The primary problem is that banks are refusing to extend credit to each other. Why? Because they do not understand the liabilities of their counterparties. Translated into English, that means they don’t know if the other bank whom they are dealing with will still to be standing tomorrow.
The thing roiling markets today is not the lack of confidence; It is capital, or more accurately, the lack thereof. Thanks to a series of very poor trades—excessively leveraged and absurdly risky to boot—banks are now dramatically undercapitalized.
As we have seen in just about every historical financial crisis, the shortage of capital is the underlying cause of monetary mayhem. Too much debt, too little equity, makes any financial system cease to function.
Why is that? Consider the way fractional banking works. Depositors open accounts with banks, earning interest, along with ready access to their accounts at any branch or ATM. The bank leaves a small fraction of the money on deposit, and uses the rest for loans, either to businesses or consumers. The smaller the fraction retained on deposit by the banks, the more money they have to lend out, and in theory, the greater their potential profits.
This is a quaint, 18th-century system. It worked well—at least before the modern era of derivatives and excess leverage. In ye olden days, a bank would get a $10 deposit, keep a buck as reserve cash, and lend out the other nine. Assuming they were careful about who they made loans to, this was a profitable enterprise.
In recent years, banks ran into three kinds of trouble: They made loans to people who failed to repay them; they did not keep adequate capital on reserve; they compounded their problems by borrowing money from each other to buy back all of those loans after they had been repackaged as fancy securities.
If it sounds ridiculous, it is only because it was.
What makes the current crisis so dangerous is that all these complex financial maneuvers have left the institutions themselves shell shocked. They no longer know who to trust. When Banks cannot tell if the other bank across the street has enough money to survive through tomorrow, they cease credit operations. As long as this condition exists, banks will be reluctant to lend money to anyone but the strongest financial institutions, who of course, do not need it.
Hence, a credit freeze.
Under these circumstances, the original Paulson rescue plan is unlikely to accomplish much. Buying up risky assets from the banks, which is what Troubled Asset Relief Program (TARP) is set to do, is like slapping a coat of paint on a house infested with termites. It may pretty up the banks for a short period of time, but it is unlikely to solve the underlying problem.
Ritholtz proposes two steps the government should take to deal with this problems: 1) nationalize the worst performing banks (or "put them down" as he puts it) and sell their accounts to stronger banks 2) buy stock in the stronger banks to recapitalize them, including investment matching dollars for private investors that want to take part. Ritzholtz argues that this is the only way in which the government can shore up confidence in the banks; once banks can trust that each other bank will still be around, lending will resume and the credit lock-up will be broken.
Paul Krugman seems to agree to a large extent, but he argues that only an international approach will resolve the problems that are bringing down the global markets:
Why do we need international cooperation? Because we have a globalized financial system in which a crisis that began with a bubble in Florida condos and California McMansions has caused monetary catastrophe in Iceland. We’re all in this together, and need a shared solution.
Why this weekend? Because there happen to be two big meetings taking place in Washington: a meeting of top financial officials from the major advanced nations on Friday, then the annual International Monetary Fund/World Bank meeting Saturday and Sunday. If these meetings end without at least an agreement in principle on a global rescue plan — if everyone goes home with nothing more than vague assertions that they intend to stay on top of the situation — a golden opportunity will have been missed, and the downward spiral could easily get even worse.
In other words we have big problems, and only big solutions have any hope of fixing them.