The Crisis - In Four Easy Steps

(this post was written by Kyle on September 22, 2008, and it concerns & )

In his Op-Ed, Cash for Trash, Paul Krugman gave the easiest-to-understand explanation for our current crisis. I’ve read a bunch of these over the last week, and this one seems the best.

  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.’

The rest of Mr. Krugman’s Op-Ed goes on to evaluate the bailout plan, and you really should go and read it, but I just wanted to post those four steps. With those in mind, I’m going to consider all Fluid Imagination readers as being on the same page.

Now we can have a conversation.