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It is Time to Address Solvency

 It is Time to Address Solvency

What will it take to get the global financial policy makers to directly address the global banking system's solvency problem and stop injecting liquidity and pretending the solvency issue will go away?

Thanks to WikiLeaks, we know that by March 2008, Mervyn King recognized and tried to explain to the global financial policy makers that:
  • The global financial system was facing a solvency crisis that required recapitalization of the banking system; and
  • While liquidity was necessary to keep the credit markets functioning, it was not a replacement for risk capital.
Furthermore, he realized that illiquid structured finance securities, including mortgage backed securities, needed to be valued if the issue of solvency was going to be addressed.
The pursuit of a valuation mechanism for the illiquid securities and addressing the issue of solvency was interrupted, in September 2008, when liquidity throughout the credit and capital markets disappeared.
Why did liquidity disappear then?  
Investors saw what happened to Lehman Brothers.  Lehman Brothers succumbed to a liquidity problem brought on by questions about its solvency.  
Credit market analysts looked at Lehman Brothers' then current disclosed exposure to illiquid securities.  They then applied a worse case loss assumption to these securities.  The analysis showed that Lehman Brothers was insolvent.  Naturally, investors wanted their money returned.  This "run on Lehman Brothers" created the liquidity problem.
It was a small step for the credit market analysts to then apply this solvency analysis to other large, global financial institutions.  The conclusion was that few, if any, of these institutions were solvent.  Faced with insolvency, there was a global "run on the bank" as investors, which included banks that lent funds to other banks, raced to withdraw their funds.

The disappearance of liquidity created a problem for the global financial policy makers.  How could they provide enough liquidity to the credit and capital markets to buy time so that the solvency issue could be addressed?
This point bears repeating.  By the time Lehman Brothers went bankrupt, Mervyn King and all the global financial policy makers knew:
  • There was a solvency problem involving most, if not all, of the large, global financial institutions;
  • Liquidity by itself would not fix the problem; and
  • Solvency needed to be addressed if the policy makers were going to be able to permanently exit all the programs put in place to inject liquidity into the financial system.
If the global financial policy makers knew that solvency needed to be addressed, why did they default to their traditional policy of injecting liquidity and publicly denying a solvency problem?
By September 2008, the global financial policy makers were already well aware that their traditional policy creates its own problems and does not cure the underlying solvency issue.
  • The traditional policy has alway created moral hazard.  Rather than make the existing risk capital investors (equity and debt holders) take a haircut when the credit markets first recognize a solvency problem, regulators give them a free pass.  
  • The traditional policy has always failed to cure the solvency issue.  
    • It failed when U.S. regulators tried it at the beginning of the Savings & Loan Crisis in the 1980s.  It failed when Japan applied it after its credit bubble burst in the 1990s.  Ironically, the U.S. financial policy makers told the Japanese financial policy makers that injecting liquidity and publicly denying a solvency problem would not work.  The U.S. financial policy makers' recommendation was to recognize the losses.
Perhaps the choice of this failed traditional policy is driven by the hope that somehow the insolvent financial institution can be force fed enough earnings so that the financial institution can absorb all the losses on its balance sheet.  
While this is true in theory, there is a wee problem with implementing this policy in practice.  
Force feeding earnings into an insolvent financial institution fails when the financial policy makers refuse to publicly acknowledge that the financial institution is insolvent.  Without this public acknowledgement, current employees and owners see "record earnings" for the financial institution and take out the earnings as bonuses and dividends.
Presumably, the reason that financial policy makers do not want to publicly acknowledge that a financial institution is insolvent is fear of sparking a "run on the" financial institution.

However, as was shown in the Savings & Loan crisis, the Japan credit crisis and the current credit crisis, investors are willing to fund an insolvent credit institution so long as the government is protecting the investors against the losses on the financial institution's balance sheet.  

It is when that protection disappears that investors want no part of the financial institution.  This is not surprising as the issue of solvency for the financial institution was never addressed!

Pursuing the traditional policy also raises the issue of who is going to absorb the losses when the solvency issue is finally addressed.  After all, no investor would buy the losses on financial institution balance sheets knowing that they exist.

