In four steps, Paul Krugman presented his view of the current financial crisis:
- Foreclosures and defaults – a consequence of the burst housing bubble – caused a plunge in the prices of mortgage-backed securities i.e. those assets whose values are derived from mortgage payments
- Due to the above losses, numerous financial institutions experienced a drying up of their capital i.e. compared to their high debts, they have too few assets. Moreover, during the aforementioned bubble-period, these financial institutions took on heavy debts, hence the problem is even more severe
- This paucity of capital in relation to their debts have disabled financial institutions from providing the credit which the economy requires for growth
- To enable them pay their debts, financial institutions have attempted to liquidate (sell) their assets especially the aforementioned mortgage-backed securities. But hey, what happens when you try selling your asset under stress? Of course, its value comes down. This devaluation in their assets has further weakened the financial position of these institutions. Effectively, they’re trapped in this vicious circle viz the paradox of de-leveraging
The Fed, based on Mr Paulson’s plan, is very likely to take on $700 billion worth of troubled assets in particular the mortgage-backed securities. How wonderful? But at whose expense? Yours truly, but of course, and yours and yours – all of us US tax-payers!
Congress must decide over the next few days to agree or not with this huge Paulson Plan.
This, in a nutshell, is Paul Krugman’s op-ed column this week. Thank you, Mr Krugman, as always, you make much sense of the nonsense going around.