Context is Everything

Says Larry Summers, and it's no time to panic and make things worse:

Over the last two decades, major financial disruptions have taken place roughly every three years -- the 1987 stock market crash, the savings and loan collapse and credit crunch of the early 1990s, the 1994 Mexican peso devaluation, the Asian financial crises of 1997, the Russian default and Long Term Capital Management implosion of 1998, the bursting of the technology bubble in 2000, the disruptions of 9/11 and the 2002 post-Enron deflationary scare in the credit markets.

This record suggests that, by the beginning of 2007, the world was long overdue for a major financial disruption. And sure enough, the difficulties around sub-prime mortgages "went systemic" in the last month as the market seemed to doubt the creditworthiness of even the strongest institutions and rushed to buy Treasury debt.

Financial crises differ in detail. But just as there are plots common to literary tragedies, financial crises follow a common arc. First, there is overconfidence, rising asset values and leverage as investors increase their confidence in successful strategies. Second, there is a surprise event (e.g., the discovery of huge problems in the sub-prime sector and the resulting loss of confidence in credit-rating agencies) that leads investors to seek greater safety.

Third, as investors rush for the exits, the focus of risk analysis shifts from fundamentals to investor behavior. As some liquidate, prices fall, then others are forced to liquidate, driving prices down further. The anticipation of cascading liquidation leads to still more liquidation, creating price movements that seemed inconceivable only a few weeks before. Reduced credit feeds back negatively on the real economy.

Eventually -- sometimes in a few months, as in the U.S. in 1987 and 1998; sometimes in a decade, as in Japan during the 1990s -- there is enough liquidation and price adjustment to make extraordinary fear give way to ordinary greed, and the process of repair begins.

And for If that process is to succeed it is crucial that some

keep [their] head when all about [them]
Are losing theirs and blaming it on...

I am among the many with serious doubts about the wisdom of the quasi-guarantees that have supported government-supported enterprises -- such as Fannie Mae, the Federal National Mortgage Assn. -- as they operate in the mortgage market.

But if there is ever a moment when they should expand their activities, it is now, when mortgage liquidity is drying up. No doubt, credit standards in the sub-prime market were way too low for way too long. But now, as borrowers face the reset of adjustable mortgages, it is not the time for authorities to get religion and encourage the denial of credit.