Insolvency

Krugman takes a stab at explaining why the economic crisis before us isn't simply one of liquidity, but of basic solvency:

It’s easy to get lost in the details of subprime mortgages, resets, collateralized debt obligations, and so on. But there are two important facts that may give you a sense of just how big the problem is.

First, we had an enormous housing bubble in the middle of this decade. To restore a historically normal ratio of housing prices to rents or incomes, average home prices would have to fall about 30 percent from their current levels.

Second, there was a tremendous amount of borrowing into the bubble, as new home buyers purchased houses with little or no money down, and as people who already owned houses refinanced their mortgages as a way of converting rising home prices into cash.

As home prices come back down to earth, many of these borrowers will find themselves with negative equity — owing more than their houses are worth. Negative equity, in turn, often leads to foreclosures and big losses for lenders.

And the numbers are huge. The financial blog Calculated Risk, using data from First American CoreLogic, estimates that if home prices fall 20 percent there will be 13.7 million homeowners with negative equity. If prices fall 30 percent, that number would rise to more than 20 million.

That translates into a lot of losses, and explains why liquidity has dried up. What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

We've already seen what these losses have meant to local governments in Florida. Eventually, the losses have to come onto the books of the banks, and the results won't be pretty -- and will likely be stunning for millions of investors who are parking their savings in "safe" money markets while they wait for the turbulence to pass. But the turbulence hasn't passed; we've barely even hit it yet. 2008 is going to be an ugly, ugly year.