Liquidity vs. Solvency

Ever since the Fed started intervening with their alphabet-soup lending facilities, I've been ranting that the Fed is helpless to solve the banks' problems because this is a solvency issue and not a liquidity issue. The Fed is providing liquidity to the banks by swapping cash for non-liquid assets like MBS. The Fed is not monetizing this debt. These are short-term repo loans that must be repaid. They do nothing to raise or prop-up the price of the underlying asset (mostly MBS). Eventually the undelying asset needs to be put back on the bank's balance sheet and marked-to-market. Therein lies the solvency issue. If the banks actually marked to market all of the existing assets on their balance sheets, you'd be hard pressed to find a bank that wasn't technically insolvent. Through Tier 2 and Tier 3 capital tricks, Fed alphabet-soup lending, off sheet vehicles like SIVs, the banks have been able to delay marking these assets to market. This has proven to be a big mistake.

From Bloomberg:

``Liquidity tools by definition can only have so much impact,'' said Dino Kos, former head of financial markets at the New York Fed and now a managing director at Portales Partners LLC, a New York research firm.

The Fed ``can alleviate the problem by helping institutions finance these bad assets,'' Kos said. ``But by itself, that doesn't lift the price of these assets. You still have an underlying solvency problem.''

The need for cash is exacerbated by rising credit losses and difficulty in obtaining capital to offset them.

The hope was that eventually this crisis would turn around and that the banks could wait out the bottoming process. This would allow the asset prices to rise again and produce more liquidity in the true marketplace. This was a false hope. Eventually these assets will need to be marked to market and slowly they have been. That is why you keep seeing the banks going to the confessional each quarter as they slowly mark those assets down. The problem is, evertime they mark down assets, they need to increase their capital base or sell those assets to stay within banking ratio regulations. Because they waited so long, the stock prices have collapsed and equity raises have become highly dilutive. Banks are now almost forced to either borrow at unsustainable rates (8-11%) in the bond market, sell assets at rock bottom prices, offload garbage for short term repo loans from the Fed (limited amount) or continue to hide the bad assets. These are all shell games that will eventually erode the banks long term sustainability, some quicker than others. The real differentiator in the financial arena is which companies contain the most bad assets (real-estate backed) and which companies were most highly levered. It's not too hard to tell that from financial statements and the results can be seen in which companies move to the front of the line in the ever growing domino effect of failing institutions.