Tuesday, February 25, 2014

2008: Liquidity crisis, or solvency crisis?



Back in 2008, as the financial crisis was unfolding, there was a big argument as to whether the crisis was a "liquidity crisis" or a "solvency crisis". It's a very important distinction. A "liquidity crisis" is when banks (or similar finance companies) are financially in the black - their assets are greater than their liabilities - but they can't get the cash to keep paying their bills in the short term. A bank run is the classic example of a liquidity crisis - even if the bank could eventually pay everyone back, it can't pay them back all at once, so if people get scared and all try to withdraw their money in a rush, they force the bank to collapse. A "solvency crisis", on the other hand, is when finance companies are actually bankrupt, and no amount of short-term borrowing will change that fact.

This question has important policy implications in a financial crisis. If companies are illiquid but solvent, you just need to have the Fed lend them money to tide them over until liquidity comes back. If they're insolvent, you either need to bail them out, or help them into an orderly bankruptcy, in order to reduce systemic risk caused by disorderly failure.

Some prominent thinkers have endorsed the idea that the 2008 crisis was a liquidity crisis, created by a "run" on repo securities. People who have promoted this idea include Gary Gorton, Robert Lucas and Nancy Stokey, and John Cochrane. The model they have in mind is the Diamond-Dybvig model, the classic model of bank runs. Instead of people rushing to the bank to withdraw their deposits, the idea goes, repo customers conducted a fire sale of repo securities, preventing banks from being able to borrow short-term.

But others disagree. They claim that the reason banks' liquidity dried up was simply that the market realized that the banks were insolvent - that the mountains of housing-backed securities on the banks' balance sheets was in fact worth a lot less than most people had previously thought. These dissenters include Paul Krugman, (who favored bank nationalization), and also Anna Schwarz. They also implicitly include those who think that "Too Big to Fail" was at the heart of the crisis. If the crisis was caused by banks taking excessive risks because they knew they would be bailed out in the case of insolvency ("moral hazard"), that implies that the big banks we bailed out were, in fact, insolvent. The "TBTF" argument has been advanced by proponents of stricter regulation, including Simon Johnson and James KwakPaul Volcker, and Jeffrey Lacker.

In a recent blog post, Steve Williamson endorses the "TBTF" argument:
One view is that the fragility is inherent to financial systems. This view is framed in some versions of the Diamond-Dybvig model, in which the maturity mismatch and illiquidity inherent in banking imply that bank panics are possible. An alternative view is that the fragility is induced...a too-big-to-fail financial institution understands that it is too-big-to-fail, and therefore takes on too much risk, relative to what is socially optimal...This high level of risk could be reflected, for example, in a high-aggregate-risk asset portfolio, or in a maturity mismatch between assets an liabilities...[I]t is possible that Lehman Brothers could have taken corrective action...to ward off failure, if it had correctly anticipated that a bailout would not occur.
Though Williamson allows for the possibility that 2008 might have been mainly a liquidity crisis, he doubts that it's of the Diamond-Dybvig type. This is because repo is not like bank deposits, which are callable (they have "sequential service"); with repo, there needs to be some other reason for a liquidity-killing fire sale. Williamson says that he hasn't seen a convincing example of such a model. Basically, he thinks the idea that moral hazard caused a solvency crisis seems more plausible, and that the "liquidity crisis" people haven't made their case yet.

What do I think? Well, I haven't seen a "convincing" theory either, in the way that Diamond-Dybvig convincingly models the bank runs of the pre-Depression crisis. I've seen a number of interesting models, including this one by V.V. Chari and Patrick Kehoe (see also this more in-depth paper by Park and Sabourian). So I think there could be something to the "bank run" theory. It also seems possible to me that solvency crises - excessive risk-taking that blows up - could be caused by a lot more things than TBTF. For example, bubbles could create unrealistically low perceptions of risk throughout the system. Or there could be other corporate governance issues, such as incentives for excessive risk-taking by financial industry executives and traders.

