Mervyn King: “Systemic Insolvency Is Now The Problem”
I want to take you through how we got from the financial system’s "systemic insolvency" to bailouts to record profits and bonuses again in the span of two years.
From the WikiLeaks cables as published in the Guardian today regarding a meeting with the US Ambassador to the United Kingdom and the Bank of England Governor Mervyn King on 17 Mar 2008:
Systemic Insolvency Is Now The Problem
2. (C/NF) King said that liquidity is necessary but not sufficient in the current market crisis because the global banking system is undercapitalized due to being over leveraged. He said it is hard to look at the big four UK banks (Royal Bank of Scotland, Barclays, HSBC, and Lloyds TSB) and not think they need more capital. A coordinated effort among central banks and finance ministers may be needed to develop a plan to recapitalize the banking system.
Unblocking Illiquid Mortgage-Backed Securities
3. (C/NF) King said it is also imperative to find a way for banks to sell off unwanted illiquid securities, including mortgage backed securities, without resorting to sales at distressed valuations. He said sales at distressed values only serve to lower the floor to which banks must mark down their assets (mark to market), thereby forcing unwarranted additional write downs.
What does this prove? That it was widely known in government circles by the time Bear Stearns went bust that the global banking system was effectively insolvent – and that banks’ unloading garbage assets at inflated prices was seen as critical in preventing the whole global economy from collapsing. It’s good to see this confirmed in writing.
Now if the U.S. Ambassador was told point blank by Mervyn King, the Governor of the Bank of England, that the banks were insolvent, then clearly everyone high in U.S. and British officialdom knew as well. New Labour under Gordon Brown certainly knew. The Bush Administration knew. The Obama Administration knew via Tim Geithner.
Here’s what I had been saying in the last two years:
- The U.S. financial system is effectively insolvent (23 Sep 2008)
I have said before that a systemic response is necessary to deal with the present banking crisis in the United States. This crisis has nothing to do with subprime assets and little to do with things like predatory lending. Those are issues that populists will use to prosecute the scapegoats we are likely to see down the line. The crisis has everything to do with low interest rates, zero regulation and a credit bubble of monumental proportions.
The banking system of the United States is effectively insolvent. Buying up $700 billion in assets is not going to solve this basic fact. A systemic response is needed. If we do not address these issues, we may see significant dead-weight loss as many institutions fail.
It’s the writedowns, stupid (19 Mar 2009)
So, it should be pretty clear that we have some serious losses still left to work through in the financial sector. I reckon the U.S. banking system is effectively insolvent. This is what Nouriel Roubini means when he says there will be $3.6 trillion in writedowns before this is all over. This means that banks do not have adequate capital to absorb the likely losses facing them later this year.
To date we have addressed this problem by throwing more money at it — bailing out the banks and attempting to prevent asset prices from falling. I predict this solution will lead to another panic if continued indefinitely. (Remember, between now and the summer or fall, the unemployment rate could reach 9-10%, while home prices would still be falling and default rates rising.) American citizens would realize the system is insolvent and would cease to trust that a reasonable solution was in the offing.
Confidence in America’s banking system is already lacking, especially in the large banks and large regional banks. This confidence can only be restored if banks are adequately capitalized now and in the future. Were we to suffer another round of major writedowns and capital injections into major institutions, I expect all confidence would be lost and bank runs would begin in earnest. This must be avoided at all costs.
Given the lack of capital the banking system now has and the likely level of writedowns, many institutions are fundamentally insolvent. They must, therefore, be liquidated or nationalized BEFORE confidence in the system is lost and bank runs occur.
The Fake Recovery (13 Apr 2009)
I last posted on Thursday before the Easter Holidays in two posts very much at odds with one another. The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009. Meanwhile, the later re-post pointed out the continued fragility of the U.S. economy and banking system and focused on liquidity and solvency as unresolved issues. I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.
Why ‘Fake’? This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem. This means the banking system will remain weak even after recovery takes hold. The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off. Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.
The real situation. In truth, the U.S. banking system as a whole is probably insolvent.
What If It’s All A Lie? (27 May 2010)
I have argued consistently for two years that the U.S. is experiencing a solvency crisis in the overleveraged financial sector. Many companies would be effectively insolvent were they required to mark their assets to market.
Most policy makers understand this point. However, many, including the past two Treasury secretaries, have argued that this is a liquidity crisis masquerading as an insolvency crisis. With enough loan forbearance, capital injections, and time, the banking system will eventually be restored to health and the American economy will be back on its fundamentally sound path.
The key in the chain of events in America came between posts two and three above. It was the changing of accounting rules to hide insolvency (and the stress tests to raise more capital certainly helped). Without this accounting gimmick, we would have seen GD2 already. Credit Writedowns = Depression; No credit writedowns = fake recovery.The systemic crisis has been halted so far because the credit writedowns are no longer being taken. If the credit writedowns re-appear, so too will the systemic crisis.
Here’s the Obama Administration’s view:
GEITHNER: I spent most of my professional life in this building. Watching the politics of the things we did in the past financial crises in Mexico and Asia had a powerful effect on me. The surveys were 9-to-1 against almost everything that helped contain the damage. And I watched exceptionally capable people just get killed in the court of public opinion as they defended those policies on the Hill. This is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives. We’ll be judged on how we dealt with the things that were broken in the country. We broke the back of the worst financial panic in three generations, more effectively and at a much lower cost than I think anybody thought was possible.
So, you see, "this is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives."