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Revisiting the Solvency vs. Liquidity Dilemma
In a contributory post that I made for another site, one of the
commenters alleged that it was misleading to say that the failed bulge
bracket banks had backing from the Federal Reserve, or else they
wouldn't have failed. This is simply not true. The blessing of the
government does not necessarily cure all of your ills. The Federal
Reserve opened its discount window to the remaining bulge bracket banks
after Bear Stearns (Is this the Breaking of the Bear?)
filed for bankruptcy. It even decided to allow much lower grade
collateral, degrading its standards to the point where it took stock
and MBS, if I am not mistaken. This liquidity backstop (among other
programs) did not prevent the collapse of Lehman Brothers, nor the very
near collapse of Merrill Lynch. The remaining two bulge bracket banks
were literally forced to become commercial banks to stave off their
downfall. This history is barely a year old and is already lost on
some.
What the government's efforts did was backstop the
liquidity of these banks, but the liquidity issues were a symptom of
the bank issues, not the cause of the bank issues. The cause of the
problem was, and still is, insolvency. I went through this in detail,
exactly one year ago when Lehman and AIG went bust (Why didn't the Fed drop rates? Because it would have done little good).
Here is a chart and excerpt from that post of over a year ago. If one
were to chart the stocks of the companies that are in that chart, I am
sure the solvency vs liquidity argument will be gelled, at least to
some point...
Click to expand the chart...
The
primary reason why the Fed's lowering of the interest rates is not
helping the banks is because monetary stimulus via discount windows and
low interest rates can solve liquidity issues, which the banks have -
but the banks liquidity issues stem from INSOLVENCY,
and illiquidity. Thus, all the Fed is doing is taking a pricey, risky
(inflation and weakening currency that pisses off our trading partners)
and volatile band aid and applying it to deep and gushing wound. Those
band aids with the pretty colors do indeed tend to make Mama's baby's
little boo-boo feel better, but from a scientific perspective do very
little in regards to addressing deep puncture wounds.
As
it turned out, the Fed did drop rates more, eventually to effectively
zero. Guest what happened? NIM still dropped at many sick banks, and
quite a few of them went out of business, and it is still happening at
nearly a record pace. The FDIC has actually been driven into insolvency
just a year after my warnings on the insolvency of the banking industry
- reference my recent missive: "I'm going to try not to say I told you so...".
In "The Anatomy of a Sick Bank!"
from over a year and a quarter ago were I again attempted to drive this
concept of insolvency and the inability of liquidity bandages to stem
the problem home. As excerpted:
"Let me explain the five major tenets of the sickness troubling banks these days.
- An
absolutely horrible macroeconomic environment with the convergence of a
downward banking business cycle, a bear market approaching, and
recession.- Rapidly depreciating assets borne from excesses during the recent real asset and credit bubble.
- High levels of these rapidly decreasing assets on (and off) the books of many banks
- High
levels of leverage (the highest historically) used to purchase the
aforementioned. Leverage which exacerbate both profit and loss (we are
in a loss moment, now). The combination of this high leverage and the
prices paid for the assets mentioned in point 2 create an INSOLVENCY
trap for companies that attempt to reduce risk by delevering (ala
Lehman Brothers or Citibank). When in this situation, the only way to
reduce risk is to realize significant losses (and some banks are trying
to hide them).- Thin profit margins that are beyond the ability of the government to help. The banks can't earn their way out of this one.
This all basically leads to insolvency if not corrected timely.
This is an insolvency issue, not a liquidity issue! I have been banging the table on this for almost a year...
As
concluded in the bullet list above, the trifecta of diminishing
margins, increasing insolvency, and high leverage leads to a sick bank.
I would like to delve deeper into each symptom and side effect in order
to identify the sickest amongst the Doo Doo.Insolvency exists for a person or organization when total financial liabilities exceed total financial assets.
