that the market is really seeing through the cheerleaders in the media who seem unable to admit that this is going to get a bit worse before it gets better? Paul Krugman: Thats the big question. On the one hand theres a panic, which may exaggerate the underlying problem; on the other, there are still a lot of unacknowledged losses. I wish I knew which was more important. Michael Petronio, Poughkeepsie, N.Y.: Your column implies that someone ought to step in and solve the liquidity crisis. But you offer no reason to do so, other than the fact that the liquidity crunch itself exists. The markets are working exactly how they should using essentially free money, the commercial and investment banks kept lowering and lowering their underwriting

standards on both the residential and commercial side in order to earn underwriting fees and excess spread. Institutional investors, hedge funds and homebuyers lapped it all up, with little or no concern for the possibility of defaults exceeding recent historical results. Now everyone most importantly, the institutional investor is taking a step back and reassessing the underlying risk of mortgage-backed securities and collateralized debt obligations. Banks are being forced to tighten credit standards, and hedge funds and investment funds that made foolish investment decisions are seeing the consequences of such foolishness. And homeowners who borrowed more than they could reasonably afford will lose homes they either never should have purchased in the first place, or should not have borrowed against to fund consumer purchases. Paul Krugman: What youre missing is the fact of a freeze in liquidity that can cause a lot of the real economy to tank. I dont weep for hedge fund losses, but I do worry about a recession. Marcelo P. Lima, Miami: Great column. Could you delve into what it means in practice for central banks to pump liquidity into the system? Weve all read the textbook description that they literally go out and buy treasuries in the case of the Fed, putting real cash into the system. But where does that cash come from? Does the Fed literally have to turn on the press and print money? As far as the E.C.B lending over 100 billion Euros, is it also a case of printing money? Does this money, in practice, get hauled over by armored cars to the institutions that borrowed, or does the E.C.B. simply transfer an electronic amount and then print the money? A column or piece investigating the mechanics would be great! Paul Krugman: Actually, very little ever gets printed. Bank reserves are mostly deposits at the central bank so theyre just electronic records. When I talked about cash in the banks vaults I was being slightly metaphorical. Cash is mostly held by the regular consuming public, plus criminals (there are a suspiciously large number of $100 and 100-Euro bills out there.) So no, the printing presses arent running all night. Eric Gustafson, Saint Paul, Minn.: In order to have a well functioning economy, dont we need a government that oversees and regulates it? What role, if any has the privatization of the federal lending agencies had on this crisis we are now facing? And are there any other areas where loosening of government regulations may have set us up for the crisis? Paul Krugman: I dont think its the privatization in this case. Instead, its what Floyd Norris wrote about in his excellent piece today: weve got things that arent called banks, and arent regulated like banks, doing bank-like stuff in the economy, and the regulatory system hasnt kept up.