Also I suspect that illiquidity and insolvency aren't as distinct phenomena as we usually think. There is ample evidence that liquidity risk is incorporated into asset prices, and there are a number of theories that try to explain this. Something that causes banks to take too much fundamental risk - TBTF moral hazard, bubbles, etc. - might also cause them to pay high prices for assets prone to sharp drops in liquidity. 

39 comments:

  1. "Also I suspect that illiquidity and insolvency aren't as distinct phenomena as we usually think."
    Right. Another illustration of the broader relationship between cycle and trend.
    Pablo

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  2. Anonymous12:05 PM

    This is an overthought and over academic argument. The question is simple, could the banks have survived the GFC without state assistance? The answer is so obviously no that that the illiquid/insolvent question does not even arise. The question left remaining is are they solvent now? bill40

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    1. illiquid/insolvent question does not even arise

      The question arises because: (1) it effects what solutions are available and (2) it effects what consequences should flow.

      If the problem is liquidity the solution is that the Fed buys unlimited amounts of good commercial paper at 3 percent over the Federal funds rate and the consequence is that companies who had to resort to the Fed cannot afford to pay bonuses or dividends for a few years.

      If the problem is "solvency" then shareholders and large creditors should lose their investment and, if the financial statements were misleading, people should go to jail. A "solvency" crisis is much more likely to justify calls for regulatory reform.

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    2. Nathanael10:20 PM

      It's not so much regulatory reform we need -- it's the imprisonment and execution of the crime kingpins who have been violating existing laws on a massive scale and getting away with it. They're called "bankers".

      Such big-scale criminals often get away with their crimes for a long time. Unfortunately, their existence erodes popular trust in the legitimacy of the government. Expect civil war if they aren't imprisoned.

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  3. Great post. I think you might be overstating the amount of disagreement though. No one questions that firms or counterparties can become insolvent. The question is whether changing the way assets are held restricts the losses to the owners of bad assets. Whether a run is caused by a realistic assessment of the balance sheets of firms or just random herd behavior does not really change the answer to that question.

    Incidently, the AFA recently started posting their archived videos to youtube and there is a nice panel discussion from the 2011 meetings featuring two of your supposed antagonists (Cochrane and Simon Johnson, with Rajan and Scholes as well). There is a lot of agreement.
    www.youtube.com/watch?v=6hXqyGBwEZY

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  4. Anonymous1:32 PM

    mark to make believe crisis = solvency.

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  5. Phil Koop1:53 PM

    "... with repo, there needs to be some other reason ..."

    If know that repo in 2008 did not have sequential service, you really ought to explain why this is so. Then the rest of us, obliged to rely on merely conventional wisdom, would not have to guess at your meaning.

    The NY Fed, for example, has just finished reforming tri-party repo procedures "by eliminating the incentive for investors to withdraw funds from a dealer simply because they believe other investors will do the same." It would be helpful if you were to explain why this does not fit the Diamond-Dybvig model.

    They view "fire-sale risk" as a completely separate mechanism, one which abides in the repo system even after these reforms: “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales.”

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    1. I'm wondering the same thing: Who says that repo isn't characterized by sequential service? I asked this question in the comments on Williamson's blog.

      If a securities firm has a small cash reserve but lots of repo liabilities, then you can have self-fulfilling redemptions by repo creditors, as in Diamond-Dybvig.

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  6. Anonymous3:10 PM

    It was a solvency crisis, but not just with banks, but the bourgeois system as a whole. If the whole thing just would have come down, the US would have collapsed and the economy basically died. There would have been a massive inversion of the yield curve as short term rates would have exploded making any financing impossible and potential 100% loss of GDP. Capital would have flee'd to undetermined global locations and it would have been anarchy, choas. The US government would have collapsed and a new system(or likely systems) of government to replace the original constitutional form.

    The "bailout" was thus forced on the US. The debate became how it went down to how it could of went down. But the "bailout" was always going to happen. The Constitution basically required it.

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  7. frank4:05 PM

    Solvency in the real world is a cash flow concept: ability to pay debts as and when they fall due. Therefore there is no distinction between solvency and liquidity.

