Paul Krugman The New York Times, December 14,2007 Present by Angie Sun After the Money’s Gone Paul Krugman The New York Times, December 14,2007 Present by Angie Sun

What’s wrong with the market? Financial system started falling apart since mid 2007 The Fed’s attempt to rescue through lending money to banks Lack of liquidity? Insolvency?

What if it’s “Lack of liquidity”? False Rumor: Bank A made many bad loans Depositors: loss of confidence Bank Run Without the Fed’s rescue Sell off assets at huge discount Bank unable to raise cash in short notice Depositors demand money out With the Fed’s rescue Inject liquidity by providing loan to Bank A Restore confidence

Real World Example: 1998 Financial market turmoil “sound bank beset by a crisis of confidence” Rescue outcome: “regained their nerve, and the crisis soon passed” Failure of Long-Term Capital Management The Fed provided temporary credit expansion Russia’s Default Market Panic

What if it’s “insolvency”? Bank A did have many bad loans The Fed Bank’s assets value providing funds Cover its debts (deposits) if bank run Bad loans: money gone

What if it’s “insolvency”? Bank A’s Balance Sheet Bank A’s Balance Sheet Assets Loans: $50M Liabilities Deposits: $50M Assets Loans: $25M Bad Loans: $25M Liabilities Deposits: $50M illiquid but sound Bank A: Solvent Gone Money Bank A’s Balance Sheet Assets unable to meet liabilities Bank A: Insolvent Assets Loans: $25M Liabilities Deposits: $50M

What’s really happening? August 2007 The Fed’s attempt to rescue The crisis of confidence worsened Bad loans made by nonbank financial institutions

Home prices would have to fall 30% How big the problem is? Fact I: Enormous housing bubble in the middle of the decade Housing prices Home prices would have to fall 30% Too high Rents or Incomes

How big the problem is? Fact II: Huge amount of borrowing into the bubble People owning houses New home buyer Refinancing: Apply for a new mortgage on the same house but with a higher principal Repay the old mortgage (lower principal) Buying house with little or no down payment principal difference: PROFITS

Collateral fails to cover the loss Negative Equity Borrowers owning $1M owing $1M Houses Value: $1M Lenders (Bank) Collateral If the house price drops to $.5M Borrowers owning $.5M owing $1M fails to repay Houses Value: $.5M Lenders (Bank) Collateral fails to cover the loss

Consequence: Market Panic Hidden bad debts lead to rational market panic How will it all end? house prices finish falling financial institutions come clean about hidden losses