Venerable global financial names are falling in the wake of this once in a century credit tsunami. The crisis has morphed from one gripped by liquidity restraints to one in which fears of insolvency are now paramount. A necessary, though not a sufficient condition for this crisis to end is a stabilization of home prices in the U.S. This will clarify the level of equity in U.S. homes, the ultimate collateral support for much of the world’s mortgage-backed securities. Losses will no longer be prospective.

The American housing bubble peaked in early 2006, followed by an abrupt and rapid retreat over the past two and a half years. Since the summer of 2006, hundreds of thousands of homeowners, many forced by foreclosure, have moved out of single-family homes into rental housing, creating an excess of approximately 600,000 vacant, largely investor-owned single-family units for sale. Homebuilders caught by the market’s rapid contraction have involuntarily added an additional 200,000 newly built homes to the “empty-house-for-sale” market.

Home prices have been receding rapidly under the weight of this inventory overhang. Single-family housing starts have declined by two-thirds since early 2006. Indeed, this sharply lower level of pending housing completions, together with the expected one million increase in the number of US households this year as well as underlying demand for second homes and replacement homes, together implies a decline in the stock of vacant single-family homes for sale of almost 500,000 at an annual rate during the second half of 2008.

The pace of liquidation is likely to pick up even more as new-home construction falls further. The level of home prices will probably stabilize as soon as the rate of inventory liquidation reaches its maximum, well before the ultimate elimination of inventory excess. That point, however, is still an indeterminate number of months in the future. But the recent slowing in the rate of decline in U.S. home prices is the first positive note in this now yearlong trauma. More conclusive signs of pending home price stability are likely to become visible in the first half of 2009.

At that point, we will be able to confront the more fundamental issue. How much overall deleveraging is going to be required to induce global investors to again become committed holders, at modest interest rates, of the liabilities of the world’s financial intermediaries? Or the question’s more useful equivalent: how much capital, both private and sovereign, will investors require of banks and other intermediaries to conclude they are not at a significant risk in holding financial institutions’ debt?

In mid-2006, the Federal Deposit Insurance Corporation, the U.S. agency that insures deposits noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.” Commercial banks’ equity equaled 10% of assets. At that capital-asset ratio, the industry compiled record net interest income. Depositors and holders of other bank liabilities felt sufficiently confident of the solvency of U.S. banks that they were willing to accept interest rates well below the rates of return on bank assets.

How the world has changed. Book equity bank capital is still hovering around 10% of assets but market capitalizations have fallen sharply. And judging by the elevated interest rate levels paid on bank liabilities (when funding is available at all), worldwide investors currently require significantly higher equity capital to confidently hold a bank liability than they did a couple of years ago.

How much additional bank capital then will be required to stabilize the world financial system? In my reckoning, it is that level of capital that will restore the U.S. Libor/OIS spread to its pre-crisis level of 15 basis points or less. (On October 9, it was almost 300 basis points.) But how much more than 10% does that imply for investors’ minimally acceptable capital-asset ratio? This is the most difficult policy question economists face in the current crisis. There are not enough 100-year crises to construct an adequate database for formal statistical analysis. But the tenacity of the global financial pullback suggests that deleveraging will not come to an end until many percentage points are added to financial intermediaries’ equity to asset ratios.

Where will the new capital come from? The pool of global private capital is being continuously replenished by a reasonably high level of global private saving of more than 20% of world GDP. Capital gains, however, are just as important, both positively and negatively. This can best be observed in the context of the consolidated balance sheet of the world economy. All debt and derivative claims offset in global accounting, leaving real physical and intellectual assets and their market value reflected as net worth. Global publicly traded equities levels are approximately $50 trillion. Obviously, higher stock prices can accelerate the recapitalization of finance while lower global stock prices would impede it. Debt issuance would also be suppressed as it leverages off the level of equity. To the extent that new bank capital is not forthcoming, the new higher capital cushions required by investors will force the sale of assets, adding to downward price pressures.

How quickly home and other asset prices stabilize will be a major factor in how long it takes to reach a new and supportable level of capital and leverage. The substitution of sovereign credit for toxic private assets, or more importantly, injections of equity capital by governments into financial intermediaries, will help stabilize the system. Eventually, the market freeze will thaw as frightened investors take tentative steps towards reengagement with risk. Broken market ties among banks, pension, and hedge funds and all types of nonfinancial businesses will become reestablished and our complex global economy will again move forward.

Alan Greenspan is the former head of the US Federal Reserve. This is an exlusive piece written for Emerging Markets.