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Very Scary Things

Paul Krugman writes in the New York Times (excerpt via Economist’s View):

In September 1998, the collapse of Long Term Capital Management, a giant hedge fund, led to a meltdown in the financial markets similar, in some ways, to what’s happening now. … The Fed coordinated a rescue…, while Robert Rubin, the Treasury secretary…, and Alan Greenspan,… the Fed chairman, assured investors that everything would be all right. And the panic subsided…

What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in … financial instruments backed by home mortgages … have shut down because there are no buyers.

This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.

The origins of the current crunch lie in the financial follies of the last few years… The housing bubble was only part of it; across the board, people began acting as if risk had disappeared.

Everyone knows now about the explosion in subprime loans … and the eagerness with which investors bought securities backed by these loans. But investors also snapped up … junk bonds, driving the spread between junk bond yields and U.S. Treasuries down to record lows.

Then reality hit… First, the housing bubble popped. Then subprime melted down. Then there was a surge in investor nervousness about junk bonds…

Read the complete text >>

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Categories: Economics
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