Dear Fed: The Problem is Solvency, Not Liquidity 42 comments
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The Federal Reserve, the Bank of England, and the European Central Bank are all keeping interest rates exceedingly low and are continuing to engage in “quantitative easing.” The central banks have claimed that they are caught in a “liquidity trap” and cannot force interest rates to go any lower, especially below zero. Their solution is to continue to force liquidity into the banking system in order to keep the financial system functioning and to encourage commercial banks to start lending again.
I have a problem with this interpretation and have been writing about it since the events of the fall of 2008. The liquidity problem the central banks have focused upon is one connected with the liquidity of bank assets and security holdings that are hard to price. The central banks, as well as the United States Treasury, has seen this problem as a liquidity problem.
I see the basic problem as a solvency problem and argue that there is a significant difference between a “liquidity problem” and a “solvency problem.” Furthermore, commercial banks will respond in an entirely differently way to a “solvency problem” than will to a “liquidity problem.” If the situation has been mis-interpreted, then this, perhaps, accounts for the lack of understanding on the part of the Chairman of the Federal Reserve System and the Treasury Secretary concerning what is happening “out there” in the banking system. It also explains their feeble recent attempts to coax banks into lending more of the liquidity that has been given them.
Right from the start of the financial upheaval last fall, beginning in the week of September 15, 2008, the Fed Chairman and the Treasury Secretary (Paulson this time) saw the financial crisis as a liquidity problem. This is what the original package, the TARP package, was designed for. It was designed to provide funds to buy troubled assets off the books of the financial institutions. It was believed that these institutions could not dispose of these “troubled” assets because the assets could not be priced and hence the banks could not find a buyer for them. The plan was for the government to provide a buyer for these assets and hence loosen up the balance sheets of these financial institutions. The plan did not really get off the ground from the first day and the funds became the source of bailout bounty that was distributed around the system to those in need.
If the problem had been a liquidity problem right from the start, this program would have helped to combat the difficulties by creating a “floor” under prices and the market could have continued on its merry way.
But, the financial institutions did not respond to the availability of these funds. And, they held onto their assets. Something else was happening.
Let me just add, a “liquidity crisis” is a relatively short term phenomenon. A shock hits the system. Say it is found that the credit rating on an issuer of commercial paper is lowered, as in the case of the Penn Central. The immediate reaction in the market is for buyers to leave the market…go play golf or tennis. The reason for this is asymmetric information, the sellers are anxious to sell because they don’t know whether or not more ratings will be lowered, but the buyers don’t know what the price level should be. The buyers will stay away from the market until they get some idea that the market is stabilizing.
The classic central bank response to a “liquidity crisis” is to throw open the lending window and to engage in repurchase agreements to provide liquidity for the market in order to help it stabilize. A “liquidity crisis” is usually over in a matter of days, if not weeks. A “liquidity crisis” is resolved without recourse to massive amounts of government support as a substitute for buyers who have left the market.
A “solvency problem” is an entirely different matter. Here borrowers have problems repaying loans and, as a consequence, the solvency of the financial institution is brought into question. However, the “solvency problem” is not just a short run problem as is the “liquidity problem”.
First, the troubled borrowers have to be discovered. In many cases, it takes a longer period of time to identify the borrowers that are having problems. Then begins the process of working with the borrower in order to see if a plan can be devised to make the bank whole or to rescue at least as much of the funds as possible. After that, it takes more time to see if the borrower can actually deliver on the restructured loan.
And, if the economy is sinking and people are losing their jobs and asset values are declining the bank is faced with the possibility that there will be a whole other wave (or two) of problem loans that they will have to deal with. The “solvency problem” to a commercial bank, and to other financial institutions, is a long term affair. Yes, some banks fail right away, but the majority of the banks face an extended period of one, two, or more years before the problem is completely under control.
The best scenario that the central bank can hope for is that the liquidity crisis will occur and be resolved. Then the solvency problem will come to the fore and will have to be dealt with. The solvency problem takes a long time to work itself out and the best that can be hoped for is that there will be few surprises, that bank failures will precede in an orderly and controlled way.
To me, this has been the evolving picture of the economy, both in the United States and in the world, for the past year. We had our liquidity crisis and then we moved into the solvency problems phase. The system is working things out in an orderly and controlled way.
