Germany said on Sunday it would guarantee all private German bank accounts ”“ currently worth €568bn ”“ in a dramatic move to prevent panic withdrawals as fears over the worldwide financial crisis spread to Europe’s largest economy.

“We want to tell people that their savings are safe,” Angela Merkel, chancellor, said at an unscheduled press conference on Sunday. The scheme would cover existing accounts and others which savers might open….

German officials said the move was agreed because of fear that the crisis at Hypo Real Estate ”“ a listed mortgage and public sector lender, whose government-backed €35bn ($48bn, £27bn) rescue collapsed at the weekend ”“ would lead to widespread panic on Monday.

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Most of the time nobody notices the credit flowing through the lungs of the economy, any more than people notice the air they breathe. But everyone knows when credit stops circulating freely through markets to banks, businesses and consumers. For almost a year the markets had worried about banks’ liquidity and solvency. After the bankruptcy of Lehman Brothers last month, amid confusion about whom the state would save and on what terms, they panicked. The markets for three-, six- and 12-month paper are shut, so banks must borrow even more money overnight than usual.

Banks used to borrow from each other at about 0.08 percentage points above official rates; on September 30th they paid more than four percentage points more. In one auction to get dollar funds overnight from the European Central Bank, banks were prepared to pay interest of 11%, five times the pre-crisis rate. Astonishingly, rates scaled these extremes even as the Federal Reserve promised $620 billion of extra funding.

Bankers have always earned their crust by committing money for long periods and financing that with short-term deposits and borrowing. Today, that model has warped into self-parody: many of the banks’ assets are unsellable even as they have to return to the market each day to ask for lenders to vote on their survival. No wonder they are hoarding cash.

This is why those politicians who set the interests of Main Street against those of Wall Street are so wrong. Sooner or later the money markets affect every business.

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In the case of households, debt rose from about 50% of GDP in 1980 to a peak of 100% in 2006. In other words, households now owe as much as the entire U.S. economy can produce in a year. Much of the increase in debt was used to invest in real estate. The result was a bubble; at its peak, average U.S. house prices were rising at 20% a year. Then ”” as bubbles always do ”” it burst. The S&P Case-Shiller index of house prices in 20 cities has been falling since February 2007. And the decline is accelerating. In June prices were down 16% compared with a year earlier. In some cities ”” like Phoenix and Miami ”” they have fallen by as much as a third from their peaks. The U.S. real estate market hasn’t faced anything like this since the Depression. And the pain is not over. Credit Suisse predicts that 13% of U.S. homeowners with mortgages could end up losing their homes.

Banks and other financial institutions are in an even worse position: their debts are accumulating even faster. By 2007 the financial sector’s debt was equivalent to 116% of GDP, compared with a mere 21% in 1980. And the assets the banks loaded up on have fallen even further in value than the average home ”” by as much as 55% in the case of BBB-rated mortgage-backed securities.

To date, U.S. banks have admitted to $334 billion in losses and write-downs, and the final total will almost certainly be much higher. To compensate, they have managed to raise $235 billion in new capital. The trouble is that the net loss of $99 billion implies that they will need to shrink their balance sheets by 10 times that figure ”” almost a trillion dollars ”” to maintain a constant ratio between their assets and capital. That suggests a drastic reduction of credit, since a bank’s assets are its loans. Fewer loans mean tighter business conditions on Main Street. Your local car dealer won’t be able to get the credit he needs to maintain his inventory of automobiles. To survive, he’ll have to lay off some of his employees. Expect higher unemployment nationwide.

Anyone who doubts that the U.S. is heading for recession is living in denial. On an annualized basis, real retail sales and industrial production are both declining. Unemployment is already at its highest level in five years. The question is whether we’re headed for a short, relatively mild recession like that of 2001 ”” or a latter-day version of what the world went through in the 1930s: Depression 2.0.