    When you say solvency you are really talking about net asset value or perhaps long run solvency.

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  8. Why assuming no miscalculation of risks? selling / buying risks doesn't mean the risks disappear

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  9. Anonymous4:54 PM

    There is usually a "banking crisis" about every 20~25 years, or a generation change. Many forget the S&L crisis during Reagan presidency. S&L as a bank simply have disappeared. It was also tied to mortgage loans. Recent banking crisis has done the same thing: Citi and Bank of America effectively were restructured - stock went worthless, bonds/structured investments were discounted by 70% or more. I know of these two first hand; I basically had to play options to regain most of the losses in these two investments. I have heard similar stories about other banks.

    My point is simple: just because the banks kept the same name does not mean they were not insolvent. They were. We - the tax payers - salvaged them because nobody really can figure out the real threat of open collapse. So, we bailed money like a bucket brigade fighting fires. Nobody really knows what we have done in keeping to crooks in happy homes. I know in about another 20 years or so, we will do this all over again, albeit, with different scenarios and plays.

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    1. Anonymous3:40 PM

      Prior to Reagan, I believe we went 75 years without a significant financial crisis. But since then we've had the Continental Bank failure in 1984, then the S&L speculative bust, followed by Orange County going bust in 1994, then the Enron bankruptcy due to speculation and fraud, not to mention the dot com speculative bubble, and finally the first real world run on North Atlantic banks of 2007-08. Yet after six serious collapses centered around banking and speculative fraud, all within 33 years, there are still those who believe we need to regulate less, not more. I think we're definitely in the “It is difficult to get a man to understand something when his salary depends on him not understanding."

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    2. Reagan took office in 1981; 75 years before would have been 1906. I feel like there had been one or two significant financial crises in that time....

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  10. So Mt Gox is in a solvency crisis?

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  11. Anonymous5:16 PM

    If it was a liquidity crisis like Bernanke still claims, where was the need for TARP etc? And now, five years later, why are people struggling to make payments on the houses they bought then? Bernanke misdaignosed it then. And he continues to now.

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  12. Anonymous6:19 PM

    Charles Ponzi was never insolvent, he was merely illiquid. Had the Fed intervened properly, he might never have become Mussolini's finance minister.

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  13. The crisis was driven by consumers. Households were insolvent, not illiquid. They didn't go insolvent because of banks being insolvent but the other way round. Households were insolvent because of overleverage and deflating bubble driving them in the red. This caused the insolvency of banks. But access to credit was never a problem, interest rates didn't spike. So bank were pretty much irrelevant, although very visible. They enabled the households to overleverage but after the crisis started they mattered little.

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    1. I think you forgot the credit crunch of 2008. That's when the crisis got really bad, and this was driven by the banks. In 2007 eveybody thought the crisis will be a minor event, because the exposure of the banks on the real estate market was largely underestimated.

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  14. Anonymous1:15 AM

    I think that during the financial crisis the question of bank solvency was much trickier than is realized. The larger banks and financial institutions were very widely counterparties to one another. So, when you are adding up the assets of a bank, what value do you place on a loan to another bank? Well, if the other bank is sound, then the loan is worth (roughly) the discounted value of the interest and principal due. BUT, if the other bank is insolvent, then the loan might be worth much less than that or even zero!

    So, bank A's solvency depends on the solvency of bank B. But, by the same kind of argument, bank B's solvency depends on the solvency of bank A. It is very easy to construct a tiny model of bank solvency in which there are two stable answers: either both banks are solvent or both are insolvent.

    The concept of insolvency, it seems to me, only makes sense in the context of a stable economic background in which assets have their "usual" values.

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  15. According to the FCIC, when the S hit the F in 2008 there were $10 trillion worth of mortgages outstanding that stood at the heart of the $46 trillion worth of non-federal debt—mortgages that were created during a real-estate bubble that had began to collapse the year before. To make matters worse, the worst of the worst of these mortgages were combined in MBSs, half of which were held on the books of American financial institutions. At the same time the five largest investment banks had leveraged their capital 40 to 1 and the leverage at Fannie Mae and Freddie Mac was 75 to1. In addition, there were $58 trillion of CDSs outstanding that had been created with no government oversight to assure that adequate capital had been set aside to honor these contracts. It is just inconceivable to me that anyone could seriously argue our financial system faced a liquidity crisis rather than a solvency crisis in 2008 in light of these statistics.

