Liquidity Vs. Solvency

LIQUIDITY vs. SOLVENCY....Paul Krugman writes today that the Fed's lastest plan to rescue the financial system probably won't work. The Fed can provide liquidity, he says, but liquidity isn't the problem. Actual bad loans are the problem:
What's going on in the markets isn't an irrational panic. It's a wholly rational panic, because there's a lot of bad debt out there, and you don't know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won't start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won't happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.
This sounds about right. There seem to be two fundamental problems at work here. First, there are huge numbers of mortgage loans out there that are genuinely hard to value. Partly that's because of lots of them were crappy no-doc-no-down-teaser-rate-two-year-reset-etc. loans to begin with, and partly because the housing bust means that even high-quality mortgage loans are tricky to value these days. Nobody knows just how far down the housing market is going to go, and that means nobody knows just how widespread the default rate is going to be on these loans.

Second, it's because the rating agencies appear to have been engaged in a massive, multi-year machination to over-rate complex financial instruments. Part of this seems to have been a genuine (if hardly excusable) mistake: the computer models they used to rate the tsunami of CDOs and SIVs coming out of Wall Street simply weren't as sophisticated as they thought they were. But it also seems to have partly been a case of the rating agencies being deliberately overoptimistic because they didn't want to lose the huge fees they were getting for rating these new financial instruments. No one wanted to piss in the punch bowl and ruin everyone's year-end bonus checks.

So: (a) lots of bad loans, (b) lots of good loans soured by the housing bust, and (c) all of them packaged up together and then given ratings that bore little relation to the actual quality of the underlying assets. And what makes it worse is that the uncertainty this causes generates even lower prices for this stuff than it deserves on its own lousy merits. CDOs and SIVs that are worth maybe 80% of their supposed value can't fetch even that much because everyone is petrified that things might be even worse than they think. Who knows what AAA really means these days? A real effort to honestly value all this stuff would cost everyone a lot of money, but it would probably be less than it's going to eventually cost them if they don't come clean. But no one wants to be first, so we are where we are: at the very beginning of a long, slow financial meltdown instead of at the midpoint of getting our arms around it all. Thanks a lot, Wall Street.

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