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Panic was spreading on two of the scariest days ever in financial markets, and the biggest investors ”” not small investors ”” were panicking the most. Nobody was sure how much damage it would cause before it ended.

This is what a credit crisis looks like. It’s not like a stock market crisis, where the scary plunge of stocks is obvious to all. The credit crisis has played out in places most people can’t see. It’s banks refusing to lend to other banks ”” even though that is one of the most essential functions of the banking system. It’s a loss of confidence in seemingly healthy institutions like Morgan Stanley and Goldman ”” both of which reported profits even as the pressure was mounting. It is panicked hedge funds pulling out cash. It is frightened investors protecting themselves by buying credit-default swaps ”” a financial insurance policy against potential bankruptcy ”” at prices 30 times what they normally would pay.

It was this 36-hour period two weeks ago ”” from the morning of Wednesday, Sept. 17, to the afternoon of Thursday, Sept. 18 ”” that spooked policy makers by opening fissures in the worldwide financial system.

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Remember the definition of the TED spread–The difference between what banks and the Treasury pay to borrow money for three months.

This really is a helpful chart. Make sure also to look at the weekly picture and then the monthly chart. Basically, the higher this goes, the more clogged the world financial system becomes, until a heart attack becomes inevitable.

The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years.

This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system (which included the likes of Thornburg Mortgage, Bear Stearns and Lehman Brothers) made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios, which was critical to its tremendous profitability. Finally, loans were usually securitized and traded among financial firms.

This business model has now proven extremely fragile. First, the model created a fundamental maturity mismatch, whereby loans were of a long term nature but funding was short-term. That left firms vulnerable to disruptions of money market funding, as has now occurred.

Second, securitization converted loans into financial instruments that could be priced according to market conditions. That was fine when prices were rising, but when they started falling firms had to take large mark-to-market losses. Given their low capital ratios, those losses quickly wiped out firms’ capital bases, thereby freezing roll-over funding.

In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.

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Here in the heart of Kansas, the sky isn’t falling and Chicken Little isn’t running around without a head. Community banks like mine are still making loans and serving the needs of customers.

I used to worry about competing in the world of mega “too-big-to-fail” banks. But now I know community banks offer something the monsters can never offer — real personal service. Many financial-type businesses say they offer the same thing, but they usually don’t list personal numbers in the phone book and probably aren’t driving the volunteer fire truck. My father always told me that character repaid many more debts than collateral ever would. Community banks form long-term relationships with customers.

During the farm crisis of the 1980s the over-line credits we had placed with the city correspondent banks were called. A community bank used to rely on participating loans with large metro banks. For example, if my bank had a regulatory loan limit of a million dollars and I made a two million dollar loan, I would “sell” the over-line to a large bank. These large banks suddenly suspended and called all rural credits. This is probably similar to what is happening to borrowers who use super-large banks in today’s panic environment. There was nothing wrong with these loans but every small bank suffered from this irrational wrath.

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A successful plan to stabilize the U.S. economy and prevent a deep global recession must do more than buy back impaired debt from financial institutions. It must address the fundamental cause of the crisis: the downward spiral of house prices that devastates household wealth and destroys the capital of financial institutions that hold mortgages and mortgage-backed securities.

The recently enacted financial rescue plan does nothing to stop this spiral. Credit will not flow and liquidity will not return to the banking system until financial institutions have confidence in the solvency and liquidity of other banks.

Because of the 20% fall in the price of homes since the bursting of the house-price bubble, there are now some 10 million homes with mortgages that exceed the value of the house. Residential mortgages are generally “no recourse” loans, meaning that if the homeowner stops making payments, the creditor can take the property but cannot take other assets or attach income. Individuals with loan-to-value ratios greater than 100% therefore have an incentive to default even if they can afford their monthly payments, and to rent an apartment or other house until house prices stop declining. When individuals default and creditors foreclose, the property is added to the stock of unsold homes. That depresses prices further, increasing the number and magnitude of negative equity houses.

