Cumulative Model

I don't think cash will necessarily address the problem.

There seems to be two problems. The structure of cash flows don't match the expectations of banks when they bought these MBSec's, so many have a bad mix. Banks are afraid to lend to each other because they don't know who has a bad mix. The second problem is that aggregated, these MBSec’s have lost value for the same reason that banks ended up with a bad mix: Default Risk went up dramatically from expectations. Just like borrowers, banks are faced with lower asset values and lots of leverage (some banks should actually have higher asset value because they may own MBSec’s that are backed by cash flows that weren’t expected but are now coming in, like balloon interest rate payments).

Why did default risk go up? After 2005 oil prices went up ~100%, gas prices ~50%, other commodities went up… costs of consumables went up in price relative to everything else. Incomes for the majority were flat and negative. Expenses/Income increased significantly for the broader population. Viola, default risk jumps.

Here’s the problems with the solutions we’ve been given: Because costs have gone up so much relative to income, it can be expected that any inflation we will see will fall disproportionately on consumables. Combine that with the assumption that consumption and taxes are probably larger than income minus principal and interest payments for most people, it means default risk will rise with more inflation [until (Income – Tax – Interest – Principal Payment) is > Non-Interest Expenses].

UPDATE: Johnathan Gewirtz of chicagoboyz.net adds:

I don't know. It seems to me that the capital destruction caused by defaults and institutional failures (and expectations of more of same) is deflationary while recent Fed behavior has been inflationary. I don't think anyone knows how this is all going to shake out.

I'll add further: the velocity of money is down, so monetary expansion might not produce much inflation. The buying of T-bills to fund the policy would be contractionary too [but I have a feeling it will pull money from places we don't want to]. However, while the capital destruction should cause some deflation, the debts used to obtain the capital remain unchanged, so it drives up the real cost of principal and interest payments.

Little things that piled on: I think there was a bit of a gas price bubble as well. Poor reaction to high gas prices caused people to adopt inefficient driving habbits. This kept gas demand from going down much at all and reduced what we got out our gallon. Unfortunately, I don't think falling gas prices will make that go away. Fortunately, I don't think falling gas prices will reduce the push for more fuel efficient technology. The possibility of higher prices is enough to keep that going.

Another Update: Arnold Kling has an excellent summary up. I think this makes for an excellent set of lessons learned.

Mortgage Losses On Owner-Occupied Homes Lower Than Assumed from PhysOrg (via commeter at Lubos Motl's)

Part of the problem is that when default risk went up, buying slowed and so values on homes went down. This means that for many people, if they sell they are still stuck with a sizeable debt and no asset to lose if they default on it. And banks end up with an oversupply of properties it can only sell at firesale prices, which push home prices down further.

Here's a way to mitigate some of the problem.

Upon sale or foreclosure, the bank gives the borrower foreclosed properties on its books for the value, or partial-value, of the remaining debt.