Financial and real estate institutions that have binged on overvalued
risky assets at the top of a bubble, paying for said assets via highly
leveraged credit, are now facing the effects of the devaluing of those
assets and that devaluation being applied against the excessive debts
that have been accumulated to buy those assets when they were
bubblicious."The only thing saving the big money center
banks are their trading arms and the government complicity in masking
their insolvency issues as liquidity issues through opaque accounting.
The credit quality of assets and the general traditional banking
business is performing horribly, across the board of the big money
center guys and many of the regionals. The trading revenue spike has
its costs, too, which is apparent as I parse through the lastest
results of JP Morgan, which I will post a little later on, followed by
a continuation of my off balance sheet series featuring Wells Fargo.Re, JPM: The
high trading revenue comes at a cost of high market risk which is
reflected in higher VaR levels. The fixed income VaR has increased
substantially and stood at $243 million at the end of 3Q09 against $183
million at the end of 3Q08.
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Good article Reggie but no mention of Minsky.
When lack of liquidity becomes insolvency isn't this called a Minsky moment?
Its a mine field, you try to move to offshore deposits but then the currencies devalue, you try to stay in FDIC insured deposits but then the whole thing is a business day away from default at any given time. So you go to gold bullion held in a Swiss vault, the value of gold goes down or you have to consider the bullion bank defaulting on your receipt. You buy some arable land but climate change ruins the water profile of the area. The center cannot hold, things fall apart.
Good stuff Reggie. But as the other posts point out, the banks have been bust before: the Latin American Crisis in the mid-80s, the S&L crisis a few years later and now. You and I are bankrupt when the bank says we are. The bak is bankrupt when the Government says it is. It's that simple.
Is it a conspiracy? Damn right. Will it work? Who knows. The difference is that the US was a creditor nation the last two times the banking system was bust. Maybe the banks are bust when China says they are.
Keep it comin' Reggie. VEry good stuff.
Spanishmoon
Insolvent, please, everything is fine. Nothing to see here, just move along.
O do not know if I agree with exactly how you arrived at your conclusions, but generally speaking you are right. I do not think this is a huge Earth shattering secret though. As soon as the FASB dumped mark-to-market earnings magically went through the roof. I am not a rocket scientist, but I can put 2 and 2 together. Also, did you really believe the markup JPM had on their earnings? Come on? Defaults are climbing and they are marking up assets, unreal. I don't know if your supposed to be a guru or something, but if you are then I am feeling pretty good about myself since I had most of this figured out for a while :-), no offense.
So why did Doug Kass buy so many calls on BAC today?
http://www.thestreet.com/author/1358076/DougKass/all.html
http://www.jubileeprosperity.com/
Remember, Volcker admitted this was the case during the S&L collapse as well, but the current macroeconomic climate is vastly different. To put things in perspective, look no further than housing charts provided by calculatedriskblog.com:
http://www.calculatedriskblog.com/2009/08/quarterly-housing-starts-and-new-home.html
I believe both the Fed and the Treasury understand this and hope that free money (Zero percent interest) loaned out at 5+ percent will eventually solve these problems. Tis will only work if they reduce their risk or increase the quality of their assets, neither of which seems to be happening.
the spread you mention is where the trading
profits come from and what fuels the dollar
carry trade which will guarantee long term
low rates....
the assets are hoplessly lost - something which
no amount of bot trading can cure...
Can we generally agree that, as the Fed manipulates the U.S. financial market it also influences, if not outright manipulates, the global financial markets? Can we generally agree that the Fed carries out much of it's manipulation through the primary dealers? (Wikipedia provides a definition of PDs for those that need one.) Can we also generally agree that most of the TBTF banks discussed on ZH are primary dealers?
