Wall Street’s insolvency crisis: Kohler

The crisis on Wall Street is essentially one of solvency, not liquidity, and it has been exacerbated by central banks and other authorities acting as if it is just about liquidity and can be hosed away with cash.

The crisis on Wall Street is essentially one of solvency, not liquidity, and it has been exacerbated by central banks and other authorities acting as if it is just about liquidity and can be hosed away with cash.

Yes, its cause was rooted in the excess liquidity created by loose monetary policy after 1998 and the Bush administration tax cuts, which helped create the greatest housing bubble in history.

But the core problem now is not that the owners of the housing assets – the homes and the mortgages – don’t have enough cash; it’s that they don’t have enough capital. They are insolvent. This applies to both the home owners and the owners of their mortgages.

This might seem like a fine point, but it explains the failure of the efforts of the Federal Reserve and other central banks to keep the system afloat by providing more and more liquidity, and accepting progressively dodgier assets as collateral from their institutional dependants.

There is now a run on the investment banking system because the providers of capital have lost confidence in the value of the assets that support their equity and loans, and are trying to get their money out while there is value left.

This will not be reversed until they have actually got their money out, or have lost it, and are happy to start putting it back in. This is probably years away, although the quicker the losses are recognised, the sooner it will end.

Solvency is much harder to recover than liquidity. This was clearly evident during the 1990s in Japan, when the collapse of its housing bubble left the banking system underwater.

The banks and the government tried to treat it as a liquidity event and to trade their way out of it. The fact that the banks were broke, and that the capital losses were not recognised, meant that it took a decade for normal lending to resume while balance sheets were repaired.

In the United States in 2007-08, the authorities have hopelessly failed to recognise the problem for what it is and to act accordingly – partly because of their own role in its creation, and partly out of fear of the implications.

Fed chairman Ben Bernanke, a student of the Great Depression, has acted swiftly to cut interest rates and provide liquidity, which has so far prevented the US economy from going straight into recession.

But the real lessons of the 1930s are not being applied.

Between the late 1920s and 1934, US house prices fell by 30%. The result was that both home owners and banks became insolvent – that is, their debts exceeded their assets. Banks collapsed, people were forced from their homes and unemployment peaked at 25%.

In quick succession in the early 1930s, Congress created the Federal Home Loan Bank system, along with the Home Owners Loan Corporation, which provided funds to local home lenders. In 1934 the Federal Housing Administration was created to promote home ownership among those who lost their homes, plus the Federal Deposit Insurance Corporation, which insured the banking system.

The Securities and Exchange Commission was also set up in 1934 to regulate financial markets, and then in 1938 Congress created the Federal National Mortgage Association (Fannie Mae) to further support the mortgage industry and foster the securitisation of home loans.

Fannie Mae worked fine until it was privatised in 1970 and its managers were encouraged by investors to act like investment bankers (that is, gear up their balance sheet excessively to increase profits, and therefore share prices and bonuses).

There has now been another housing bubble followed by a bust. Most of the regulatory institutions set up after the last one in the 1930s still exist, but they have been subverted by a “shadow banking system” – a vast system of under-regulated investment banks, hedge funds, structured investment vehicles, conduits, and other off-balance sheet vehicles that have been used to channel funds into the housing bubble for profit.

That system was set up to subvert the rules governing banking capital ratios.

Conflicted ratings agencies and the use of derivatives such as collateralised debt obligations and credit default swaps were used to create the illusion of solidity when in fact greater and greater risks were being taken with modest capital structures by executives and mortgage brokers who were personally divorced from the consequences of their actions.

Do a Google search of “mortgage fraud” in the US, either in general or state-by-state. The result is stunning; there is an epidemic of it. Every state seems to have dozens of criminal cases running against mortgage brokers and borrowers accused of fraud.

On Wall Street the bonus culture created incentives for massive proprietary trading, especially in mortgage securities and derivatives.

Instead of being brokers and transactions advisors, as they historically have been, investment banks were turned into colossal hedge funds, furiously trading with each other using a huge variety of instruments, and borrowing money from each other do it.

And now the music in this game of pass the parcel has stopped, and house prices are falling. The lack of capital is exposed.

The losses must now be either borne or socialised, and the cost of the Iraq war, on top of the Bush Administration’s tax cuts, means there is a severe limit on how much the government can wear.

That limit has now been reached.

This article first appeared in Business Spectator

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