"...the greatest destruction of wealth in our history..."

I just have a question with this analysis: Where is FRAUD mentioned?
Everyone is haunted by the fear our financial crisis might unwind into something like the Great Depression. The world of finance is undergoing a hundred-year storm. It has inflicted the greatest destruction of wealth in our history. It swept away giant blue-chip financial firms, in a few months, even in a few days of fear, panic, and mistrust, that had made it through the Great Depression. It's turned out worse than the most pessimistic of us imagined.

Most critically, the financial world is seized by a collapse of confidence. The uncertainty over the value of the securities they hold has led to an enormous risk aversion. Customers, creditors, and shareholders of the major financial firms wonder whether they might survive. Once confidence collapses, there is no telling when the selling will stop. It all brings to mind the story of the economist who walked past a hundred dollar bill and didn't pick it up. When asked why, he responded, "It can't be a hundred dollar bill for, if it were, somebody else would have picked it up by now."

All of this has produced an unprecedented credit squeeze in which banks are refusing to lend to other banks, much less to businesses and individuals. This squeeze has had a particular impact on the newly unregulated emergent shadow banking system made up of mortgage lenders, investment banks, broker-dealers, hedge funds, private equity funds, money market funds, structured investment vehicles and conduits. Many of these names we have never heard of before but cumulatively, they now provide a majority of America's financing. They are not banks but they act and seem like banks. They borrow short and invest long, mostly in illiquid securities; they have more debt in relation to equity than banks but have lacked, until recently, both deposit insurance and the support of the Federal Reserve as the "lender of last resort." They do not have deposits but have relied on roll-over, short-term funding obtained through borrowing in the money markets that has left these firms vulnerable to disruptions in the money markets. To the extent that they have bundled these investments into securities that were sold to the markets, they were are also vulnerable to mark to market losses when these markets, or their securities, start falling.

This quickly wiped out the banks' capital base and ended their roll-over funding. The functioning of the credit markets was brought to a virtual halt. Even worse, there is a quiet run on hedge funds and private equity funds ongoing that threatens to bring the shadow banking system to its knees. Now the question is whether this will produce an economic contraction on Main Street comparable to the Great Depression.

The inescapable bad news is that a serious recession is inevitable given the damage to the financial sector, as well as in the degree to which business and the general public has been traumatized by collapsing stock prices and the daily headlines. But this does not mean we are bound to have a spiraling recessionary dynamic comparable to the thirties. The unprecedented debt American families and businesses have assumed will continue to constrain the easing of the credit crunch. But we have avoided some of the mistakes of 1929.

Take monetary policy. This time the Treasury and the Federal Reserve moved quickly and positively. They understood that when banks lose money they have to shrink their balance sheets and since bank assets are its loans, this would mean a drastic reduction in credit and worsening business conditions. The Fed has sought to ease the credit crunch by injecting over $1.5 trillion into the financial system and, most recently, added another $250 billion directly into the banks to re-liquefy them, plus increasing deposit insurance, extending it to money market funds, aggressively lowering interest rates and, importantly, doing that in concert with the other major economic powers.

In the early 1930s, the Fed refused credit to bankers and forced more and more of them to sell assets in a frantic dash for liquidity. Some 10,000 commercial banks, or 40%, failed between 1929 and 1933 compared to only 20 this time. Many people back then stopped using checks and conducted transactions in cash. The money supply declined by more than a third, creating a major contraction of credit.

The contrast in fiscal policy is equally dramatic. A generation of economists inspired by John Maynard Keynes in the 1930s taught us that the government should not try to run a balanced budget in a crisis of demand, as both Hoover and Roosevelt did. This time the government is running a $500 billion deficit to stimulate demand, and next year it will exceed $1 trillion. Orthodox adherence to the gold standard in the thirties didn't help, compared to a free floating US dollar today that has declined by 16% on a trade weighted basis. Another critical fiscal difference is that the federal government today has more sway. It makes up 21% of GDP compared to just 3% in 1929. On top of this a large component of GDP is devoted to health and education that is substantially decoupled from the problems of the private sector, not to mention that the Social Security program adopted in 1935 today provides unemployment benefits. All these contribute to maintaining the real economy.

Finally, we haven't repeated the great blunder of Hoover's 1930 Smoot-Hawley Tariff Act. It raised duties on some 20,000 foreign goods, causing many other countries to retaliate, reducing world trade by two-thirds. Now growing exports have been a major plus for our economy - something the protectionists in the Democratic Party need to remember.

Since virtually none of the necessary programs to counter the decline were implemented between 1929 and 1933. By the time FDR took over, the economic entrenchment had begun to feed on itself and turned a serious recession into the decade of the Great Depression. The reaction this time was virtually instantaneous.

All to the good, but there's also an "all to the bad" element in our present predicament. Americans are incredibly indebted. Household debt rose from about 50% of a $3 trillion GDP in 1980 to over 100% of a $13 trillion GDP today. The debts of the financial world, which amounted to 21% of GDP in 1980, soared to 120% of GDP by 2007. The financial world's unprecedented accumulation of debt in relation to equity sometimes with over $30 of debt for every $1 of equity means that small variations in their asset values, which once produced profits, have now brought them huge losses.

Much of this debt takes the form of securities and derivatives that remain on their balance sheets. In fact, another systemic risk and one that cannot be measured is based on the opacity and complexity of these exotic securities, mainly credit default swaps and derivatives that remain mainly on unknown financial balance sheets in amounts that exceed $50 trillion. The financial risk and exposure to loss is misunderstood and underestimated even by the credit agencies so the ensuing financial damage could be of a magnitude that could threaten the financial system.

