The Credit Crisis: Solvency vs. Liquidity, and Why Bailouts Won't Help

The last three weeks have been extremely challenging for anyone who invests based on fundamentals, not sentiment.

First we had the SEC inducing a short-squeeze on financial stocks. In a nutshell, the SEC announced that naked short-selling is illegal for 19 financial firms. What’s truly bizarre is that naked short-selling has been illegal for years. So the SEC was, essentially, reiterating what was already public knowledge.

No, the SEC is not insane. This move was a fire across the bow of anyone shorting financial stocks. The significance of this move cannot be overstated: the government body that was chartered to protect shareholders from corrupt management is now protecting corrupt management at financial firms from shareholders.

I know this because the SEC only stepped in to protect financial firms, rather than companies whose business fundamentally affects the US economy—Microsoft (MSFT), Exxon (XOM), Proctor & Gamble (PG), etc. True, the short interest in financials was at a record high. But that was because investors had finally caught on that Wall Street was lying about the severity of the credit crunch and the amount of junk assets on their balance sheets.

After the SEC’s intervention, we had the Fannie Mae (FNM)/ Freddie Mac (FRE) bailout. In simple terms, Secretary of the Treasury, Hank Paulson, convinced Congress to write a blank check to these quasi-governmental companies. Thus, you and I are now on the hook for whatever junk Fannie and Freddie own.

These two groups sit atop some $5 trillion in mortgage loans. I don’t know how much of this is junk. But I do know that most smaller banks and financial institutions tried to keep their high quality mortgage loans for themselves—loans to local CEOs, executives, lawyers, etc—and pass off their lesser quality loans to Fannie and Freddie.

I also know that because of an implicit guarantee from the US government, Fannie and Freddie pursued a host of awful business practices, including leveraging their balance sheets up to 65-to-1. In simple terms, this means that for every $1 in capital these companies have, they owe $65 in debt. At this degree of leverage even a 2% drop in asset prices renders the company insolvent.

Aside from excessive leverage, Fannie and Freddie execs used the companies like virtual piggy banks, paying out enormous salaries to themselves and their boards. They also engaged in unusually large donations—dare I say bribes?—and other deals with members of the US government. Sounds a bit like Enron, doesn’t it?

So Congress’s decision to give these organizations a blank check to cover their losses is essentially another Bear Stearns deal—putting the US taxpayer on the hook for more financial firm losses ... losses that were generated via terrible business practices and corruption.

Typically when a bill of this stature is signed into law, there is an enormous self-congratulatory ceremony with souvenir pens and the various members of Congress behind the bill slapping each other on the back.

However, in the case of the Fannie/Freddie bailout, the bill was signed into law by President George W. Bush at 7AM in a closed ceremony. Only a few aides and officials were present, including Secretary of Housing and Urban Development Steve Preston and James B. Lockhart III, the director of the Federal Housing Finance Agency. The whole thing was so secretive that many people don’t even know it was passed.

However, as was the case with the Bear Stearns deal, investors market-wide took these developments to indicate that the worst was over, the market had formed a bottom, and that the bull market had begun anew.

And just like in March, they’re wrong.

These interventions don’t actually change anything about the market fundamentals. They don’t erase the billions in bad loans from Wall Street firms’ balance sheets. They don’t increasing lending standards at Fannie Mae or Freddie Mac, they don’t solve the fact that banks and financials firms are no longer lending money like they used to, and they certainly don’t indicate a pick up in consumer spending and the US economy.

You see, the credit crisis is a solvency crisis, not a liquidity crisis. Put another way, you cannot solve a debt problem—and the problems facing the US, the US consumer, and even Wall Street are all debt problems—by issuing more debt. This is why the Fed’s interest rate cuts and frantic pumping of liquidity into the system haven’t done much to solve the situation.

Since September of last year, the Fed has cut interest rates from 5.25% to 2%. It’s also taken about $400 billion worth of junk onto its balance sheets. And it’s pumped more than $300 billion into the financial system. And yet, stocks have yet to come anywhere near their October 2007 highs.

This latest rally has all the hallmarks of the last one—it’s spurred on by government intervention rather than a change in actual fundamentals or value. However, unlike the rally in March 2008, this rally has aborted twice at the 1380 level. Even the permabulls and dumb money are beginning to realize that these interventions aren’t actually fixing anything.

Comments

[Larry House:]

You are absolutely right. No current steps are helping to fix the underlying problems at all. There is going to be hell to pay, and that day is only getting pushed back. In the mean while, there is no reason to trust this market. Nothing is really getting better. It will eventually sink in to investors that '09 is going to be a very blah year, and there is no quick fix or soon turn around for what is wrong with our economy and the world economy.

2008 Aug 07 11:00 AM

[rm:]

[Put another way, you cannot solve a debt problem—and the problems facing the US, the US consumer, and even Wall Street are all debt problems—by issuing more debt. ]

And I'm beginning to think that debt- not innovation, not ingenuity, not productivity, not REAL value creation, is the cornerstone of our economy.

2008 Aug 08 12:09 PM

[CaptBob:]

The evidence pile just grows higher!
It's crooked Bankers helping crooked Bankers with the aid of Corrupt Politicians passing bills to make crime legal.

While the American taxpayer stands on the sidelines in the Buff, wondering if,--in this company--maybe the virtues of that dropped soap are overrated.

2008 Aug 08 12:53 PM

[xsuddensam:]

rm:

"And I'm beginning to think that debt- not innovation, not ingenuity, not productivity, not REAL value creation, is the cornerstone of our economy."

You're starting to think right! This Ponzi scheme is about to fall under it's own weight of debt. The Fed and its banker masters have been able to keep it going by printing more and more money. This time around, they just got too greedy.

Buy GOLD and SILVER!

2008 Aug 08 01:53 PM

[Robespierre:]

I wish this was like Enron but you see in that case people did actually went to jail or were sentenced to jail. I doubt that anyone other than the taxpayer will pay for this...

2008 Aug 09 03:34 PM

[mmg:]

debt is the problem but the riches of the politicians will continue to fuel our failing economy...riches and greed...the biggies are not going to allow the common guy or gal to get their head above water...it is the top 2% who will continue to exacerbate the rest of us to let them get richer...they have no personal interest in seeing this mess straighten out...the current condition of the market is conducive to them buying like 5 cents on the dollar for stocks that they know will fall through the bottom before it ever appears on cnbc or anywhere else...call it what you like, but insider trading by any other name, yada, yada, yada...same ol same ol...why else are all of these deals done & signed off behind closed doors...e.g., fannie & freddie...bush & cronies !!!

2008 Sep 16 05:50 PM

[investokai:]

Why is there such a huge concern for growth in the global economy today? We have made it possible to let people live way beyond their means, what their REAL worth should allow them to. I think people need to take a good look in the mirror, and change their lifestyles and understand that some things in life might just have to wait... instead of taking on piles of debt. The last 5 years has seen some serious growth but I wonder... how much of this growth was funded by debts that are still outstanding, and possibly debts that can not be paid? I think the greed in the finance industry, along with the blatant foolish spending of people without money, is finally unraveling completely. Stability is more important than growth when growth isn't backed by any real value. It's going to be a major adjusting year, people will lose money but hopefully it will teach us all a lesson to learn to live within our means. Growth is not as important as stability in developed nations. And now to try and create growth over the past 5 years, instead of producing more efficiently or creating new innovative products, we simply made things available to people who couldn't afford it, to increase spending, which looks good on the books, unfortunately, a lot of that money will never be seen.

2008 Oct 12 01:42 AM