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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Comments (5)

1. Posted by fedgovernor on October 14, 2008 @ 10:08 | Permalink

Isn't it just plainly obvious that the illiquidity affecting the credit markets is just a symptom of the larger problem of bad loans?

I think everyone realizes that banks which refuse to lend their resources, even to each other, isn't the real problem in the economy, but it is a separate problem that can cause violence.

Injecting liquidity then, merely buys time and slows the market crash down to a speed that humans will support without resorting to violence (evidence of which we have already seen in some suicides and bankers being threatened).

The goal of the liquidity injection is to prevent violence and keep the credit and equity markets functioning in such a way that wealth can continue to be destroyed, but slowly enough that people's senses are dulled by it rather than being energized by it to action.

If the market falls 100 points a day for 100 consecutive days, society would certainly be poorer. But it would also be imminently safer than if the market fell 10,000 points in 10 days.

And that's all to the good, but let's not kid ourselves. Giving bankers a new $250 billion to hand out to illegal aliens in the form of no-doc, no down loans is just insanity.

Home equity is being systematically destroyed as a means of wealth redistribution and that is the underlying problem. And that problem isn't going to change.

It's going to metasticize.

2. Posted by Suzie Orman on October 14, 2008 @ 10:23 | Permalink

The goal of the liquidity injection is to prevent violence and keep the credit and equity markets functioning in such a way that wealth can continue to be destroyed, but slowly enough that people's senses are dulled by it rather than being energized by it to action.

3. Posted by Jake on October 14, 2008 @ 20:45 | Permalink

"Home equity is being systematically destroyed as a means of wealth redistribution and that is the underlying problem. And that problem isn't going to change."

Tee hee. The same claim was made 30 years ago. And it was made 15 years ago. Home equity value holds up just fine over time, so long as the homeowner has the good sense to ignore such dire prophecies, and not get spooked into a hasty sale, refinancing, or default.

4. Posted by fedgovernor on October 15, 2008 @ 6:13 | Permalink

"Home equity value holds up just fine over time ..."

Jake what you have said is true, but obliviously ignores how people use their home equity.

At one time in our country's history, home equity was not realized until you sold your home ... in which case your statement would hold some interest.

Today, however, people use their home equity many times during the course of their home ownership. Many people, for example, take out a home equity loan to finance their children's college education.

So to suggest that, if homeowners would merely avoid panic and wait out the loss of their equity, then everything comes out in the wash ... that's just not thinking through the problem well enough.

The problem is that home equity is being destroyed very fast - today. Thus, college educations will be unfunded ... today. People who used their home equity to maintain and improve their homes will be unable to do so. This puts real people out of jobs (just ask Home Depot what their employment plans are for the next 12 months.)

The destruction of home equity has enormous negative effects for our economy. To blithely dismiss it as something to be ignored by "smart long-term homeowners" is just dumb.

5. Posted by fedgovernor on October 15, 2008 @ 6:21 | Permalink

So, now that we realize just how important home equity is to the functioning of our economy, we'd want to do everything possible not to kill the Golden Goose.


Congress is systematically erasing your home equity every time they force a bank to lend money to a deadbeat. Here's how:

When that deadbeat stops paying on his mortgage, your property value drops. Foreclosure not only effects the deadbeat, and the bank, but affects the homeowners nextdoor. Crime rates increase in lock-step with foreclosures, study after study has proven.

Get enough foreclosures in your neighborhood, and a stigma becomes attached to your street, eliminating the hard-earned equity you have in your home. Foreclosures inherently lower home sales prices in your neighborhood; this also erases your equity.

So, the Congress, and Barney Frank in particular, are working extra hard to make sure that banks are forced to loan money to illegal aliens and people who's credit is otherwise so tainted that they wouldn't be able to qualify for a home loan. People who don't have the discipline to save for a down payment. People who don't make enough money to afford all the extra expenses that come with owning a house versus renting (financing maintenance and repairs, for example.)

The Congress, using FNMA and laws like the Community Reinvestment Act, are granting credit to these people. Every one of them who default on those loans are erasing your equity.

They're stealing YOUR money.

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