Back in 2008, as the financial crisis was unfolding, there was a big argument as to whether the crisis was a “liquidity crisis” or a “solvency crisis”. It’s a very important distinction. A “liquidity crisis” is when banks (or similar finance companies) are financially in the black – their assets are greater than their liabilities – but they can’t get the cash to keep paying their bills in the short term. A bank run is the classic example of a liquidity crisis – even if the bank could eventually pay everyone back, it can’t pay them back all at once, so if people get scared and all try to withdraw their money in a rush, they force the bank to collapse. A “solvency crisis”, on the other hand, is when finance companies are actually bankrupt, and no amount of short-term borrowing will change that fact.
This is difficult to unravel. The high officials talked as if it were a liquidity crisis. But one might argue that they acted as if it were a solvency crisis. The Fed could have lent to Citigroup through the discount window. Instead, they injected capital into Citigroup, via TARP.
I think that AIG suffered from a liquidity crisis, because the contractual arrangements in their credit default swaps evidently allowed their counterparties to make “collateral calls” as the underlying securities declined in market value. The way the government dealt with AIG’s liquidity crisis was to give AIG enough money to meet the collateral calls (to Goldman Sachs and others) and essentially taking away capital from AIG, so that AIG had to dismember itself in order to remain a company.
Among the many problems with sorting things out is the problem of valuing brand equity. If you think that Citigroup had brand equity, then they were not in a solvency crisis.
If you think that Freddie and Fannie had brand equity, then they suffered from a liquidity crisis, because once their borrowing costs were held down, they became profitable again.
So I don’t have a crisp answer to Noah’s question, even in hindsight.
Every debtor can make the same claim- “If you just give me enough time, or if you just lend me enough to roll my debt over, I can pay you back…..eventually.”
I would say in retrospect the liquidity vs solvency debate looks to have been the wrong question. The issue was tight monetary policy arising from a poorly understood instrument: IOR.
The question to have asked was liquidity problem (cause) or monetary problem (cause).
The monetary problem caused liquidity and solvency issues. The effort to respond to the liquidity crisis caused bad (tight) monetary policy.
At pretty much every point along the way, investors and regulators underestimated the solvency problems. In hindsight, JPM lost more on WaMu than it ever anticipated. As for brand equity, I don’t understand – Citigroup is still trading below tangible equity. If it has brand equity or franchise value, the market still fails to recognize it.
Seems to me a that huge issue here is the dual nature of intermediation.
Banks borrow short and lend long. A side effect or necessary colateral to that is that they also borrow hard and lend soft.
What I mean by that is that when you make a deposit of currency with a bank, there is no debate about what that is worth, of how real it is, etc. There is no “judgement” on the net present value of today’s paycheck deposit.
When a bank makes a loan, they (at least hopefully) believe that it is in time worth more to them than the money they lent out. But that’s a future looking judgement based assessment. There is time risk. But there is also counterparty risk (the borrower could in theory default tomorrow – the currency in general will not.)
It’s not that fiat currency is “infinitely hard” but rather that it’s much much harder than lent money….
Solvency. That’s why they got rid of mark to market and paid interest on reserves.
Yes, but impaired markets offering fire-sale prices due to regulatory vagaries improved. Additionally, the implicit gov’t bailout value surely plummeted after Lehman. So, they made a liquidity crunch into a solvency issue transiently and possibly somewhat artificially. I don’t mean this as an accusation.
I’d argue that the pre-bust market prices were the unreasonable ones, unless you’d like to argue that the housing bubble could’ve lasted in perpetuity. Mark-to-make-believe means that many banks could still be insolvent for all we know…
Lehman will determine what brand equity is worth, likely not much. AIG was insolvent; they needed to keep their tax losses to repay Treasury. There really isn’t much difference between liquidity and solvency when it gets as bad as it did. If Treasury hadn’t intervened they would all have been insolvent; intervention reduced this to liquidity.
Too much illiquidity or too little liquidity? Dunno?
Try sorting the things on a liquidity scale, and look to see if any unusual jumps in illiquidity show up.
Dr. Kling: wrt Mark-to-Market – what say you?
I think that mark-to-market is a necessary tool. Start with the best estimate you can of current value. Then choose forebearance if you want to. But don’t blind yourself.
This whole line of thinking is erroneous. There is no such thing as a liquidity crisis. If you are insufficiently liquid to pay your bills, you are insolvent. This is doubly true for fractional reserve banks which are insolvent at all times by design.
This viewpoint tends to get dismissed as just so much Rothbardian radicalism. Nevertheless, it is indisputably true. Fractional reserve banking has its roots in fraud, but evolved to dominate the world by acquiring state sanction. Regardless, its tendency toward failure is inherent. That mode of failure cannot be designed or regulated away, it can only be bet against. Once in a while that bet does not pay off.