The Fed Cannot Resolve a Solvency Crisis

In recent weeks, we have heard a lot about something called a Solvency Crisis. In this article, I discuss is meant by a Solvency Crisis and differentiate it from a Liquidity Crisis. A central bank has to be concerned about both types of Crisis, but it has to be able to distinguish one from the other because the monetary authority must respond differently to each kind.

A Liquidity Crisis is a short term phenomenon that arises because someone must relieve themselves of some financial assets. The recent example is that of the French bank which had to unwind a securities position that had been established by a trader working at the bank. The bank had to sell off the position in order to minimize any further losses it might have to take. The amount of the securities that were involved in the position was estimated to be around $75 billion, so we are talking about a substantial amount of securities that must be sold within a relatively short period of time.

In normal times for markets that are relatively liquid, the bid-ask spread between what people will buy a security for and what they will sell the security for is relatively narrow. That is, I can buy a security and then turn around and sell the security and will only lose a small amount of money. The narrow bid-ask spread is an indicator that the market is relatively liquid. Less liquid markets experience bid-ask spreads that are more or less wider depending upon the illiquidity of the market.

If the seller of a security has to sell a noticeably larger amount of securities within a relatively short period of time, potential buyers may reduce the ask price somewhat, but the increased discount is not unusually large. If the discount is not large, this is used as evidence of the liquidity of the market. In other words, if a sizeable amount of a security can be sold relatively quickly without much concession in price then the market is termed a liquid market. Liquid markets are, of course, very important for financial (and other) organizations because securities that trade in liquid markets can be used to adjust portfolio positions under normal circumstances with little or no penalty in terms of price concessions to the market.

However, if a large amount of securities must be sold within a very short period of time, even liquid markets can experience liquidity problems. This is what is termed a liquidity crisis. What happens in these cases is that market participants know that the securities must be sold and they know that a large amount of the securities must be sold. Very often market participants will even know which institution has to sell the securities. Under such circumstances the problem becomes one of price.

In a normal situation when a larger block of securities is sold, potential buyers know that this sale is just a ‘bump’ in the market and that the market will return very quickly to the range that this type of security had been trading within. Thus, market participants know where the market is and they are willing to continue to ‘make a market’ in the security.

In a liquidity crisis this is not the case. Market participants know that price concessions must be made but because of the quantity of the securities that must be sold on the market and the short time span over which they must be sold, confidence wanes as to where the market will continue to trade. Buyers become unsure…sellers become desperate! The problem, therefore, switches to the buy side. Buyers don’t want to buy a security, even if the seller is willing to give up a substantial discount, if there is a concern that they, the buyer, will soon be holding a security for which they overpaid. Buyers withdraw…they head for the sidelines…they go and play golf. And, buyers will stay on the sidelines until the markets exhibit some kind of stability and they can become confident about where prices should be.

The job of stabilizing the market in a liquidity crisis is that of the central bank. There are two actions that the central bank can take that are the classical responses of central banks to such a market situation. Putting these responses within the structure of the Federal Reserve System we call them the lender of first resort response and the lender of last resort response. In terms of the former, the Federal Reserve reduces the operating target for the Federal Funds rate, which, in essence means, that the Fed will become a buyer of securities at a set price so that the market knows there will be a buyer for their securities…hence, institutions that need to adjust their portfolios know that they can sell to the Federal Reserve. The latter response has to do with the Borrowing window at the Federal Reserve.

In the case of a liquidity crisis, the Fed, for a short time, will throw open the borrowing window so that banks can borrow funds from the Fed and not have to sell securities into a declining market. In both cases, the Federal Reserve, in classical central banking style, provides liquidity to the money markets in order to stabilize markets and keep buyers at their trading desks. This is how a liquidity crisis can be stemmed.

It is time to get back to the problem of the solvency crisis. The problem of solvency occurs when there is a decline in the value of assets that are being carried on the balance sheet of an organization. Solvency can be an issue within the context of a liquidity crisis when the securities on, say, a bank’s balance sheet lose market value. However, the problem becomes of much greater concern if the institution, the bank, experiences a decline in the value of other assets on its balance sheet, say in its loan portfolio. Here the difficulty may be the ability of the borrower to repay the loan that they have outstanding with the bank. In these cases, the bank knows that it will not receive back the total amount of the loan outstanding and, therefore, must write down the value of the loan.

The concern here is that when asset values on a balance sheet are written down the impact ultimately impacts the capital position of the organization. When we write off a loan, for example, we write it off against income reducing profits, which means that the increase in net worth will be less than it otherwise would be, or, it the charge-offs result in a loss, net worth would actually decline. If the capital position of the bank gets too low, then the bank will have to raise more capital, sell itself to another financial institution, or close. When many banks have this kind of problem there is a solvency crisis!

