Isn’t this all one big crisis? In a word, yes. But the devil is in the detail, and so is understanding. In this article, I propose that behind all these crises is the crisis of solvency.
The Root of the Problem
The origin of the current crisis can be traced to unsound real estate lending practices by banks, which resulted in unsound loans. Those loans were securitized – bundled and sold to investors – by broker dealers like Merrill Lynch and others. But the root of those investments was unsound loans. To make matters worse, some investors borrowed money to buy these securitized unsound loans.
The solvency crisis is the essence of the credit crisis. Credit (lending) is an integral part of an economy. Without credit, the economy would grow far more slowly and there would be less opportunity; imagine everyone having to pay cash for a home or car – few people would own either. Most businesses, and hence employment – from making commercial jets to medical services – depend on the use of credit. Go insolvent, and you lose the ability to get credit.
Solvency and Banks
The source of credit is savings. Banks pay rent (interest) on deposits (savings) and lend those savings to someone else – home buyers, businesses, even government. Savings are also the raw material used by investment advisers, who allocate their clients’ savings to loans (bonds) or to buy ownership stakes in businesses (equity or stock).
Banks do not put most of their depositors’ savings in the vault. Instead, they lend their depositors’ savings to others at a higher interest rate than the bank pays the depositor. This is how banks make most of their profits. If panicked bank depositors decided en mass that they wanted their money back (a “run on the bank”), the bank could not pay them back because the depositors’ money is loaned out to others.
Borrowing – the acquisition of credit – is based on both cash flow solvency and balance sheet solvency; i.e., having sufficient income to make timely loan payments, and having assets that exceed the value of the loan.
A bank can become balance sheet insolvent when its assets (its loan portfolio) are not paid back in full. The bank’s loan losses are the result of having to take back property that secured the loan and selling the property for less than the loan amount. It stands to reason that a critical aspect of balance sheet solvency is the ability to value the borrower’s assets, something that has been particularly hard to do when those assets are riddled with loans both sound and unsound.
A bank becomes cash flow insolvent when depositors, believing that the bank’s balance sheet is insolvent, initiate a run on the bank, demanding immediate repayment of their deposits. Since most of a bank’s assets (loans to businesses and individuals) are illiquid, the bank runs out of liquid assets with which to pay depositors, and fails.
The purpose of FDIC insurance is to prevent bank runs by assuring depositors that their money is safe – they don’t need to hurriedly withdraw all their money and leave the bank’s illiquid loans to community businesses as the only remaining assets.
The entire banking system is predicated on statistically predictable behavior – that only a relatively small number of depositors need their money at any one time, and even fewer need all their money at once. The system fails if this behavior radically changes and too many depositors demand all their money at once.
The Great Solvency Crisis is rippling out from overleveraged homeowners to banks, broker dealers, institutional investors, large corporations, and municipal governments. All are caught up in a domino effect of collapsing credit worthiness, both real and imagined.
A Closer Look
Here are some of the main issues in more detail:
Balance sheet solvency: No one knows whether borrowers (for example, banks and brokerage firms) have asset values sufficient to cover their loans. Illiquid loans and loan derivatives have estimated values at best. Real estate values continue to drop, making the related loan values uncertain.
Cash flow insolvency: Even when corporate liquidity is greater than normal, a loss of confidence due to rumors or volatility in a firm’s publicly traded securities can spark a self-fulfilling run on the institution, rendering it cash flow insolvent.
Credit default swaps: Some financial institutions created a mess of gigantic proportions by creating quasi insurance contracts to buy and sell the risk that loans would not be repaid in full. These contracts actually encouraged more risk taking. Ignored in the calculus of risk taking was the fact that risk cannot be eliminated, it can only be moved around. Someone has to be financially prepared to absorb the risk.
One problem with these credit default swaps is that no transparent market exists for them because every contract is somewhat different.
Another problem is that insurance is only as good as the issuer’s ability to pay the claim. Many sellers of credit default swaps will be unable to do so, which means the buyer will no longer be insured and will suffer unanticipated losses. AIG needed to be rescued by the U.S. Treasury because it had billions of dollars in losses on credit default swaps it had written. Had the company failed, a chain reaction would have ensued, forcing every company that had purchased an AIG credit default swap to recognize more losses on assets thought to be insured.
The situation is like a homeowner who buys hurricane insurance from a small Florida company and then loses the house in a Category 4 hurricane. If thousands of other homeowners lost their homes, too, the insurance company may become insolvent because the losses exceed its ability to pay claims. The homeowner will now bear the cost the hurricane losses, or a portion thereof.
Downgrades, write-downs, and a downward spiral: Many investment firms held AAA-rated mortgage securities only to find that the assumed default rates on the underlying property loans that supported the AAA rating were wrong. These mortgage securities have been downgraded, some below investment grade, making them ineligible to secure other loans, thus forcing companies to repay loans that had relied on the downgraded collateral.
An environment of fear: Banks, broker dealers, institutional investors, and large companies are all warily circling one another, unsure of the risk they are taking. As a result, those that are lending are charging far more than normal. If a company needs to borrow, it may be paying punitively high interest rates, which further reduces the borrower’s ability to repay the loan. Those companies that are shut out of the credit markets face cash flow insolvency if their credit line is cut off and they cannot find another lender.
Recent losses at the Reserve Fund (estimated to be only 3%) sparked a panic and a flight of money from money market funds to U.S. Treasury bills. This movement of money reduced the amount of short-term financing available to businesses, including banks. The government’s effort to stem the panic was to insure money market funds. It is interesting, however, that fear and the attempt to escape the problem caused greater contraction of the credit markets.
What’s Being Done to Restore the Functioning of the Credit Markets?
The past eight weeks have brought almost daily government announcements of new steps – many of them without precedent – to restart lending in the economy.
Some of these steps are in response to other countries’ efforts to deal with their own credit crises. The government of Ireland, for example, recently guaranteed all the deposits in their banking system. Not long after, the U.S. government offered a similar guarantee of U.S. banking deposits. As Alan Blinder, former Fed vice chairman, and economist Glenn Hubbard pointed out in a Wall Street Journal op-ed piece, “Blanket Deposit Insurance Is a Bad Idea,” there are three problems with blanket insurance: 1) there is little evidence that it is needed, 2) the policy could actually lower confidence by making it appear that the government is desperate, and 3) the 100% guarantee could pull assets from other sources like money funds and other countries’ banking systems as nervous investors scramble to a global safe haven for their funds. This scramble for safety is, in fact, partially responsible for destabilizing the credit markets.
We have “experts” in government today who have carefully studied the solvency challenges of past economic crises (Fed Chairman Bernanke is an expert on the Great Depression). Yet the situation is analogous to being led by generals who are experts on past battles and strategies, but have no experience fighting on the ground, under new circumstances, in the fog of war. No two wars – or recessions – are alike, and historical turning points are usually clear only long after the fact. Expect some mistakes as the Fed and Treasury shovel billions of dollars into “politically too big to fail companies” to stave off insolvency-led bankruptcies.