Solvency Crisis: Fed VP Called it in May … but didn’t NAME it.

(noon. – promoted by ek hornbeck)

OK, now, Wash-Mooooo has been taken to the slaughterhouse and the choicest cuts bought by JP Morgan Chase (full disclosure: I bank at Chase).

Didn’t anyone know that this was going on? Well, of course people did. For example, back in May of this year, William C. Dudley, an Executive VP at the New York Federal Reserve Bank said:

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks.

And, obviously, “balance sheet pressure” is a nice way of saying trending toward a risk of insolvency.

Of course, the Fed has been acting for a year now like we are facing a liquidity crisis, when we are actually facing a solvency crisis … but if you carefully read an analysis by a fairly senior person in the Federal Reserve System, its all there. What’s up?

Join me below the fold.

Executive Summary

We’ve got a solvency crisis here, not a liquidity crisis … terms explained below … and at least some within the Federal Reserve System have known about … shown below … but for some reason couldn’t bring themselves to use the word.

The original Paulson plan could address the solvency crisis if we assume the idea was to buy toxic waste financial asset at sweetheart prices. That would not only re-capitalize the fortunate recipients of government insolvent institutions selected for special treatment by Paulson, but would have done so without the normal quid-pro-quo of giving up a share in the company. IOW, if it addresses solvency, the method involves Welfare for the Rich.

The Dodd plan allows conversion of toxic waste into liquidity at whatever its value eventually turns out to be. At that time, the excess payment, which was the re-capitalization, is matched by stock in the company with a 25% penalty on top. So after the crisis is passed we sort out how much was a interest free loan and how much was capitalization, and the capitalization part results in public ownership of an equivalent amount of corporate stock.

The plan of the radical reactionaries in the House to set up an insurance system is not just closing the barn door after the horse has left the barn … its closing the barn door after the horse has broken its leg in a groundhog burrow running around outside. If the assets are price fairly, it does nothing about current insolvency, while reducing the liquidity of the system by the amount of the insurance payments. If it over-prices the assets, then the correct insurance premium would be a massive rate that would drive many more firms into an illiquid position.

The Public Preferred Share plan, discussed under this username last week, uses the halfway-house between debt and common share ownership, the preferred share, to immediately give the public a claim on the future profitability of firms that are to be bailed out, without creating new liquidity problems in the middle of a recession.

Ah, what’s the difference between liquidity and solvency, again?

Liquidity and solvency are about the two different ways of being broke. Liquidity is about having a bill to pay today and no cash money to pay it with … Solvency is about being over your head in debt compared to your total assets.

You can be liquid but insolvent. Enough money to meet your current obligations, but obligations facing you in the future that you do not have assets to cover. Take the old fraudulent con game where someone sets up a company with a slick cover story, sells shares in a company that does nothing but pay the salaries of the people in the company and dividends. The classic trick is to make the dividends lucrative enough that more and more people buy in. Eventually, of course, the dividends run out, but the con-artist would hope to skip town with a big slice of the remaining cash ahead of anyone realizing it.

You can be illiquid but solvent. You have a series of bills to pay each month, and are owed a big payment, more than enough to cover all your bills for the balance of this year and the next at the end of next year. As long as that discounts the future payment for the fact that its December 2009, and as long as whomever owes that money is ready, willing and able to pay, that’s an asset … and you are solvent but not liquid.

In terms of a commercial corporation (whether productive, financial, or both):

• a company that is insolvent needs an injection of financial capital. Normally, what someone gets who injects financial capital is a piece of the action in the future profits of the company … a “share”.
  
• What a company that is illiquid needs is a loan … liquidity now against future income.
  
• Obviously what a company that is both illiquid and insolvent needs is an injection of financial capital in liquid form.
  

There was Detailed Analysis at the Fed about Solvency Problems

Its a lot easier to prove existence than to prove lack of existence … one example proves existence. So here is that example.

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reintermediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

Now, that may sound “like Greek” to you, but I’ll break it down:

If the Fed “Knew” This, What Were They Doing?

