As if it hasn't been talked up enough already, I would really recommend to anyone who is still unclear about the root cause of the credit freeze to check out the most recent episode of "Planet Money." I couldn't figure out how to link the episode directly, so you'll have to rummage through the archives yourselves if you're interested.
If not, the episode is essentially about bank insolvency: how it's define, how its relevant to the current crisis and what the government can or should do about it. It's that last point that I find the most interesting and which I don't think the episode got sufficiently all up in.
To summarize for those who don't know and don't want to listen to the podcast, a bank is insolvent when its liabilities exceed its assets. Actually, the way it's typically stated is when liabilities plus equity exceed its assets, but essentially the concept is the same. A bank is insolvent when it owes more than it has. A bank's liabilities is money it owes to other people (depositers, bondholders, direct lenders, nowadays the government...), while owner's equity is money that the bank itself has (or, more likely, that it owes is shareholders). In any event, liabilities and equity both constitute money that the bank owes to someone or something--either within or outside the bank. Assets, on the other hand, is all the value that the bank has. If Sol's Bank lends $1000 to Sarah, that loan is obviously a liability for Sarah, but for Sol, that grand plus interest is an asset.
Unfortunately, assets aren't always easy to price. If Sarah loses her job and all of a sudden it seems much less likely that she will be able to pay Sol back, the value of Sol Bank's asset is much diminished. By how much? Ask Sol and he will tell you that in all likelihood, Sarah will find a new job, that she will get the money to pay him back, and that his asset is still worth around $1000. Ask investor Dave, though, and he takes a look at Sarah's credit rating, at her person history, at the fact that she spent her $1000 on baking supplies and knitting material, and Dave will say that that asset is as good as worthless. Maybe he would be willing to take it off Sol Bank's hands for $200 (just in case, by some miracle Sarah does get a job and pay back the loan), but no more.
So here we have an asset of indeterminate value. Now imagine that there are trillions of dollars of such loans plugging up the balance sheets of banks everywhere. The banks can't/won't sell their assets because, especially since so many of them are loans collateralized by houses (a default forfeits real estate to the bank) and home prices are down many-a-percent all over the country, selling off these assets would force the banks to seriously write down the value of their overall assets. For many banks, its very likely that if they were forced to sell these "toxic" assets into the market at face value, they would all be insolvent. And by regulation in the U.S., once a bank is recognized to be insolvent, it must be shut down by the FDIC.
Why is this regulation in place? Because insolvent banks are not only recognized to be a problem for the banks creditors (i.e. if TD goes bankrupt tomorrow, without insurance I, the depositor, lose all of my money), insolvent banks are bad for the entire financial system. Like the living dead, these zombie banks can sustain their tenous grasp upon an unholy lifeforce only by feeding on the living. Aside from not having any money to lend out and freezing up credit for everyone, zombie banks are dangerous.
Above: "GAINS! GAAAAIIIIINNNNSSS!"
The issue is one of that characteristically vague and generally unhelpful economic concept (like most economic concepts), moral hazard. If someone doesn't face any additional risk in participating in risky behavior, so goes the idea, that person will be more likely to engage in that behavior. The standard economic example takes health insurance as an inducer of moral hazard behavior: if you're insured, you're going to be less careful when you decide to, say, allow your friend to piledrive you off of a roof into your mom's coffee table. But, like most standard economic examples, it's really stupid.
A better example of relevant and realistic moral hazard behavior is, conveniently, one of an insolvent bank. If Sol Bank discovers that he owes $100 billion to his depositors and lenders, that $10 billion is owned by the bank's shareholders, and that the $110 billion in loans he has on his books is actually worth, due to an ill-timed and entirely unexpected downturn in everything in the economy ever, $50 billion at current market prices, Sol Bank is effectively bankrupt. Even if Sol tries to sell off all of his assets, he would only be able to pay half of his liabilities off, to say nothing of his shareholders. Likewise, if Sol tries to make up the difference by borrowing the difference, that is only a temporary solution because that only increases the money he owes. Sol Bank is a Zombie Bank--its alive, but it shouldn't be--but don't tell the Treasury Department.
Sol (Braaaainns!) Bank only has one option. He can borrow some cash and try to find a series of investments that provides a much higher rate of return. Introduce Dan's Bean and Hard Boiled Egg Restaurant. Fortunately for Sol, since Dan has a terrible credit rating and is well-known for leaving his hard-boiled eggs on the stove for hours at a time, nobody will lend to him. It's for that reason that Dan has to accept a higher interest rate and it's for that reason that Sol can make big money by lending to Dan. It's a bit of a gamble for S(B!)B, since it may not be likely that Dan will actually pay any of the money back, but then again not too big a gamble: if Sol doesn't invest risky, he's certain to go under, if he does, he only might.
And that's moral hazard behavior. An insolvent bank is much more likely to make risky decisions than one that isn't, which is why almost every country in the world has fairly unequivicol regulation stating that insolvent banks cannot be allowed to exist.
So this is the potential problem the U.S. Department of Treasury now faces. If they don't act, many a-bank will go insolvent, which puts an enormous amount of pressure on an already overburdened FDIC and rattles the confidence of everyone in just about anything. If they do act, they can either a) effectively subsidize the banking industry by buying up their assets for more than their market value (giving Sol Bank $1000 for his loan to Sarah even though it isn't very likely Sarah will pay back), or b) buy the bank and absorb all of its losses. In both cases, the government is taking an enormous hit, but in the first case, the bank management stays in place and is basically rewarded for lending to bums like Sarah and Dan in the first place.
And that is moral hazard behavior. In the second case, on the other hand, you might end up with (gasp!) bureaucrats (likely handpicked off Wall Street anyway) managing the bank without succumbing to moral hazard behavior, since the demands of depositors are now insured by the proverbial printing presses of the Federal Reserve. There is no pressure to get the bank rapidly out of insolvency, only responsibly. But then we'd have something very bad which I won't even say except that it rhymes with fashion-ballzation (kind of) and then the shareholders might lose out.
Above: the face of fashion-ballzation
And in the end, when the shareholders lose out, don't we all?
*Get it? 'Cause the banks are "in the red," right? Would "Night of the Living Fed" have been better? Not quite as relevant. Maybe "Night of Living Ted-Spread"? God, I'm so lonely.
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