Solvency and liquidity
UK Prime Minister Gordon Brown at the EU summit today, via WSJ:
“I want the message to go out that no solvent bank should be allowed to fail for lack of liquidity”
That’s the nub of the issue, and it’s a pity that we had to get to this point to finally have clarity. Banks often fail, not due to a lack of solvency, but due to a lack of liquidity.
In recent days, we have seen solvent institutions like AIG and arguably solvent firms like Lehman Brothers, get wiped out in the wake of the government’s decision to nationalize Fannie and Freddie — companies whose stocks were rated a ‘buy’ at the very moment the government decided to step in. The wiping out of the shareholders of Freddie and Fannie briefly re-established “moral hazard,” but even more than that, the US government established a virtually risk-free strategy for traders and speculators to bankrupt every other bank and financial institution.
As Anatole Kaletsky pointed out, at that moment, Henry Paulson’s Treasury Department created a Doomsday Machine that could sequentially wipe out every other leveraged financial institution on the planet. All because the government didn’t want to be seen to be bailing out shareholders. And now we have the biggest bailout in history as a result — and it’s likely to get even bigger.
Maybe things would have gotten this bad on their own. We don’t know. But the government’s to-date inconsistent actions have not helped matters. As one market observer noted: “The government’s capriciousness is legion: Fannie and Freddie ‘are well capitalized,’ then they are seized. Bear is too big to fail at $300 billion in debt, Lehman is not too big to fail at $700 billion.”
One thing that is clear is that, by letting solvent institutions fail, and thus make liquidity in the system dry up, the government has made itself the biggest lender on the planet. Tony Crescenzi explains in his analysis of the Fed’s fascinating weekly publication, Factors Affecting Reserve Balances:
the U.S. financial system is currently on life support, with the Federal Reserve seemingly the only lender of any consequence…This was apparent in Thursday’s figures on commercial paper issuance, which posted a record weekly drop of $94.9 billion, and in figures on bond issuance ($7 billion in three weeks — a tenth of the norm), and bank lending, although new data indicate that there has been some shift to bank credit from other sources of borrowing.
Federal Reserve credit, which measures all monies injected into the financial system by the Federal Reserve, increased massively, by an unprecedented daily average of $253.6 billion to $1.388 trillion in the week ended Wednesday, following an equally massive $203.6 billion the previous week. Mind you, this is a figure that tends to increase only a few percent per year. Last week’s increase was about five times greater than the last two large infusions, which occurred in September 2001 and the period surrounding Y2K.
Many factors bloated the Fed’s balance sheet. For starters, primary dealers increased their borrowing by a daily average of $59.5 billion to a record $147.692 billion, a clear sign of stress amongst dealers. Three weeks ago, this figure was zero.
Question: back at the time of the Bear Stearns fiasco, if the government had made it clear that “no solvent bank should be allowed to fail for lack of liquidity,” but made ambiguous the means by which that would achieved in particular cases, would we still be in this pickle today?