Tuesday, October 7, 2008

It's Capital, Not Liquidity, Stupid

I wrote an article over the weekend on how all the massive, desperate liquidity injections by the Fed have failed, and indeed created a short-term liquidity cash burden at the top of money supply chain, banks. Today, I'm seeing a lot of the old, predictable battle cry: "Lower rates! Inject more liquidity!"

I feel compelled to repeat myself.

While liquidity has been a persistent symptom since the start of the crisis last August, it was never the cause. The cause has always been the Incredible Shrinking Captial caused by a combination of:

  1. deteriorating housing market;
  2. over-leveraging while ignoring systemic risk such as counterparty risk in CDS and elevated correlation in CDO;
  3. and positive feedback loop between declining price and loss of capital base created by mark-to-market accounting.

Take a look around. US banks are buried with short-term liquidity cash, so much so that NY close overnight repo rate is almost zero. Does this mean US banks value each other's credit risk as equivalent to treasuries? Of course not. They just know their counterparts will have unlimited supply of short-term liquidity cash tomorrow and that's enough. Why don't they use the cash to start lending to people who need it, such as municipalities, companies, homeowners, and consumers? They can't. The cash is short-term liquidity supply, not their capital. If they use it to expand the asset side of the balance sheet, they run into two big, familiar problems that have burned them, their counterparts, and a few former counterparts:

  1. capital requirements, which everyone has already been struggling to meet, and
  2. risk of inability to roll the short-term debt to finance the long-term asset.

Sure, the Fed is their personal Santa now. But everyone knows at some point it has to suck out this massive excess liquidity. How do you roll the debt then? When will it happen? With every government agency changing rules of the game everyday for the last several weeks, often without any rationale except just for the heck of scaring people (as one official said of the short ban), nobody is willing to take the risk this close to Christmas and bonus time.

Hence the irony: on one hand we have a bunch of sickly banks sitting on an unlimited supply of liquidity, choking the money supply chain from the very top; on the other hand we have the rest of money supply chain dying for liquidity.

Now the Fed is considering buying commercial papers directly. What a concept. Why don't we just get rid of banks altogether and go to the Fed for a mortgage?

The Bailout Pork Package, for all its ills, at least has the diagnosis right: banks need capital injection. But the mechanics of it is too complicated -- what to buy, whom to buy from, at what price, how to set the price, who to manage it. By the time the doctor cuts to the tumor, some patients may have died from an overdose of pain killers.

We need to inject capital, not liquidity, into the banking system FAST. Once banks have enough cushion on top of the minimal capital requirements, they'll start opening up the money supply chain. After all, it's not like banks hate profit.

There are many ways to inject capital fast. Buffett's Goldman Sachs model is one. Immediate shift to capital ratio based on mark-to-history is another. Even emergency lowering of capital requirements is much better than this madness of blind liquidity injection.

It doesn't take a rocket scientist to figure out these solutions and at least give them a serious thought. Why haven't we seen any sincere push for any of them?

Buffett's GS model dilutes equity and may hurt executives' pay this year, nothing like the instant gratification of the Bailout Pork Package.

Amending rules involves no money flow, thus no direct, immediate profit.

I hate to be a cynic, at least when writing here. If there's a better explanation, I'm open.

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