The prospect of a downward spiral of house prices depresses the value of mortgage-backed securities and therefore the capital and liquidity of financial institutions. Experts say that an additional 10% to 15% decline in house prices is needed to get back to the prebubble level. That decline would double the number of homes with negative equity, raising the total to 40% of all homes with mortgages. The mortgages of five million homeowners would then exceed the value of their homes by 30% or more, which could prompt millions of defaults.

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The government is out with more bad economic news this morning: The job market began to deteriorate even before the financial crisis reached a more serious stage two weeks ago.

Employers cut 159,000 jobs in September, more than twice as many as in August or July, the Labor Department reported. It was the biggest decline since 2003, when the economy was still losing jobs in the wake of the 2001 recession.

Economists had been expecting a loss of about 100,000 jobs in September.

The new number was especially worrisome because the government conducted its survey during the week of Sept. 8, before the credit crisis took a new turn for the worse on Sept. 17.

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California Gov. Arnold Schwarzenegger, alarmed by the ongoing national financial crisis, warned Treasury Secretary Henry M. Paulson on Thursday that the state might need an emergency loan of as much as $7 billion from the federal government within weeks.

The warning comes as California is close to running out of cash to fund day-to-day government operations and is unable to access routine short-term loans that it typically relies on to remain solvent.

The state of California is the biggest of several governments nationwide that are being locked out of the bond market by the global credit crunch. If the state is unable to access the cash, administration officials say, payments to schools and other government entities could quickly be suspended and state employees could be laid off.

Plans by several state and local governments to borrow in recent days have been upended by the credit freeze. New Mexico was forced to put off a $500-million bond sale, Massachusetts had to pull the plug halfway into a $400-million offering, and Maine is considering canceling road projects that were to be funded with bonds.

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The world economy is on edge as it awaits the next round of American roulette. The US Senate has voted to create a $US700 billion ($880 billion) rescue vehicle for distressed debt. But the bill now goes to the House of Representatives, which has already rejected the idea once.

What will happen if the House says yes? And if it says no? What is the prize for winning this high-stakes game of chance? And the consequences of losing?

If you strip away the jargon, the core problem is pretty simple. There is an estimated $US2 trillion in dubious debt instruments, tied to the subprime mortgage market, outstanding at the moment. The US banks and institutions that hold them need to do one of two things – either sell them, or put a value on them in their financial statements.

At the moment, they can do neither. Why not? Because there is no functioning market. It’s not like the American sharemarket, where there are dedicated market-making firms that are charged with the job of standing in the market to buy shares, come what may.

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In a move suggesting how the credit crisis could disrupt American higher education, Wachovia Bank has limited the access of nearly 1,000 colleges to $9.3 billion the bank has held for them in a short-term investment fund, raising worries on some campuses about meeting payrolls and other obligations.

Wachovia, the North Carolina bank that agreed this week to sell its banking operations to Citigroup, has held the money in its role as trustee for a fund used by colleges and universities and managed by a Connecticut nonprofit, Commonfund.

On Monday, Wachovia announced that it would resign its role as trustee of the fund, and would limit access to the fund to 10 percent of each college’s account value. On Tuesday, Commonfund said that by selling some government bonds and other assets held in the fund, it had succeeded in raising its liquidity to 26 percent.

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On Friday, with its stock plunging 27 percent, Wachovia experienced a “silent run” on deposits, but the bigger worry for regulators was that other banks wouldn’t provide the Charlotte bank with necessary short-term funding when it opened for business Monday, sources familiar with the situation told the Observer.

With Wachovia already looking for a merger partner, the Federal Deposit Insurance Corp., in consultation with other regulators, required the bank to reach a sale to Citigroup on Monday morning.

The FDIC, for the first time, used legislative authority created in 1991 to help it deal with a “very large complex bank failure” on short notice. It requires approval from heavy hitters ”“ two-thirds of FDIC board members, two-thirds of Federal Reserve board members as well as the Treasury secretary, who must consult with the president.

