It's the Capital, Not Liquidity, Stupid

I wrote an article over the weekend on how all the massive, desperate liquidity injections by the Fed have failed, and indeed created a short-term liquidity cash burden at the top of money supply chain, banks. Today, I'm seeing a lot of the old, predictable battle cry: "Lower rates! Inject more liquidity!"

I feel compelled to repeat myself.

While liquidity has been a persistent symptom since the start of the crisis last August, it was never the cause. The cause has always been the Incredible Shrinking Captial caused by a combination of:

1. deteriorating housing market;
2. over-leveraging while ignoring systemic risk such as counterparty risk in CDS and elevated correlation in CDO;
3. and positive feedback loop between declining price and loss of capital base created by mark-to-market accounting.

Take a look around. US banks are buried with short-term liquidity cash, so much so that NY close overnight repo rate is almost zero. Does this mean US banks value each other's credit risk as equivalent to treasuries? Of course not. They just know their counterparts will have unlimited supply of short-term liquidity cash tomorrow and that's enough. Why don't they use the cash to start lending to people who need it, such as municipalities, companies, homeowners, and consumers? They can't. The cash is short-term liquidity supply, not their capital. If they use it to expand the asset side of the balance sheet, they run into two big, familiar problems that have burned them, their counterparts, and a few former counterparts:

1. capital requirements, which everyone has already been struggling to meet, and
2. risk of inability to roll the short-term debt to finance the long-term asset.

Sure, the Fed is their personal Santa now. But everyone knows at some point it has to suck out this massive excess liquidity. How do you roll the debt then? When will it happen? With every government agency changing rules of the game everyday for the last several weeks, often without any rationale except just for the heck of scaring people (as one official said of the short ban), nobody is willing to take the risk this close to Christmas and bonus time.

Hence the irony: on one hand we have a bunch of sickly banks sitting on an unlimited supply of liquidity, choking the money supply chain from the very top; on the other hand we have the rest of money supply chain dying for liquidity.

Now the Fed is considering buying commercial papers directly. What a concept. Why don't we just get rid of banks altogether and go to the Fed for a mortgage?

The Bailout Pork Package, for all its ills, at least has the diagnosis right: banks need capital injection. But the mechanics of it is too complicated -- what to buy, whom to buy from, at what price, how to set the price, who to manage it. By the time the doctor cuts to the tumor, some patients may have died from an overdose of pain killers.

We need to inject capital, not liquidity, into the banking system FAST. Once banks have enough cushion on top of the minimal capital requirements, they'll start opening up the money supply chain. After all, it's not like banks hate profit.

There are many ways to inject capital fast. Buffett's Goldman Sachs (GS) model is one. Immediate shift to capital ratio based on mark-to-history is another. Even emergency lowering of capital requirements is much better than this madness of blind liquidity injection.

It doesn't take a rocket scientist to figure out these solutions and at least give them a serious thought. Why haven't we seen any sincere push for any of them?

Buffett's GS model dilutes equity and may hurt executives' pay this year, nothing like the instant gratification of the Bailout Pork Package.

Amending rules involves no money flow, thus no direct, immediate profit.

I hate to be a cynic, at least when writing here. If there's a better explanation, I'm open.

Disclosure: none

Comments

[Smarty_Pants:]

The author is correct. Banks have no reserves except those they have borrowed from the FED. FED data supports this:

research.stlouisfed.or...

Technically the banks are bankrupt. If not for borrowing from the FED they would have negative reserves. Term Auction Facilities and the like are nothing more than life support for the banks, hoping that a solution can be found before it's "too late".

Further, until housing prices firm up and stop falling, the capital position of banks with illiquid level 3 MBS will continue to erode as prices fall. Expect more FED borrowing just to keep banks' heads above the water line.

Sadly, recent business models seem to rely a great deal on the use of borrowed money to fund day-to-day operations. This combined with the capital positions of the banks has resulted in everyone being in the same boat, begging for funds to keep the store open.

Expect a considerable shift back to prudent management practices where operations are funded from actual revenues, once short term obligations can be covered. Until then it will be rough going.

2008 Oct 07 10:23 AM

[Moon Kil Woong:]

The Fed should butt out and let the market contract so we can get on with a new unbubbled expansion. Recovery, true recovery can only come once the bad stock is cleaned out. Let new banks replace the old ones that fail and give a little prayer to those dumb enough to finance their dumb bets by buying their stock or bonds or buy CDS insurance from them. Otherwise, the US will look like Iceland and I doubt the Russians will bail us out too.

Right now it looks like they're opting for the 30 year recession Japan is experiencing except we may have it with inflation thrown in because unlike Japan we are a massive debtor nation.

2008 Oct 07 10:31 AM

[Brice Timmons:]

Bravo! First truly sensible analysis I've seen here.

2008 Oct 07 11:09 AM

[JasonC:]

Everyone on earth is "dumb enough" to fund "dumb bets", since 90% of the world's money supply is debt of banks, none of which is solvant at the 20% rates being demanded now. Depositers or takepayers are already on the hook. The only question is whether they want to still have a financial system or would prefer to try living without one. That they take the hit is baked in either way. I have no doubt whatever that the pain is less if they recapitalize the existing banks than if they deliberately destroy them all.

It is flat stupid for senior creditors to insist on bankrupting what they already own. And that is what depositers and their agents, the governments, now are. They own the banks they are destroying.

2008 Oct 07 11:16 AM

[Bo Peng:]

The government is in paralysis. They continue doing what's been proven ineffective and wrong repeatedly, injecting liquidity. This is getting pathetic.

2008 Oct 07 07:33 PM

[BlackyBlack:]

I think they must know something we don't - like there are too many businesses out there that would be bankrupt without the built in debt forgiveness of constant growth and inflating money supply. So that if they stop pumping the liquidity in, unemployment would sky-freaking-rocket. Isn't that the real fear?

2008 Oct 08 11:39 AM

[BlackyBlack:]

Do you think it's possible that they know something we don't, such as - maybe there's a huge number of businesses that would be bankrupt without the built-in debt forgiveness that constant growth and increasing money supply we've had for the last twenty years. So that the real fear is that if they stop pumping the money in, unemployment will sky-freaking-rocket. Not that they can pump fast enough anyway. But maybe that's the real fear. Not collapse of the markets, but collapse of the real economy (which really hasn't been very real after all).

2008 Oct 08 11:42 AM

[BlackyBlack:]

Sorry for the duplicate posting - I hate that

2008 Oct 08 11:43 AM

[flow5:]

Under the Financial Services Regulatory Relief Act of 2006 Capital ratios are already scheduled /legislated to decrease. Congress issued in payment of reserves early, why not a reduction in capital ratios?

2008 Oct 08 12:09 PM

[surgcare:]

Its the CONSUMER stupid .

2008 Oct 08 08:04 PM

[H&S:]

Whatever it is they better get it right quick before the economy goes into paralysis!!!!
A very quick fix could be to suspend the "Mark-to-Market' rule. This is a siily rule that has no scientific basis for its implementation as the crystal-ball of markets has never been found or defined-especially not by the green eye-shade folks!!!!!

2008 Oct 09 11:14 AM