AIG is a classic example of the inability to estimate the exposure. Management first estimated they would need $40 billion to get past their financial crisis; the government increased this to $85 billion; and within thirty days the cost had soared to $121 billion. Lehman is another example. When it went bankrupt, they had to unwind the credit insurance on Lehman, at a cost that has just been revealed to exceed $360 billion, an amount unrecognized by the Treasury when Lehman went under. These kinds of staggering losses could be multiplied many times over by defaults in cascading derivatives.

Then there is the housing bust. The current crisis in housing has an important history. When the Fed tried to respond to the dot.com bust in the year 2000 and 2001, that is when the Internet bubble burst, littering the country with bankruptcies and layoffs -- not to speak of investor losses of more than $1 trillion -- the Fed rapidly increased the money supply to offset these losses and slashed short-term interest rates to 1%, the lowest in 45 years. The result was the greatest housing boom this country had ever encountered. From 2002 to 2006 housing values appreciated at the astonishing rate of 16% per year compared to only 3% for the 55 years between 1945 and the year 2000. We finally came to the point where it was impossible for the typical American family to buy an average priced house using a conventional 30-year mortgage.

The response to this was an explosion of new mortgage products that enticed home buyers into supporting escalating housing prices while reducing their financial requirements. The need for the traditional 20% down payment was eliminated. Then we had interest only loans, low- or no-doc "liar loans," piggyback home-equity loans, as the mortgage and banking industries made it possible for anyone, even without a credit score, to purchase a home. These mortgages were packaged into complex financial products and sold on to other investors, many of whom had no idea what they were buying or the associated risks.

Then the housing bubble burst. Housing prices have dropped roughly 20% and the decline is continuing. Plummeting house prices mean more foreclosures, more homes on the glutted marketplace and a further house-price slump. There are 12 million homes today with negative equity where the mortgage exceeds the home's value and it may rise to 15 million over the next few months. As many as half of them have mortgages that now exceed the value of the homes by over 20%. If half these people drop the keys in a box and walk away, the losses will be in the trillions and may well destroy the equity in our banking system. That is why it is critical to find ways to keep foreclosures to a minimum. The entire attempt to re-liquefy the financial system could be undermined by this collapse in housing prices.

These are substantial threats and for all the measures (belatedly taken) distrust remains. American policymakers have seemed to be responding at an ad hoc, unfocused fashion, not fully taking into account the looming insolvency issues and the frightening complexity of the bundles of exotic securities. It is fair to acknowledge that they've been dealing with a crisis on a scale not seen before, and one that unfolded with terrifying speed. But the fact remains that by the time they acted, measures that might have re-stabilized the markets were ineffective. Robert Brusca of FAO Economics, captured it well when he said, "There is sense that if policymakers were surfers, they would have missed every wave."

Lehman's bankruptcy is a case study in government ineptitude. It was the $785 million of losses on Lehman's securities that pushed the value of the assets of a major money market firm below their $1 per share paid value, described as "breaking the buck." This caused $400 billion to be taken out of money market funds in a matter of days, while the rest of the funds were frozen in anticipation of further withdrawals. Banks were relying heavily on these funds for their commercial paper and the result was a spiral of illiquidity. The Lehman decision prompted the following from the French Minister of Finance, "Horrendous!" an assessment echoed by many others.

It remains puzzling that our Treasury officials did not foresee that the Lehman failure would not be just another failure, but a catastrophic failure undermining faith in the system. After Lehman, all remaining trust vanished in the financial world. Money market and interbank lending froze virtually completely. The spread on credit default swaps rose to levels that caused fear and speculation.

This mistake was followed by the Treasury scheme to buy toxic mortgage-backed securities. It was a flawed approach from day one. If the government bought them at a price above market and thus provided a huge bailout of Wall Street, it would have caused a political upheaval for it would have been seen to rescue them from the consequences of their misjudgment and greed. But if the government bought at current market prices financial firms would take enormous write-offs. In turn that would dramatically damage their balance sheets and force them to freeze their lending, the exact opposite of the purpose of this program.

Alas, the necessary defeat in Congress of Bailout Mark 1 was followed by Bailout Mark 2, purchased from politicians at the cost of a wholly unjustified $120 billion in additional pork barrel tax benefits.

The wiser approach, now adopted by the Treasury, but long advocated by economists and privately favored by Fed Chief Bernanke, according to the New York Times, has been for the government to invest in preferred stock in banks. This stock, convertible into common stocks if the companies later do well, is a much better deal for the taxpayer and assigns the sifting of the toxic assets to the system that created them.

What next?

Here are some proposals:

1. We must have a quick and efficient way to sustain more banks with capital injections, not just the major banks, using appropriate information gathered by bank supervisors.

2. We need to expand the definition of banks to extend appropriate regulatory regimes to the shadow banking system.

3. We will have to oblige the newly defined banking system to build up equity capital when their lending is expanding, for financial busts too often follow credit booms.

4. We must establish a standard for risk management and risk assessment covering mortgages, derivatives, debt, and even equity and especially on new financial instruments.

5. The Fed will have to continue to guarantee interbank borrowing by banks eligible for recapitalization to reactivate the interbank lending market and reduce abnormally high rates of interest on loans that float above the LIBOR interbank rate.

6. If there is to be a fiscal stimulus program, it should be primarily in infrastructure and not on tax cuts: these tend to be saved and not spent (and Obama's are more of a new entitlement program to people who don't pay any tax at all)

The danger is that politicians, who have little understanding of the financial world, may draw the wrong conclusions from Wall Street follies and make the wrong decisions, as they try to revive our financial system.

We must get this right. The new administration must draft the best of our national talent into shaping and administering these new policies. Otherwise the recession will not be U-shaped and relatively short. It will be L-shaped and extend for many unnecessary years.