Tuesday, January 20, 2009

Worse then the 30's and 80's?

The current headlines that our banking system is or will be insolvent and needs to be nationalized is gaining some currency.  Today, Roubini made that assertion and Sunday, Paul Krugman referred to the money center banks as insolvent.

In finance, solvency is the ability of an entity to pay its debts with available cash.
A traditional bank in a fractional reserve banking system funds loans of varying terms with demand deposits. Demand deposits are money in checking and savings accounts, and are effectively debt. They typically hold a small fraction of their total assets (loans) as capital. Since typically loans are for longer terms then the deposits, and since banks have limited capital, they can never pay ALL their debts at once with available cash.

So in this almost trivial and totally obvious sense, banks are never solvent.  The entire banking system is designed to manage this inherent mismatch between assets and liabilities.  It can get out of whack in several ways.  In the 1930's, general price deflation from 1929 to 1933 was between 30% and 40%.  The assets or loans of a bank were "upside down."  The collateral couldn't be sold for anything close to the stated value of the loans, for simple liquidity reasons, if nothing else.  About half the banks failed and half didn't.  Yet technically, they were all insolvent in more then the trivial sense that they couldn't pay their depositors in cash immediately.

In the 1980's things were also dire for banking for the exact opposite reason.  General price inflation rather then deflation.  According to William Issac, former head of the FDIC:
The underlying economic problems of the 1980s were more serious than the economic problems confronting us this time around – at least until very recently. The prime rate exceeded 21%, and the economy plunged into a deep recession in 1981-82, with the agricultural sector in a depression. These economic problems led to massive problems in the banking and thrift industries. The savings bank industry was more than $100 billion insolvent if we had valued it on a market basis, and the S&L industry was in similar condition. A bubble burst in the energy sector, and a rolling real estate recession hit one region after another. Continental Illinois (the eighth largest bank) failed, many of the large regional banks went down (including nine of the ten largest banks in Texas), and hundreds of farm banks failed, as did an even larger number of thrifts. Three thousand banks and thrifts failed from 1980 through 1991, and many others went out of business through mergers.
And there is more. Things could have been even worse:
It could have been much worse. The money center banks were loaded up with third world debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of our money center banks would have been insolvent. Indeed, we developed a contingency plan to nationalize them.
However, inflation was tamed, the banks were able to fund their loans at a profit due to falling interest rates, and we all know the history.  

The current situation is the exact reverse of the situation in the 1980's -- but a basic principle is that banks are designed to be "unbalanced."  One aspect of this is that they go from insolvency in the trivial sense to insolvency in a more tangible sense.  If they are sound enough to survive in less extreme circumstances -- then they need to "get to the other side" and it is in the interest of regulators and politicians to apply some judgment regarding how that is achieved.

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