Yet, the Federal Reserve (and the Treasury) has stayed with the interpretation that the problem continues to be a liquidity one. That is why all the innovative facilities were created by the Fed. That is why the Fed supports the mortgage-backed securities market and the federal agency market. Their “Fed speak” is couched in the terms of the “liquidity needs” of the system.
Isn’t $1.0 trillion in excess reserves in the banking system sufficient for the liquidity needs of the commercial banks? Isn’t the purchase of $800 billion in mortgage-backed securities and $150 billion in federal agency securities enough liquidity for the financial markets?
And, yet, banks are not lending. Just as you would expect in a “solvency crisis.” Historically, bankers have always held onto funds and stopped lending when there is a “solvency crisis.” They will not commit funds to any extent while they are fearful that they might be going out of business in the next 12 to 18 months. And, as has just been reported this week, default rates continue to rise, and foreclosures continue to rise, and personal bankruptcies continue to rise, the commercial banks will continue to sit on their hands.
To me, the Chairman of the Board of Governors of the Federal Reserve System and the United States Treasury Secretary have interpreted the situation all wrong. The problem is solvency and not liquidity. The evidence of this is the behavior of the banking and financial system. This mis-interpretation has caused the central bank to act in a totally inappropriate way and, as a consequence, exposes the banking system to massive operating problems over the next year or two if the Fed actually does try and remove all the reserves that it has pumped into the banking system.
One could argue that putting the Federal Reserve in the position it is now in is Ben Bernanke’s third major mistake. Some argue that it is really his fourth major mistake!
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facts.....group sophistry....
There is no monetary solution to a solvency problem: the only solution is systemic fiscal reform.
I am sure there would be as many suggestions for that as there are posters!
"What we think of as "money" in the West is nothing but a Ponzi scheme. When there are no new buyers to take out the old buyers, Government steps in and forces taxpayers to become buyers. When the Government stops buying - once they've bankrupted remaining taxpayers and run out of money themselves - the system will (finally, mercifully) collapse. "
Does the Government ever need to stop buying? If so, why? I really don't think so. I think that gold will go up, and the fiat of the buying-governments will go down. It borders on runaway inflation. But, there's no reason for the Govt to ever stop buying.
And, at the end, when the fiat has dropped in value so much, the frog in the hot pot, then debt will have devalued so much that the crisis will have been resolved.
The losers are obvious, the holders of fiat and treasuries and bonds and local-centric assets. When I talk to the losers, they're sure they are safe, holding fiat and treasuries. So, this is the highest probability, imo.
What do you think?
On Nov 06 11:55 AM tunaman4u2 wrote:
> Ben will go down in history as the worst Fed chairman... creating
> a massive disconnect between middle class americans & those that
> have access to this liquidity
YOU'VE BEEN GRIN F..KED again.
> What solution do you propose for the solvency problem?...what
> would you have the Fed do?...
I’m not sure the Fed needed to get involved with this at all. Their participation has encumbered the US citizenry far greater than having declared a type of jubilee on mortgage holders, perhaps a sliding scale based on years of solid debt service. In addition, I continue to believe no US citizen should have to pay a penny of interest on any debt to a financial institution that has taken, is taking or has profited from the Fed’s QE. Any payments to these entities should be deducted from principle exclusively. Any expansion of currency, i.e. FRN, should be at the sole benefit of the sovereign citizenry and not the forces that extorted concessions from our employees in the government in the middle of the night last October 18, 2008. imho
Greenspan caused the problems; Bernanke is making them worse, although he is buying time by flooding the world with more lures to further indebtedness.
On Nov 07 01:43 AM The WaveNET Perspective wrote:
> The central theme for focusing on bank solvency instead of liquidity
> is right on! But, blaming it on Ben Bernanke is not. He had nothing
> to do with the misguided monetary policies of Greenspan and the irresponsibly
> lax regulations that accompanied them since the repeal of Glass Steagal
> in 1991.
>
> That being said, the liquidity problem referred to by the Fed is
> NOT that the banks don't have enough money ,but that a large portion
> of the assets on their balance sheets are impaired. (i.e. worth a
> lot less than believed if sold -- hence illiquid.) The solution which
> was discussed but never implemented with TARP funds ( namely, fencing
> off these assets and sitting them out for a while) is the only reasonable
> way to stabilize the system; but that has unpopular political ramifications;
> hence ignored ... but for how long ?