I've been reading here since Feb 09 and it seems that the general sentiment is that the better course of action would have been to let gravity run its course and let the TBTF banks fail. The pieces could be picked up by local and regional banks and the U.S. could get back to business. I tend to favor that approach also, but I'm left wondering about the unintended consequences of that vs.a vs. the Fed and the primary dealers. I may have missed it, but I've not seen any analysis of what effect allowing the TBTF banks / primary dealers to fail would have on the Fed's ability to carry out its congressional mandate. That is, I'm curious about how the Fed could/would influence the U.S. and world financial markets during the period that it's primary dealers were broken up and sold off. Could the primary dealer functions continue with few hiccups if they were purchased by local or regional banks? Or would the Fed be basically impotent for the time it took to rebuild its primary dealer network? Would Reggie or anyone care to comment on this - or point me to articles that discuss the subject?
i guess implicit in your questions is the notion
that the tbtf banks are indeed the primary dealers....
there are foreign primary dealers who would still
function as well as domestic ones who are not
part of the so-called 19 tbtf banks...
those failed banks who act as pd would see their
businesses sold off to healthier entities who
would continue the pd role....
it is also possible that not all tbtf banks would
necessarily fail although i think that is the
insinuation of the article....
i believe that all insolvent banks should be
closed with haste.....a little schumpeterian
creative destruction is good for the soul....
i could be wrong in my view of the composition
of the pd network so any corrections would be
welcome....
Thanks for the response. I was speaking to the circumstances that occurred a year ago, not now. The general consensus seems to be that Goldman Sachs, JP Morgan, Morgan Stanley, Bank of America, and Citibank all would have failed if the Fed had not intervened, starting with the AIG bailout. I believe all of these are primary dealers. My question / curiosity centers on how badly the Fed's ability to operate through the primary dealers would have been compromised if all of these banks had been allowed to fail at the same time. Would the institutional knowledge about primary dealer operations have been picked up intact by smaller, healthier banks (implies a transfer of primary dealer staff to smaller banks)? Or would there have been a mess created? I'm guessing that the desire to keep the primary dealer operations running smoothly is at least part of the motivation for the Fed propping up the TBTF banks, then and now. But I have not seen a discussion of this angle anywhere as justification for keeping the big banks alive. Does this line of reasoning have any merit?
You mention that there are foreign primary dealers. Did you mean that foreign-owned banks can act as primary dealers for the Fed?
Foreign banks that run US operations are able, yes. Here is the most recent listing courtesy of your local New York Fed. That wonderful broker, Nomura, appears the most recent addition:
http://www.newyorkfed.org/markets/pridealers_current.html
Your point is quite interesting, but I'm lacking for any real answer. Institutional knowledge would have been sopped up quickly, I assume by others who have stepped up their game in any case (such as Jeffries, et al).
McGriffen
The government giving the banks billions seems to solve the solvency issue pretty well.. If it wasn't enough they'll print more and give more.
Pardon my ignorance, but was the suspension of mark-to-market temporary? If it is to be restored (yeah...right), when is that supposed to be?
Thanks -
last i heard mark to market was supposed to
be reintroduced 1/1/2010....however don't expect
it...it's more prattle from oligarchs to create
confidence....it's a a charade...
Yes Reggie's new Discovery channel "Banks after
people" based on the award winning "Life after
"people".
Insolvency only matters IF the banks are forced to recognize their insolvency. Because the Fed is taking the banks bad assets in exchange for dollars, the banks will never be forced into bankruptcy since they are being recapitalized through dollar debasement. The poor American savers are literally giving their money to the banks by dollar debasement in order to cover bank losses. It is theft and fraud -- pure and simple. And it won't stop. The financial oligarchy runs this country and the US Congress. Until a majority of Americans are poor, starving, penniless (through hyperinflation), and homeless will they rise up and take this country back from banksters. Unfortunately, that is many years and much misery from now.
Finally!!!!
This is precisely the truth - We MAY...just MAY see one more major bank allowed to fail (BAC??) and it will ONLY be because efforts will be to prop up the remaining others to even greater extents.
The Federal Reserve in Conjuction with the US treasury are Spending SO MUCH money, and allowing so much of it to literally mop up the banks insolvency issues, that by the time were done, the banks WILL be solvent, and a loaf of bread WILL cost $10.