That a policy of liquidity injections and public denial of solvency problems would not address the solvency issue should not be a surprise to readers of this blog and its companion web site,  Readers knew in 2007 that in the absence of access to loan-level information on an observable event basis for these illiquid structured finance securities that:
  • Once the devaluation process on these securities began, there was no logical stopping point in the downward price spiral other than zero;
  • The few Wall Street firms which did have access to this current loan performance information preferred to keep the information for themselves so they could trade against their "clients".
  • Injecting capital directly, through investments, or indirectly, through earnings, would not answer the question of whether a financial institution was solvent.  Since the illiquid securities could still not be independently valued by the credit market, it would still be impossible to determine whether a financial institution had enough capital to cover the losses on these securities and related credit exposures.
There is a reason your humble blogger refers to a downward spiral.  The first loop of the spiral was focused on the banks and their solvency.  When the governments stepped in and protected the senior investors, which were frequently their country's banks, they transferred the issue of solvency to their balance sheets.  This created the conditions for the second downward loop in the spiral.
So let's review where we are at after three years of pursuing a policy of injecting liquidity and publicly denying the solvency problem.
  • The illiquid structured finance securities can still not be valued.
    • Existing once-per-month or less frequent loan-level disclosure practices leave investors blindly betting on the value of the securities (for more on why this is true, please see the Brown Paper Bag Challenge).
    • The sell-side of the structured finance industry, through the trade associations that it dominates, is blocking regulatory efforts in Europe and the U.S. to provide investors with the current loan-level information that investors need to value the securities.  
      • The sell-side opposition reflects its desire to preserve its informational advantage from servicing the underlying assets and using this information to profit from trading against their clients.  
    • Buyers of structured finance securities are aware that the sell-side has the equivalent of "insider information" that it uses in its trading against them (see the experience of the buyers with securities like Abacus).  There is a buyers' strike until the buy-side receives the same information at the same time as the sell-side.
  • The private RMBS mortgage market is still frozen and the other consumer backed securities markets are faltering.
    • Neither direct bribes, through programs like TALF and PPIP, or indirect bribes, through implementation of zero interest rate policies to encourage investors to chase higher yields, has resulted in sustainable liquidity returning to the market for existing structured finance securities. 
      • If there were sustainable liquidity in the market for existing structured finance securities [where sustainable liquidity equals active trading], then the regulators would have pushed to restore mark-to-market accounting and eliminated mark-to-myth accounting for financial institutions.
    • Issuance of consumer backed structured finance securities are becoming less frequent.  This is a direct result of the Fed providing zero cost funds to the banks and crushing the economic attractiveness of issuing structured finance securities.
  • Banks still have a portfolio of illiquid structured finance securities that cannot be valued as well as other residual exposures to the credit bubble (like commercial and second mortgages).  
  • Without an active secondary market for the current outstanding structured finance securities and the return of mark-to-market accounting, investors still do know know which, if any, of the large, global financial institutions is solvent.  
    • The size of these institutions' exposure to the illiquid securities and therefore the potential losses on the balance sheet dwarfs the capital base of the financial institutions.
  • Governments are explicitly or implicitly guaranteeing all unsecured investments in these financial institutions while publicly denying there is a solvency problem by asserting that the financial institutions are solvent.
    • The European stress tests are confirmation of the extent of public denial of a solvency problem.  
      • First, there are two banks in Ireland that needed to be recapitalized but 'passed' the stress test. 
      • Second, there are only five cajas, a real estate oriented bank, in Spain that failed the stress test when a reasonable expectation given the size of the decline in real estate valuations since the peak of the Spanish real estate bubble would have been only a few of cajas passing.
  • The solvency of individual countries is being questioned as credit market analysts question the financial strength backing up the guarantees of the financial institutions' debt.
    • Credit market analysts are performing a Lehman Brothers' solvency analysis on each European government.  At its peak before the credit crisis, the global illiquid structured finance market exceeded $15 trillion dollars.  The absolute size of the potential losses in each country's banking system calls into question the solvency of each individual country through its bank debt guarantee.
  • Credit market participants are still engaging in "runs" when there is doubt about the solvency of the banks in a country's banking system and the government which supports them.  
    • As Ireland has shown, investors are leaving both a country's banks and its sovereign debt.
  • Governments are adopting austerity in their fiscal policy to 'convince' the credit markets that the governments are solvent after plugging the hole in their banking systems.
    • For this to work, the credit markets have to believe what governments are saying about the size of the hole in their banking systems.  
The morphing of a bank solvency crisis into a sovereign debt crisis and its related austerity measures is a sure sign of the failure of the policy of injecting liquidity and publicly denying the solvency problem.

Despite spending trillions of dollars, the global financial policy makers find themselves facing the same solvency problem as in 2008, but instead of just involving the banking system it has now spread to sovereign debt and involves cutting back on services to the taxpayers.  

Hopefully, while there is still time to halt this downward spiral, the global financial policy makers will abandon the failed policy of injecting liquidity and denying the solvency issue.  

Clinging to this failed policy is the equivalent of telling the capital markets that the financial institutions are insolvent and that the hole in the banking system exceeds the government's ability to fill while remaining solvent itself.  

If the combination of the financial institutions and the government are solvent, there would be nothing to hide.  

In this case, the governments should be leading the way to have the financial institutions provide the current asset level data that would enable the market participants to see for themselves that the combination of government and financial institutions is solvent.  

Ultimately, showing who is or is not solvent is a four step process:
  • Provide current asset level performance on an observable event basis for all illiquid securities and all exposures on financial institution balance sheets to all credit market participants.  
  • With this data, credit market participants can independently analyze each illiquid security using the valuation models of their choice. 
  • Using these independent valuations, investors can then make buy, hold and sell decisions based on the prices being shown by Wall Street and a liquid market created for the previously illiquid securities.  
  • With an active market for the previously illiquid securities and all the assets for each financial institution, it is easy to determine which financial institutions are solvent, which are not solvent and how much capital the insolvent institutions need.  
Once the insolvent institutions have been identified and the amount of capital needed to cure their insolvency determined, regulators can then oversee a resolution of the insolvent financial institutions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.