Liquidity or Solvency?

The debate over the Public-Private Investment Program (P-PIP) put forward by Treasury Secretary Timothy Geithner seems to be focusing upon a technical point concerning the condition of the market for troubled assets. In the eyes of some, the question relating to whether or not the program will work depends upon whether the problem being dealt with is a liquidity problem or a solvency problem.

The preliminary judgment is that if the problem is a liquidity problem then P-PIP will be an adequate solution. If the problem is a solvency problem then P-PIP will probably not do the job.

Unfortunately, this debate has gone on for a long time…going back to at least December 2007 when the Federal Reserve initiated its Term Auction Facility (TAF). The Fed’s action at that time was an effort to relieve pressures on the banking system by providing a more direct and more liquid approach (than borrowing at the discount window) toward getting short-term funds to the banks that needed liquidity. Additional efforts have been made since then to provide liquidity for different sectors of the financial markets.

The crucial issue connected with a liquidity crisis is addressed in the first sentence of the last paragraph. A “liquidity crisis” by its very nature is a short-term phenomenon. To say that the debate has gone on for a long time is to confirm that the “crisis” we are in is NOT a liquidity crisis.

A liquidity crisis occurs when some kind of shock hits short term financial markets. The “shock” usually takes the form of a new piece of information that is contrary to the current beliefs held by the participants in these markets. A classic example is the situation that revolved around the Penn Central Railroad and the commercial paper market. Because of financial problems at Penn Central the rating given to Penn Central’s commercial paper was revised downward. This revision shocked the commercial paper market and the market basically closed down. The reason was that if the Penn Central rating needed to be lowered, the question became “what other commercial paper ratings needed to be lowered?” The buy-side left the market. Hence, the “liquidity crisis.”

Since borrowers in the commercial paper market could not roll-over their paper, they had to go into the commercial banks and draw on their back-up lines of credit. The problem then fell to the banking system. And, if the banks tried to sell short-term securities to get funds for to honor the lines of credit this would cause security prices to plummet.

The Federal Reserve responded in classic central bank style by opening the discount window, supplying sufficient liquidity to the banks that needed funds to support lines of credit. The banks were able to honor the back-up lines of credit without having to sell securities and the commercial paper market was given the time to access the information on borrowers in the commercial paper market and the buyers returned and the market stabilized.

The point of this is that a “liquidity crisis” is a short-run problem. The crisis occurs because market participants get some information that is not consistent with what they had formerly believed. They need to process the new information and until they do, the buy-side of the market usually disappears. The solution to this problem is for the central bank to supply sufficient liquidity to the market so that the participants have time to process the new information. Liquidity problems usually last only a few weeks.

Solvency problems are of a completely different nature. And, as I have written about over the past year or so, resolving solvency problems take a long, long time. And, with solvency problems it is not an issue of providing liquidity to the market so that assets can get sold. Solvency problems have to do with charging off book values to reflect the underlying economic values of assets. Yes, there is uncertainty with respect to what is the underlying economic value of the assets, but that is why time is needed and cannot be hurried along.

There is only one way to hurry time along in issues relating to solvency and that is to charge off the asset, or at least charge off a major part of the asset. The problem is that banks, and other institutions, don’t like to rush this process. They want to see how the situation with respect to the asset can be worked out, what can be recovered, and whether or not they can hold onto the asset long enough so that economic conditions can improve which will lead to higher asset values. This is not a liquidity problem!

Why would private investment funds want to get into such a deal?

Only if they smell blood!

And, where would this smell of blood come from? It could come from two places: first, if the probability of the improving economy were high enough to cause these private investors to believe that their speculation on these assets has a fair chance of turning out favorably; and second, these investors believe that the government is providing them a rich enough protection of their money to make it worthwhile to commit to such a speculation.

These private investment funds will not purchase these assets as a public service. Thus, they will only purchase assets if they believe that they can earn a bunch of money, because it is a risky investment. Thus, they either have to see the opportunity to make a lot of money or to believe that they are sufficiently protected on the down side to take a chance.

The two issues for the public on the P-PIP are these: first, is the government, once again, giving away a lot of loot to the ‘bad guys’ in the financial community; and second, is the government providing protection on the down-side that will cost the tax payer a lot of money in the future if P-PIP doesn’t work.

But there are still several other issues hanging around. For one, the success of P-PIP depends upon the economic recovery beginning later this year as Chairman Bernanke has projected. For another, the success of P-PIP depends upon the willingness of the financial institutions that now hold the “toxic” assets—whoops—the “legacy” assets, to begin lending once they are able to dispose of these assets. And, the success of the P-PIP depends upon the ability of existing managements to really turn their businesses around (see my post of March 23, 2009, “A Lesson from AIG for the Bank Bailout Plan”, http://maseportfolio.blogspot.com/), a possibility of which we are not yet certain. And, there are more.

As is obvious, I still have concerns about policymakers (as I have had for the past 18 months or so) and whether or not they are attacking the correct problems. In the case of the P-PIP, if they are fighting a liquidity problem I fear that the program will not be very successful. We have a solvency problem and a solvency problem, by its very nature involves a concern about capital adequacy. In my mind, the capital problem is going to have to be faced, one way or another, before we get out of this crisis. The sooner we realize this and attempt to do something about it, the better off we will all be.