Today, the banks have a problem on the asset side of their ledgers — “all these exotic securities that the market does not know how to value.”
“Why are they ‘toxic’?”
“They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound. So if you could get rid of them, that would be an improvement.”
What are the “exotic”, “toxic” instruments?
Despite all the money going directly to the big banks, despite all the government guarantees and loans and special tax breaks, despite the shot-gun weddings and bank mergers, despite the willingness of the Treasury and the Fed to do almost whatever the banks have asked, the reality is that credit is not flowing.
Why? Because the underlying problem isn’t a liquidity problem. As I’ve noted elsewhere, the problem is that lenders and investors don’t trust they’ll get their money back because no one trusts that the numbers that purport to value securities are anything but wishful thinking. The trouble, in a nutshell, is that the financial entrepreneurship of recent years — the derivatives, credit default swaps, collateralized debt instruments, and so on — has undermined all notion of true value.
Many of these fancy instruments became popular over recent years precisely because they circumvented financial regulations, especially rules on banks’ capital adequacy. Big banks created all these off-balance-sheet vehicles because they allowed the big banks to carry less capital.
Banks and financial houses have indeed hidden their derivatives exposure off the balance sheets.
And remember, mortgages were repackaged into derivatives called collateralized debt obligations (or “CDO’s”) and sold to both big and regional banks and investment companies worldwide. The CDO’s were highly-leveraged — many times the amount of the actual loans. When the subprime loan crisis hit, the high leverage magnified the fallout, and huge sums of CDO derivatives became essentially worthless.
And remember, almost no one really understood derivatives.
No one knows what their own derivatives assets and liabilities are, let alone anybody else’s (which is why Lehman’s credit default swaps have caused so much anxiety, as just one example). Every bank knows that – because of its derivatives exposure and their poor business practices – its derivatives exposure may be many times bigger than its assets. And every bank fears that the other guy’s ledger might be even worse.
Uncertainty about the impact of financial distress of one entity [from derivatives] on all other market participants causes trading in the inter-bank market to freeze up further increasing volatility and potentially risk of failure of weaker firms.
So its not a liquidity problem. As Schwartz says, it is an insolvency problem. Or more accurately, a lack of trust that the other guy not going to go belly up because of his derivatives liabilities.