Raising capital is the only long term way to resolve a solvency problem and there are basically two ways to raise capital. First, over time, profits will increase the level of capital that an organization will have. This takes time and is the solution to the crisis only if institutions have sufficient remaining capital to replenish capital by means of longer run profitability.

Second, the institution must go out and obtain capital from other sources. The availability of capital is dependent upon two things…that there are pools of capital available for investing…and that the institution has sufficient viability to justify investors risking their funds by investing in that institution. The Sovereign Wealth Funds have provided the pools of capital required to meet at least some of the needs of the current solvency crisis. One presumes that these Funds have done their due diligence and hence believe that their investments have long term viability.

The Federal Reserve cannot resolve a Solvency Crisis. That is, a central bank is not in a position to inject capital into banks or other organizations in order to resolve this kind of crisis. If there are not pools of funds available to put capital into troubled institutions then the solvency crisis can cumulate and spin out-of-control like it did in the Great Depression of the 1930s. The only thing the central bank can do is to help create a favorable environment so that the economy can grow and sufficient profits can be generated to replenish capital in this way. But, this takes time and patience…it cannot be done quickly.

It has been argued that Ben Bernanke and the Fed failed to realize the severity of the economic problem soon enough and did not act quick enough to lessen its impact. In my next post I am going to look at the operational behavior of the Fed in 2007 in an attempt to discern whether market conditions existed during 2007 indicating the existence of a liquidity crisis. If a liquidity crisis did not take place in 2007, then this may explain why the Fed did not want to take any precipitous action during that time when the extent of the problem was not obvious…particularly when there were other issues on the table like the decline in the value of the US dollar and the inflation being slightly above the range acceptable to the policymakers.

Comments

[Lilguy]

Rather than looking backward at the Fed last year, give us some indicators--quantitati... behaviorial, historical, whatever--we should look for to assess the possibility that individual banks or the banking system are becoming less solvent.
Now that's a challenge.

[flow5]

Just get the commercial banks out of the savings business. Weren't there alot of mergers combining solvent & insolvent institutions in the last housing crisis?

[flow5]

I.e., repeat the measures taken in 66 to rescue the intermediaries.

[TexasRadio]

From everything I've read lately, the deflation genie is out of the bottle. That's fine with me, the sooner bad debt gets liquidated, the sooner a recovery can begin. I'd prefer not to see this mess extended by government ignorance for another 10-20 years. Not that an economic collapse is the worst that could happen: last time I checked, nuclear weapons were far more popular now than they were in 1945.

[BNV]

Thank you for the great article.
Question though:
From my admittedly incomplete knowledge, I thought that one of the practical effects of a rate cut was to allow banks to re-capitalize their balance sheets (at least in the mid term). By depressing the short end of the yield curve, banks are able to raise funds more cheaply, while their income still comes from 30 year mortgages at ~5.5-6%. I know this doesn't have the immediate impact of massive write downs, but it does seem like a path out for the better managed banks.
Again, my banking knowledge is limited, so let me know if my logic is incorrect.

[JohnnyBitchdog]

I think your knowledge may exceed that of the author. That's precisely what the Fed did to recapitalize banks, including Citibank, in the early 90's........let them borrow short cheaply and lend long expensive, keeping the spread. This was an approach to deal with insolvency.

[contractdriver]

Can't ? I think when the real problem is explosed there
will already be a plan of action in the works.
Question how can you insure a CDO and remain AAA
rated? Unravel this one and your on the way to fixing
the problem. IMHO

[Abe Mishima]

Liquidity, insolvency? It's all tied together. Banks are having this problem because there is so little liquidity in a CDO portfolio, that they have to grovel to sell them at 20 to 30 cents on the dollar. Even if 95% of the portfolio is non-delinquent. And why do they have to sell at these ridiculous prices? To meet solvency requirements. I think the regulators have to give the banks a break for the moment. As long as the cash flow is there, waive the asset valuation requirement. Back during the Chrysler bailout, the government guaranteed their loans. The government can do something similar here. Instead of 20 cents on the dollar, the government backs the CDO to 50 cents on the dollar. I know, I know, you ask. How does the government get back its money when a bank must liquidate a CDO? Appoint a government agency to service the various mortgages, that's how. This agency will sell back the mortgages to the financial sector when times are better. The homes that must be foreclosed can be sold to charitable organizations at 60 cents on the dollar. Do gooders can fix the properties and resell them.