“When Wachovia opened Monday it would not have had a source of liquidity,” a source familiar with the situation said. “It really could not have opened under those circumstances. That’s why (the FDIC) put together the assistance package.”

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Bloomberg.com reports the cost of borrowing in dollars in London for three months rose for a fourth day, making clear that banks haven’t started to lend after the U.S. Senate approved a $700 bln plan to rescue beleaguered financial institutions. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 6 basis points to 4.21% today, the highest since Jan. 11, the British Bankers’ Association said.

Some small companies say they are no longer able to get loans from newly cautious banks as credit tightens across the country, and even those who do qualify are increasingly reluctant to borrow and expand, fearful of overextending themselves in the midst of the financial crisis.

Alan Petrucci, whose small factory near Chicago makes metal molds that other manufacturers buy to form plastic parts, says his bank recently offered him an additional loan. Though orders for his molds are still plentiful, Mr. Petrucci says he will borrow only to upgrade existing machinery, not to expand.

“We are bracing for the downturn that is coming,” Mr. Petrucci said. “It is coming; there is no question about that.”

Mark Snyder, another businessman, is more optimistic, but his bank refused two weeks ago to grant another loan to his fledgling medical supply company near Denver. So he turned to a commercial lender, which has offered credit ”” at 30 percent a year. Mr. Snyder does not want to borrow much at that rate. “We desperately need more capital to grow our sales,” he said.

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The ongoing turmoil in the financial markets has diverted me from my usual tax academic pursuits, including this blog, for which I apologize. This post explores the causes of that turmoil. My next post will explore solutions currently under consideration, including aspects of the so-called “$700 billion bailout.”

The current financial crisis has many causes, some long-term and structural. I focus here, however, on three immediate aspects of the crisis: the trigger, how problems generated by that trigger spread through the markets, and how this produced the liquidity freeze that persuaded Mr. Paulson and Mr. Bush to act (unsuccessfully thus far).

Read it all. This is a pretty good basic analysis. It is missing some important pieces, especially the 1999 decision to expand Fannie Mae and Freddie Mac’s purview and the role that had in encouraging more risky mortgages. Also, I disagree with him about Lehman, he is way too kind– it was a big mistake by the Fed. More about credit default swaps would have helped too.

Anyway, you take a look and see what you think–KSH.

At the core of the financial crisis is a simple problem: Banks don’t fully trust each other. So they hoard cash and only lend to each other if the borrowing bank pays enough to justify the risk.

The best indicator of the simmering interbank distrust is an obscure-sounding interest rate known as Libor, which is flashing red. Libor, or the London interbank offered rate, is the rate that banks worldwide charge each other for short-term loans.

Yesterday, the annualized rate for those overnight loans spiked by more than four percentage points, to 6.9 percent, its highest level ever. Normally, Libor on dollar loans is not much higher than what it costs the U.S. government to borrow short-term money, which yesterday was nearly zero.

That tells experts that banks around the world are basically unwilling to lend to each other at any price. It means that cash is not flowing to places that need it. And, if sustained, would ultimately lead to higher borrowing costs for ordinary U.S. households and businesses.

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…there is good reason for the public’s skepticism. The experts and policy makers who so desperately want to take action have failed to tell a compelling story about why they’re so afraid.

It’s not enough to say that markets could freeze up, loans could become impossible to get and the economy could slide into its worst downturn since the Great Depression. For now, the crisis has had little effect on most Americans, beyond their 401(k) statements. So to them, the specter of a depression can sound alarmist, and the $700 billion bill that Congress voted down this week can seem like a bailout for rich scoundrels.

Bernanke and his fellow worriers need to connect the dots. They need to use their bully pulpits to teach a little lesson on the economics of a credit crisis how A can lead to B, B to C and C to Depression.

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Update: A related article from AP is here.