October 14, 2008
Anna Gelpern: ... and Another Thing: Illiquency
Posted by David Zaring

Recent guest Anna Gelpern has been thinking about the solutions chosen pursuant to the crisis.  I asked her if she would be willing to share her insights.  And she said yes ... good news for the Glom and its readers.  Here's Anna:

“Some said we should just stick capital in the banks, take preferred stock in the banks. That’s what you do when you have failure,” Mr. Paulson told the Senate Banking Committee on Sept. 23. “This is about success.”

The Paulson quote, which made the crow-eating rounds last weekend, dredged up my years of suppressed unease with the liquidity-solvency distinction in a financial crisis. I know it is super-important.  Economists and policy types obsess about it and with good reason.

If the problem is illiquidity from a temporary confidence shock, the policy solution is to lend profusely and get paid back when things calm down. There is no need for workouts because in the end, there will be no losses. This is the premise behind the Lender of Last Resort (LOLR) and, it seems, TARP I.

But if the problem is solvency - too much debt relative to assets (bank, firm or household) - there will be losses, and there must be loss-sharing, for example, through debt reduction or public subsidies.

Illiquidity is the standing presumption for three reasons. First, insolvency is failure and no one likes to admit it. Second, no government likes to preside over loss distribution. Third, we have LOLR on the ready. The old joke says when the only tool you have is a hammer, everything around looks like a nail. The Fed has dispensed $1.3 trillion or so in liquidity support so far. Still no mortgage modification in bankruptcy.

More problems: It is virtually impossible to get agreement on liquidity vs. solvency at 3 a.m. Liquidity-solvency judgments are often wrong, fudged, or irrelevant, as illiquidity can quickly become insolvency. This study reports that central bank liquidity support in the Japanese crisis went overwhelmingly to failed banks. Same result in countless other places. Surprise.

So how about illiquency? Quit squabbling and split the baby. Shift the presumption and consider debt reduction sooner, perhaps in tandem with zillion-dollar liquidity injections. (Moral hazard is a foregone conclusion in either case, the only open question is whose.)

To wit, some economist propose insolvency-style responses to macroeconomic shock. Ten years ago, Stiglitz and Miller advocated automatic across-the-board corporate debt relief in Asia; they called it "Super Chapter 11" and it looked kind of radical. These days Luigi Zingales suggests something similar for home mortgages. (see also here and here). And then there is the Kroszner study of FDR's gold clause adventures. 

Linking public money and debt reduction is tricky: there is no dollar-for-dollar correspondence, and securitization has done away with neat debtor-creditor pairings. Requiring banks to write off debts in exchange for public capital injections may deter some from applying.

Absent mandates, the prospect of debt reduction may worsen panic in some quarters. But waiting until everyone is at peace with failure is not free.

(I have a paper on crisis containment coming out shortly, stay tuned for more rantings in footnoty format.)

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