>
> The real issue is ideology -- retail and commercial banking are
> like social utilities and running them with unrealistic profit goals
> will do to our economy the same thing that HMOs did to our healthcare
> costs. As to investment banks, they are really like hedge funds:
> subsidizing them with taxpayers money borders on insanity.
>
> When sanity is missing, why argue about solvency vs. liquidity ?
On Nov 07 03:25 PM stev53e wrote:
> I believe he will go down as the second worst.
>
> On Nov 06 11:55 AM tunaman4u2 wrote:
How do you solve the insolvency problem? You face the truth. You make the hard decisions about bankruptcy. You don't cure a dope fiend by offering them more and more dope, at clearinghouse prices.
Americans are debt addicts. We need to be taken off the fix. We need to be saving money instead of spending it. We need a deflation generation to teach us a better way of living.
On Nov 06 04:54 PM bbro wrote:
> How is the system insolvent??? Not one discussion of non performing
>
> assets,net chargeoffs,Fair Value in 10q's loan loss reserves,tangible
>
> common equity,preprovision earnings or delinquency rates....this
>
> article is sophistry.....
On Nov 07 08:06 PM The Geoffster wrote:
> Anna Schwartz made the same observation last year but the policy
> makers were not willing to allow the insolvent banks to fail so they
> propped them up with massive liquidity hoping the private sector
> would come back and right the system. It hasn't happened and we may
> be out of options. The correct policy would have been bankruptcy.
> Politicians couldn't handle the truth and now we all have to pay
> the price of socializing the economy.
important but it is apples to oranges...like your mortgage to your income....debt service that is what you need to ficus on.....
On Nov 08 04:29 AM Michael Clark wrote:
> Take a look at the total US Debt to US GDP chart and that will explain
> what insolvency is. Americans could manage to service their debt
> as long as home prices appreciated, and they could refinance. Once
> home prices fell....bankruptcy followed.
>
> How do you solve the insolvency problem? You face the truth. You
> make the hard decisions about bankruptcy. You don't cure a dope fiend
> by offering them more and more dope, at clearinghouse prices.
>
> Americans are debt addicts. We need to be taken off the fix. We need
> to be saving money instead of spending it. We need a deflation generation
> to teach us a better way of living.
On Nov 07 03:25 PM stev53e wrote:
> I believe he will go down as the second worst.
>
> On Nov 06 11:55 AM tunaman4u2 wrote:
Pay financial instrument commissions on an earned basis, save money on lawyering claw-backs, and put the proper mindset in the heads of financiers.
Here are the great man's words, live and unedited, the words of the man who one of the sugar plum fairies termed "the best" Fed chairman:
youtube.com/watch?...
This is the guy our Congress wants to affirm for another term... they should all be forced to sit in a room for a month and listen to this tape 24/7 until they GET what "the best" has done through his denial and malfeasance and misdirected support for his pals the big bankers.
And so while the American taxpayers' purchasing power gets crushed by the great man's trashing of the dollar, the band plays on and the banksters take hundreds of billions of his freshly printed dollars and play their high frequency/dark pool/ flash trading games and DO NOT LEND.
Isn't it quite possible that when a system of fiat currency has been so disjointed it can have dillution problems with liquidity crisis at one or several interacting levels, while it has counterproductive constriction and interdependent solvency problems interacting at other spectrums of essentail economic segments? Until we begin to assess a comprehensive and interactive vertical WITHOUT a DIRECTIONAL BIAS (up/down demand / supply) along with interactive factors from horizontal measures,... these "classic economic terms" for banking and finance do more to "razzle & dazzle" than actually provide handles on a healthy correction for a stable All American Economy (let alone a model for a Global base and reserve). Perhaps worse, they just keep pushing us from one end of "WRONG" to the other!
A selected variable set of interest rates directed at different segments of finance might be a consideration. Why should the rate of borrowing to refinance a bad debt be the same as the rate to build a new office building or add to a constructive infrastructure? If debt rates were differentially programed for the desired effect , everything from residential and commercial neccessities to a full gamut of "less vital" essentials (increasing debt...pure speculation) could be graded. Why can't the "cost" of money be ajusted to be a market itself!
This is the innovative fiat capital of the world. Why can't we have a differential "smart rated" differential interest rate for selected sectors? Obviously "universally cheap" money is not going where we want it, so why not mark the bills and follw the money?