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  16. And basically, if you look at the households who defaulted on their debt (there was a study from the fed abnout mississipi), most of them decided to default after the prices went down, i.e it was not worth anymore to' get the house but reimbourse the debt. Thigs got really bad because of the uncertainity and contagion created by the cdo, cds and all the types of mbs. The insolvency of the households is the tree which hiddes the forest.

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  17. Collin Street5:35 AM

    Don't forget that many of the mortgages were -- prior to the various legal settlements -- of extremely dubious legal status, with dodgy paperwork and outright fraud that would have made collecting on them difficult under then-current law.

    If you've lent out money and you can't practically get it back in any reasonable timeframe, you have a liquidity problem. If you've lent out money and you can't legally get it back, now or in future... you don't have a liquidity problem.

    ... which means that the US now has a history of overriding or ignoring fairly clear land-title law where needed to ensure that private-sector banks remain liquid and solvent. A minor administrative decision, not something that's likely to cause any problems with investor confidence going forward.

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    1. Nathanael10:17 PM

      Indeed. Ignoring land title law is going to have very very nasty long term effects. Very *VERY* nasty. Already starting to, by the way.

      This is the sort of stuff which causes governments to be overthrown as illegitimate.

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  18. "Moral hazard" is a bit simple. Any competition where money is the key measure is likely to drive towards destroying the underlying assets (fish stocks, sustainably managed land, loans) simply because money is a secondary measure - there's no way to tell from the money return whether the asset is being conserved. And the entity that makes the highest money return will be rewarded with greater investment and better access to capital - it will succeed until the asset fails, and then fail catastrophically. The finance sector, which deals only in money, has of course the fastest cycle of all - it crashes every 25 years unless regulation reduces competition. But the players are caught in the system - it's not that they are careless, but that they have no non-money metric.

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  19. It would be as accurate to say that all banks are solvent until they are not. The liquidity/solvency distinction is just a gambit to maintain confidence in the quality of "assets". Even a mid-size bank failure brings these into doubt.

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  20. Seems to me that we can conceive of a situation where there is a negative shock to a bank's assets, leading it to suffer a liquidity crisis, but not a solvency crisis. My thoughts here.

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    1. When insolvency leads to a crisis it is inevitably accompanied by a liquidity crisis. If a financial institution is leveraged 40 to 1 it only takes a 2.5% fall in the value of its assets to make it insolvent. When it becomes known (or feared) that an institution is insolvent it will face a liquidity crisis as its creditors scramble to recover their cash.

      It seems to be fairly clear that in 2008-2009 the value of the assets of the major banks and shadow banks were taking a substantial hit and that a fairly large number of them were insolvent. At that point they all faced a liquidity crisis, and if they had been forced to dump their assets on the market to meet this crisis they would have all also faced a solvency crisis as the prices of all their assets were driven down.

      I have explained my understanding of how this played itself out here:

      http://www.rweconomics.com/WD/Ch10.htm

      and some of the mechanisms that led to this situation here:

      http://www.rweconomics.com/WD/Ch_9.htm

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  21. It seems like a false dichotomy to me.

    When a bank is more than 20:1 levered (and at it's maximum) it is forced to sell assets or issue equity on even the smallest change in price of it's assets (say a 1% drop in the asset side makes it 24.75:1 levered exceeding some maximum leverage criteria). When many banks are this levered, you have all sellers and no buyers [they are already maxed out for the most part even if they don't sustain similar losses], and what used to be safe [though heavily levered] assets [with an equity cushion sufficient for their price volatility] now need to trade down significantly enough to attract new buyers - typically buyers who see reasonable *unlevered* returns, as the leverage itself is now scarce. It's a vicious cycle, but not one that necessarily began with a solvency question. The lack of ability to provide leverage to the system creates the solvency issue.

