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In my February 25 post I discussed “the solvency issue” and stated how important it was for financial institutions to ‘recognize and disclose problems earlier rather than later.’ The crucial thing about acting in this way is that it limits, as much as possible, the deterioration of the value of asset portfolios. Postponing dealing with the issue merely delays the realization that there is a problem and also delays taking actions that might lessen the pain and even turn the situation around.

Here we are now, more than a month later. During this time, the Federal Reserve moved to salvage what was left of Bear Stearns (NYSE:BSC). This has seemingly calmed markets and has indicated that the central bank, with the support of the Federal government, will do what is necessary in order to keep the financial system functioning. Greater write-downs and charge-offs have been taken during this time period, both nationally and internationally. Executives have been let go and have been replaced. Additional capital has been sought and, in most cases, found. The system seems to be working through the crises.

Obviously, it is too early to say that we are out-of-the-woods, but it is crucial that time is passing. In the case of liquidity crisis, everything happens within a very narrow window in the time spectrum. Action has to be immediate in order to stem a crisis and allow for order to return to the market. In the case of credit crises it is crucial for firms to have time to work out the problems that are on their balance sheets. Bear Stearns ran out-of-time. However, it seems, other institutions are experiencing the time that they need to discover the value of their troubled assets and to do something about them.

The whole process of resolving a credit crisis is not really in the hands of a central bank or of a central government. The process is really in the hands of the financial institutions themselves: it is dependent upon their willingness to suffer the immediate pain they must suffer; it is dependent upon their willingness to get the right people in place to resolve the problems that exist and restructure the organization. The more time that passes the more hopeful the situation becomes.

Part of the problem in trying to analyze an environment such as the current one and make prognostications about the future is that we are working with very incomplete information. We don’t really have a good handle on how grave the condition is of specific financial institutions and how effective boards and managements have been in attempting to get the situation under control. There is a tremendous amount of uncertainty out there!

This is where time is so important. We get this piece of news about Bank XYZ charging off another billion or two, dollars of loans. We hear that the board of the investment bank of M & M is letting go its CEO and bringing in so-and-so to take charge of their organization. Company ABC is getting additional capital. Yes, there are still problems ‘out there’ but something is being done about them. And, time is passing.

As I have mentioned before, since so much of the dislocation has seem to be centered upon assets that, in one way or another, are connected to some form of security that is ‘traded’ the problems have been determined relatively quickly. When financial institutions just originated assets that were kept on their balance sheets, discovery was not so rapid. Identification of problems and the taking of action seemed to get postponed with the hope that ‘things would work out’ and the loans would right themselves. None of this information, however, was available to anyone else other than the organization, itself.

Now, everything takes place in larger quantities and with a much shorter fuse. This is what we get with the advancement of Information Technology and the innovation in financial assets that have gone alone with it. If information is transferred much more rapidly and is much more public, then markets will be more efficient, but they also may be subject to periods of greater volatility. The reason for this is that traders and arbitrageurs who have tended to take similar positions in certain assets may all have to adjust positions at the same (relative) time and this can create imbalances in the marketplace. With the new technology all this can happen in a very short period of time and in very large numbers.

I use the term ‘relative’ for a very specific reason. The time horizon that is relevant in each case is, of course, dependent upon the particular situation under review. In a case where a position must be ‘unwound’ as, say, in the case of the French bank, Societe General (OTCPK:SCGLY), a large volume of assets must be sold within a very short period of time. This results in a ‘liquidity crises.’ In the case of the value of assets being written down, the timing is somewhat different. Yet, the identification of such a problem at an earlier time than would have been the case in the past, leads an organization to move on to resolving the problem faster than formerly. This is possible in the current environment.

It is also true that larger numbers are likely to be involved in the current situation than before. The reason is that financial institutions need to be very conservative at this stage of the process. I have heard organizations being criticized because they might be charging off too much so that they can recognize the excessive charge offs later and make the ‘turnaround’ look good. My experience in working with troubled institutions is that the real tendency is to charge off too little, with management hoping, with a false optimism, that things will get better and the managements will be able to hold onto their jobs. The emphasis is on the management trying to protect itself and not on what is the best for the shareholders. I conclude from this is that it is better for managements to be ‘conservative’ in their marking down of asset values and write them down far enough to make sure that you will not have to face another write-down in the future. The reason for this is that you don’t want to have to ‘surprise’ the financial markets with more future write-downs than you have to.

The aim of all of this activity is for order and confidence to be restored to financial markets. If order and confidence are to be restored, the troubled institutions themselves must show that they are ‘in charge’ of the situation and that, they have control over the value of their portfolio. Until market participants believe that managements are in charge, they will continue to be nervous. This nervousness is because they still do not have sufficient information concerning the quality of the portfolios and the ability of the managements to do what is necessary.

I am sure that there are still surprises ahead. There is still great uncertainty to overcome. We all hold our breaths, hoping that the next week we face will not contain any shocks that may set things off again. Time is important because financial institutions need time to work things out. Financial markets need time in order to digest information and adjust incrementally to the news they are receiving. Each week that goes by without further shocks is good. But, we continue to keep our fingers crossed.

Source: Financials: It's the Solvency Issue - Again