Tuesday, 8 January 2008

It's Solvency Stupid, Not Liquidity

The Financial media continues to drone on about the Fed and other central banks efforts to combat the liquidity problems in the banking system by injecting huge wads of cash. However as John Hussman has been pointing out for weeks it is little more than a simple magicians vanishing act.

I posted back in August that rather than bailing out financial institutions the Fed is acting as a pawnbroker. Temporary increases in the amount of cash in the form of repos are just that, temporary, very little new money has made it's way into the economy since August.

These temporary repos are just what the doctor ordered when it comes to addressing liquidity issues however liquidity is not the only problem nor the biggest one. As Nouriel Roubini and others have argued it is the problem of solvency or debt that is the bigger issue. Another excellent article on this issue appeared on Minyanville yesterday:

1. Debt Crisis Vs. Liquidity Crisis

Here is an interesting datapoint that many may not have noticed. Since the Federal Reserve Open Market Committee began lowering interest rates on Sep. 18, the S&P 500 has declined more than 7%. For those that have noticed the decline, particularly the decline in shares of Financial stocks as the PHLX Bank Index (BKX) has plummeted by 24% since Sep. 18 - a bear market by any measure - the most frequently asked question is "Why isn't the Fed's liquidity working?"

It's a reasonable question, after all, central banks in both the U.S. and Europe have said without equivocation that they will provide "as much liquidity as the market needs" to "fix" the problem. So why has this liquidity not been enough to maintain and support asset prices? Because this is not a liquidity crisis, it's a debt crisis. The difference is important, and grasping it can help us sort through a number of market actions that appear to be counterintuitive.

During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:

Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.

Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.

The battle in financial markets is currently between reflation and deflation. The reason reflation is not winning is because the Federal Reserve is powerless to make bad debt good. The Fed can only provide liquidity, and then hope that liquidity spawns credit creation. The market is fighting this by taking that liquidity and using it to deflate, pay down debt.

Click on the link for the all of yesterday's "5 Things You Need To Know" and if you don't already you should check out Kevin Depew's 5 Things You Need To Know everyday for an easy explanation of some seemingly complex issues.