Estimates of Losses

Nouriel Roubini, a prescient observer who forecasted in 2006 and 2007 the financial crash, believes total credit losses will be "closer to $3 trillion'' than the $1 trillion to $2 trillion he previous estimated. Legendary prognosticator Marc Faber puts the total bill at $5 trillion. The International Monetary Fund put the figure at $1.4 trillion on Oct. 7, 2008. As of October 14, financial firms had reported $637 billion in losses, according to data compiled by Bloomberg.

Estimates of losses are inherently conjectural. For residential real estate, the question becomes: how many people walk away, such that the lenders absorb the losses, and how many stay in their homes, even though they are underwater? But housing is just one element of the picture. There are also credit card loans, auto loans, student loans, all of which have been hammered by the rise in interest rates. Commercial real estate, heavily dependent on the credit markets, was also driven to historic heights during the boom, with price to rental ratios reaching unprecedented levels. On top of this was overlaid the growth of extreme leverage throughout the financial system. Because of the interlocking nature of the obligations among financial institutions, the failure of several imperils the survival of all.

The great dilemma of government policy is fairly straightforward:

If financial institutions “mark to market” the various assets on their books, a great many are insolvent. To allow them all to fail would imperil the entire financial system and lead to a cascade of bankruptcies. On the other hand, to save them through governmental action risks “moral hazard” on an unprecedented scale, bailing out the foolish choices of Wall Street at the expense of taxpayers. It also imperils the balance sheet of the Federal Reserve and the US government.

The main point to keep in mind is that one cannot arrive at a just view of the government's bailout program without considering the likely scale of the losses. The higher these prove to be, the more irrational and wasteful will appear the current attempt to prop up financials and bail out current shareholders with public capital. It is only if the crisis we face is a liquidity crisis--a short term rush for unencumbered cash--that Paulson and Bernanke's approach stands a chance of vindication. But we have every reason to believe that insolvency is in fact at the root of the problem.