    Forcing banks to take equity capital [and stop reducing leverage in the system], it seems to me, was an extremely smart way limit the contagion and stop the downward spiral of asset prices. Limiting leverage going forward seems the right end game - and letting banks earn their way to lower leverage seems a relatively painless way to get there.

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  22. Both? Clearly there was a run on the shadow banks by themselves. Clearly many were also insolvent.

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  23. Kyle M9:42 PM

    TBTF makes more sense as a liquidity put. That's what you might actually get from the Fed, it doesn't mean the trade is negative expected value, and the bank might come out on the other side with equity left.

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  24. As you say, it's ultimately a distinction without an difference. Banks were "insolvent" because the the huge piles of mortgage assets they held were worthless - at the time.

    But many of those mortgage-related assets would prove not to be worthless as the panic waned, so during the acute phase, there was a solvency crisis that would ultimately resolve itself if treated with the prescription for a liquidity crisis. Which is what happened.

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    1. Nathanael10:16 PM

      Actually, the mortgage assets are still worthless, because most of these banks never actually owned any mortgages -- they had never bothered to file mortgage papers at the county clerks' offices and the mortgages were void and illegal.

      This puts a much darker spin on the situation. The banks are quite literally attempting to steal land they don't have any claim to, and are also selling fraudulent mortgage paper to investors. They topped this off with robosigning.

      The crisis has not resolved itself. It is still ongoing. It will not be resolved until the criminals running the banking crime syndicates are stopped, which usually means imprisoning or executing them.

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  25. Forcing banks to take equity capital [and stop reducing leverage in the system], it seems to me, was an extremely smart way limit the contagion and stop the downward spiral of asset prices. Ratings and reviews SA
    Limiting leverage going forward seems the right end game - and letting banks earn their way to lower leverage seems a relatively painless way to get there.

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  26. As you say, it's ultimately a distinction without an difference.
    Emergency Dentist Manhattan NY
    Banks were "insolvent" because the the huge piles of mortgage assets they held were worthless - at the time.

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  27. From memory what I saw around me in Britain went as follows:
    - globally, confidence in the value of and risk attached to sub prime related assets suddenly disappeared
    - the potential losses faced by holders of such assets suddenly became a concern because no one had a clue what they were or much sense of who was holding them (or how much they were holding)
    - monoline insurers going phut added to the mix (with every other headline by now stating "Is XXXX the next subprime?". Febrile.
    - banks and institutions responded to this by reeling in their lending to each other
    - a domino effect kicked in where, with hindsight, you could predict which bank would be next to fail depending on how reliant it was on wholesale funding/deposits e.g. here Northern Rock, which was the most reliant by a mile, went first, then the other former building societies
    - it just so happened those banks most reliant on wholesale funding were typically regarded - rightly - as the more aggressive lenders (go figure) e.g. Northern Rock and its 125% mortgages, B&B and its buy to let stuff, so they were both the most vulnerable and the ones about which the biggest questions were getting raised from a credit perspective.
    - as banks ran out of money, credit got reeled in (2007/08 being the onset of a credit crunch after all) and asset values, particularly commercial property, fell off a cliff.
    - this in turn meant lenders began (and were expected) to take big losses, particularly the more aggressive ones.
    - things got more than a bit self-fulfilling
    - thats kind of it really.

    Not sure how solvency vs liquidity plays in the above. However, the UK regulator's initial focus on capital appeared a bit beside the point. In terms of lessons learned/practical prudent policy steps - loan to deposit ratios and restrictions on really bad lending were/are the biggies

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  28. Nathanael10:13 PM

    It was a solvency crisis, driven by fraud. Read Naked Capitalism and learn about robosigning and the menu of frauds committed by servicers (starting with fee fraud and moving on to transfer fraud), fraudulent foreclosures, and the rating agency frauds, and that's before you get to the rest of the frauds on investors.

    The major banks are crime syndicates. The correct model is Bill Black's criminological model. Try it.

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