1. 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

2. 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?

3. 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

4. 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

5. 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

6. 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

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

8. 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

9. 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

10. 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

11. 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