Deja Vu Again: Is Liquidity or Insolvency the Problem?

Two schools of economic thought have squared off in the current financial crisis over the nature of the problem.  A similar quandary faced the Hoover administration in 1932[1].   The Keynesians hold that the crisis is one of illiquidity in the credit market. Banks are unwilling to sell their CDOs--now innocently known as "legacy assets" within 44's administration--because the market is not fairly pricing the assets but subjecting them to distressed evaluations[2].  Their prescription is to flood the banks with money regardless of the long term inflationary effects and take the pressure off the banks.  When the crisis began Fed Chairman Bernacke said, "To ensure that adequate liquidity is available, consistent with the central bank's traditional role as the liquidity provider of last resort, the Federal Reserve has taken a number of extraordinary steps..."  This liquidity rationale for intervention was later echoed by the Treasury Department when it launched its Public-Private Investment Program (PPIP) to finance the purchase of toxic assets at public expense, "...there is evidence that current prices for some legacy assets embed substantial liquidity discounts...This program should facilitate price discovery and should help, over time, to reduce excessive liquidity discounts embedded in current legacy asset prices". 

The Austrian school thinks that the toxic assets are bad loans overpriced to begin with because of the speculative bubble in real estate. The market is now pricing them fairly given the risks of non-performance.  There is no liquidity problem, but a bank insolvency problem. Banks holding overpriced assets on their books refuse to sell them at low value because they are playing politics to get a better deal from sympathetic government officials.  Insolvent banks should be allowed to fail, not propped up by morally unjustified wealth transfers.  New theoretical analysis supports the Austrian school position.  The conclusion of the study authors, none of whom are identified with the Austrian school of economics, is that the market is correctly pricing the toxic assets held by the banks:  "The [mathematical] analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals...correct prices in the secondary market for these assets essentially imply that many major US banks are now legitimately insolvent.  This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market."  The bottom line is that there is no equitable justification for transferring taxpayer wealth to these insolvent banks other than protecting their remaining owners, the bondholders[3].  As right-wingers are so fond of telling us, "the market works".  Someone should tell that to Timothy Geithner.

[1]  Hoover created the Reconstruction Finance Corporation in 1931 to make short term guaranteed loans to banks, railroads, and governments.  Of the $1.6B loaned, $1.3B went to banks.  But the loans did not solve the problems of unhealthy banks.  It became clear under the Roosevelt administration that solvency was the real issue.  A bank holiday was declared on March 3, 1933 and the Emergency Banking Act was signed on March 9th.  Healthy banks were allowed to reopen. Banks whose assets did not allow a full return to depositors and creditors were placed in receivership for reorganization or liquidation as bank examiners determined. Between 1930 and 1933 10.7% of commercial banks failed.  Depositors, investors, and bondholders all suffered losses totaling $2.5B or about 2.4% of GDP.  Too big to fail?  No, too big has failed. 

[2] The benchmark index of the market for securities backed by home loans shows the AAA tranches for 2007 are valued at about 23%.  Lower tranches (more risky) show losses greater than 97%.

[3] Shareholders participate in a company's assets.  An insolvent bank has liabilities in excess of assets.  The IMF reported in January that banks and insurers are facing losses on toxic assets of $2.2 trillion.  Those losses are expected to rise to $3.1 trillion next year.  The IMF said in its report, "Going forward, banks will need even more capital as expected capital losses continue to mount." Dr. Doom (Nouriel Roubini) estimates losses will reach $3.6T by the middle of next year, and he expects that figure to rise as bad debts from other sectors (credit card, commercial loans, and regular mortgages) are included.  The next bubble to burst will be the commercial real estate market. In New York, the home of expensive commercial reality, vacancy rates are up 12% and square foot leasing costs down 12.5% in the last three months.  The iconic Hancock Tower was sold recently for half what it sold for in 2006.  The US Treasury reports a decrease in commercial real estate commitments in contrast to a rising rate at the end of 2008.