If you know that there is a looming risk of insolvency, you’ll do something about it, right? Trying to think through how to re-capitalize the useful parts of the financial system would make sense.

And yet, the actions taken, as reported in May, were all discussed in terms of liquidity:

The number of liquidity facilities developed and introduced by the Federal Reserve is another list that has gotten much longer. Policymakers have responded to the persistent pressures in funding markets by introducing several new liquidity tools. …

Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions. …

On one side, actual risks-due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity-and perceptions about risks-due to the potential consequences of this risk for highly leveraged institutions and structures-have shifted. …

Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

During the past eight months, the financial sector as a whole has been trying to shed risk and to hold more liquid collateral. …

In essence, the Federal Reserve’s willingness to provide liquidity against less liquid collateral allows the reintermediation and deleveraging process to proceed in an orderly way, which reduces the damage to weaker counterparties and funding structures. …

The Federal Reserve has introduced three new liquidity facilities during the past five months. …

… and etc.

By contrast, in this analysis under the cover of an analysis that talks about “bank balance sheet pressure, and is therefore about banking system solvency … where is “solvency” used? Here is a complete list:

Or, IOW, {*crickets*}

Corporate Group Think and the Danger of Euphemisms for Insolvency

So here could well be part of what has been going on. An Executive VP is willing to talk in terms of liquidity. He is willing to talk about solvency. But the Executive VP is not willing to talk in terms of solvency.

And of course, in a corporation the information that gets to the senior decision leaders is most often not the detailed analysis. It is taken from the Executive Summary. And further, for the very top levels where truly strategic decisions are made, Executive Summaries of reviews written mostly on the basis of Executive Summaries of detailed analyses.

If you are willing to say “liquid” and “illiquid”, that very easily rises up through the Executive Summary pyramid. However, if you are unwilling to say “solvent” and “insolvent”, but rather talk around it in more cumbersome terms … and side by side much clearer discussion of liquidity … that faces a much harder time climbing up the Executive Summary pyramid.

And then if “a broad reading” of analyses shows that a problem is a liquidity problem, it is easier for the next round of analyses to talk in those terms of a single issue … and if “a broad reading” obscures solvency problems under a range of euphemisms, it is easier for the next round of analyses to act as if a single solvency crisis is instead a disparate collection of distinct smaller problems in distinct parts of the finance sector.

Which is why I said that the Fed (well, at least William C. Dudley on May 15, 2008) “called it” … but didn’t name it.

“Solvency Crisis”: a brain tool for your use

Having the name for the problem really does make it easier to make sense of things … like various “bail-out” plans.

• The original Paulson proposal … well, formally it was, “give me $700b, I’ll do what I want” … but if it was to re-capitalize financial institutions, that would occur by buying junk at inflated prices to recapitalize financial institutions under extreme sweetheart terms that left them without any countering obligations at all.
• The Dodd proposal is to buy the assets, sell them off in calmer times after the crisis has (hopefully) passed, and then judge at that time how much of the original payment was liquidity and how much was capitalization. The liquidity is received for free, but the capitalization requires the firm to hand over shares (stock) equal to 125% of the value of the recapitalization.
• The “close the barn door after the horse has broken his leg” plan by the House radical reactionaries to set up some kind of insurance fund after the car has been wrecked would be clearly moronic if we were, say, sliding into a recession a year into a long running solvency problem that is becoming a solvency crisis … if the assets to be insured are priced fairly, the firm is still insolvent. Oh, right, we are in the middle of a financial crisis and sliding into recession … indeed, most likely already in and sliding more deeply into recession. So under current conditions, the House radical reactionaries have the kind of brain-dead plan you would expect from ideologue hacks facing a crisis created by their precise ideology.
• The Public Preferred Shares system recapitalizes firms with Preferred shares, which are like a debt when the firm is making a profit, but with dividends that do not have to be paid while a firm is running a loss, so unlike a bond (or an insurance premium like the bone-headed proposal by the House radical reactionaries), they cannot drive an illiquid firm out of business.
  

So there you have it. There are mikes scattered around for concerns, comments, criticisms, complaints, etc. Have at it.