Worst Crisis Since '30s, With No End Yet in Sight

The financial crisis that began 13 months ago has entered a new, far more serious phase.

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem -- troubled subprime mortgages -- in areas like credit-default swaps, the credit insurance contracts sold by American International Group Inc. and others firms. There's also a growing sense of wariness about the health of trading partners.

Fed and Treasury officials have identified the disease. It's called deleveraging, or the unwinding of debt.
- During the credit boom, financial institutions and American households took on too much debt. Between 2002 and 2006, household borrowing grew at an average annual rate of 11%, far outpacing overall economic growth.
- Borrowing by financial institutions grew by a 10% annualized rate. Now many of those borrowers can't pay back the loans, a problem that is exacerbated by the collapse in housing prices.
- They need to reduce their dependence on borrowed money, a painful and drawn-out process that can choke off credit and economic growth.


At least three things need to happen to bring the deleveraging process to an end, and they're hard to do at once.
- Financial institutions and others need to fess up to their mistakes by selling or writing down the value of distressed assets they bought with borrowed money.
- They need to pay off debt.
- Finally, they need to rebuild their capital cushions, which have been eroded by losses on those distressed assets.

But many of the distressed assets are hard to value and there are few if any buyers. Deleveraging also feeds on itself in a way that can create a downward spiral:
- Trying to sell assets pushes down the assets' prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms' share prices and makes it harder for them to sell new shares to raise capital. Mr. Bernanke, as an academic, dubbed this self-feeding loop a "financial accelerator."

"Many of the CEO types weren't willing...to take these losses, and say, 'I accept the fact that I'm selling these way below fundamental value,'" says Anil Kashyap, a University of Chicago Business School economics professor. "The ones that had the biggest exposure, they've all died."