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Aug 13, 2009


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Dave Ribar


This is a part of the financial crisis that has gone somewhat (though not completely) unnoticed. Policymakers and some analysts have described the crisis as simply a "liquidity" crisis, meaning that banks and other financial institutions have been too frightened to make loans. Behind this notion was the idea that some assets were temporarily under-valued but would recover. In truth, it has actually been a "solvency" crisis. There remains a ton of bad debt on banks' and institutions' books, with much more to come as the economy continues to struggle. The crisis is abating, but it has not completely passed. My recollection is that personal and business defaults are expected to continue growing through this year, even as the output in the economy stabilizes.

Ed Cone

Dave, I would disagree only insofar as even pissant local bloggers have been talking about solvency for some time; here's a link to the evil Krugman back in '07, one of many in the past couple of years. Atrios, among others, has been good on the subject.

If you narrow it down to regulators and government officials, then I think your analysis is painfully correct


Part of the problem is that super-low fed rates - zero - means banks can still eke out interest margins with large percentages of non-performing loans. Say a bank has two loans at 5%, but is borrowing from its depositors at 0.25%. If only one loan is getting paid, the bank is effectively earning 2.5% interest - still > 0.25%, so OK...until it needs to repay principal. As long as it's got enough deposits, a bank can hang onto its non-performing loans (NPL).

If it had to sell the NPL today, it might only get 50% of its value. Enough of those and you have a solvency crisis. As long as a bank can borrow at near-zero interest, the solvency issue can be covered up. Often liquidity issues bring to light solvency issues - it was either Indymac or WaMu that had a mini-run that forced it into receivership.

The biggest problem with this is that the NPL's are not getting foreclosed and flushed through the system. Sitting on a loan because you don't want to recognize a loss should not be allowed. Once a loan enters default, even one missed payment, it should have to be marked-to-market, as that loan has identified itself as a problem.

The flip side is that a good bank has two fixed-rate 5% performing loans and today its cost of capital is near zero. What happens when the cost of capital goes to 4, 5, or 6%? Those loans will be net losers, along with their value decreasing. No one will refi at the higher rates, and sales could potentially fall.


Irony is that Regions stock was up yesterday after that news, and is up again today. If your equity is 0, and you get any return, that is an infinite return-on-equity!

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