If you disagree, Id simply ask you to go look at the national debt, and bank debts in 1970, look at the cost of food in 1970, and then see how much your Dollar would Buy in 1970 compared to now...
Its all being done in absolute Plain site.
by 2030 a dollar will buy what a quart buys today, this will be done by a paultry 5%-7% per year rate of inflation.
Its not even gunna take Hyperinflation to do it....the slow grind worked from 1970 til 2009, and by god it will work from now until 2030 and beyond.
Ok, I see how it goes. Don't ever question the might of financial contribution postings here. Seriously pal, business is business. This is, well, quite lame to retort to those who find disagreeable statements. Historically speaking, both of us are correct.
Sloppy financial analysis begets misinformation, that was a concern. Many of your points are relevant and very true, such as TBTF and the insolvency of institutions. But come on, there's a deep pool of financially adept folks here. Cheers
McGrif, don't be a party pooper. Everyone knows that Reggie has to earn his spot at the zerohedge cafe. The Zerohedge readers are a tough audience to play to. Of course we could ask him questions, but he would just try to charge us for information that we already know. :)
I pissed off a few lemmings who tend to agree the sky is blue and every thread on ZH is 100% true.
My attempt to draw a distinction between banks who fail (Wachovia, IndyMac, Wamu) and IB's that fail (BSC, LEH) were in different classes when it came to official backstop by FED, etc. It's from an earlier post (this derived from an earlier contribution this week).
I'm glad I pissed a few off, but intend zero disrespecting to Middleton or his work, especially exposing the TBTF entities we all love & cherish so well that we own them
McGriff (asshole of the day award to me)
Did you have an earlier post on this thread? If you did...its gone and so the rest of us have no clue what the hell your saying.
What is the nature of your malfunction? Your post makes no sense, and Reggie has absolutely zip to apologize for.
wipe that brown off you nose pal. Nope, still some of it left.
Your witty repartee is so interesting, please don't stop now.
fuck you bitch....
you have said one coherent thing in your pixilated
postings....
I'm not sure I get your point. I have no problem with your questioning postings, mine or any others. If you are somehow getting offended, don't be. Are people not allowed to disagree? If I am not mistaken, you are not even the commenter I had in mind, relax...
You guys are awfully touchy.
Hello kettle, this is pot. Everyone's touchy about their own results and the hard work that produces it.
reggie, unfortunately for me, I just discovered you here. but have become a quick fan. How much are profits like these from the big money centers just ponzi feedback loops supported by govt? & how much is real, organic, sustainable profits? Obviously borrowing for nothing or close to nothing is helping. Any sense for how much is due to asset write ups on their balance sheet from govt stimulated liquidity?
Dear Reggie,
"Thank you for your submission request. In addition to 9-11, Mythbusters will not be entertaining any of your suggestions on banking insolvency experiments."
Sincerely,
The Discovery Channel
good article reggie.
As Foreclosures Hit All-Time High, Wall Street on Pace to Hand Out
Record $140B in Employee Bonuses
Blackweb
The Dow Jones Industrial Average has topped 10,000 for the first time
in a year, as JPMorgan Chase reported massive profits in the third
quarter. Meanwhile, the Wall Street Journal is reporting that major US
banks and securities firms are on pace to pay their employees about
$140 billion this year—a record high. But on Main Street, foreclosures
are also at record levels, and the official unemployment rate is
expected to top ten percent. We speak to former bank regulator William
Black, author of The Best Way to Rob a Bank Is to Own One.
http://www.democracynow.org/2009/10/15/black
Sooner or later an old family cannot make it on reputation or looks alone and must pay their bills.
The sad fact is that the US is like every other "developed" nation in so far as our banking system is now too big to save. Our political & corporate leadership is too scared of losing their power & lifestyle so they have resorted to printing the money to hold off the bill collectors, for now. Sooner or later the collectors will want something of tradable value and the old family will throw a temper tantrum before finally being tossed to the curb.