The media often use the term "credit crisis", but they seldom define it. And they're similarly foggy about what caused it, and what sustains it. Here's a short explanation.
The "credit crisis" is a situation in which banks are unwilling to lend, both to each other and to their non-bank customers.
The credit crisis began with rising defaults on subprime mortgages, but it is now a self-reinforcing phenomenon that cannot be addressed solely by reining in defaults.
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Here's, in part, what happened:
- Banks bought mortgage-backed securities ("MBSs"). These securities confer various forms of ownership in underlying mortgages.
- To enhance their profits, banks borrowed money from each other at low rates to buy even more MBSs. In many cases they borrowed 10, 20, or even 30 times what they owned (their "equity").
- This worked well while housing prices were rising, since even the least-creditworthy borrowers could pay off their mortgages by refinancing them or by selling their houses.
- But then houses became so expensive that the pool of buyers dried up, and the boom petered out. Housing prices peaked, then began to fall. The weakest borrowers began to default. Simultaneously, many borrowers' variable-rate mortgages adjusted upward, further increasing the default rate. Banks began to sell foreclosed houses at a discount, pushing housing prices even lower.
- Mortgage defaults caused MBSs' market prices to decline.
- This didn't directly cause a problem, since most banks initially didn't need to sell their MBSs. However, accounting rules require banks regularly to determine their holdings' value, which they do by using the "mark-to-market rule".
- Mark-to-market requires banks to value their holdings -- including their MBSs -- according to current market prices, even if they have no intention of selling them.
- When banks did this, they found that their holdings' value had fallen. Their creditors (the banks that had lent them the cash to buy the MBSs) saw this, and grew nervous, since those holdings constituted the collateral for their loans. The creditors insisted that the borrowing banks raise more cash to improve the quantity and quality of their collateral.
- Borrowing banks sold MBSs (and other stuff) to raise this cash. This further depressed MBSs' market prices. That, in turn, caused banks' holdings to further fall in value, since the declines in MBSs' prices forced them once more to apply the mark-to-market rule (go to step 7).
- The end result is that banks' balance sheets have continuously deteriorated, which makes banks hesitate to lend to other banks...and thus to everyone else. And that's the core of the "credit crisis". [1]
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All of the "rescue" and "bailout" plans aim to persuade banks to increase lending to each other, and to everyone else. Generally they attempt to do this by interrupting the destructive feedback in steps 7-10, above.
The Paulson plan attempts to interrupt the feedback by directly buying MBSs, thus setting something of a floor on their market prices. Other plans attempt to interrupt the feedback by insuring banks against losses on MBSs, and still others by suspending the mark-to-market rule itself.
I think that the last -- temporarily suspending mark-to-market, and valuing MBSs based upon their probable returns and value at maturity -- is the best, and cheapest, way to interrupt the feedback and restore something of a normal credit market. Of course, the suspension must be temporary -- and we must have a solid plan to re-introduce some form of mark-to-market accounting -- lest banks re-enter fantasyland and we inflate a new bubble.
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[1] This ignores the role of "credit-default swaps" (CDSs), which did in AIG. That's another discussion, but, very briefly, I think that the remedy -- if one is needed -- is to void all CDSs except those owned by persons who also own the corresponding debt that the CDSs insure. The rest of the CDSs were just put-option-style gambles that, in extremis, we shouldn't bar ourselves from nationalizing.