Historically, a liquidity
crisis occurs when there is a change in expectations in the financial markets
that causes the buy-side of the market to re-evaluate values. The re-evaluation is always on the down-side
and buyers do not re-enter a market until they re-gain some confidence as to
where prices should be set.
Until that confidence is
re-gained, market prices can be in free-fall.
A classic case is that of the
financial crisis that occurred in 1970 that was related to the commercial paper
market. The shock that hit the market:
the credit rating of the Penn Central’s commercial paper was downgraded. The downgrade surprised the market because the
financial condition of the Penn Central had been assumed to be solid until the
downgrade was announced.
Market participants responded
by questioning the ratings on other issuers of commercial paper. If a company, like Penn Central, that was
carrying a high credit rating could be downgraded what other companies might
face the same fate.
As a consequence of this
downgrade, companies issuing commercial paper could not roll-over their debt
and therefore had to go into their commercial banks and draw on their “backup”
lines of credit to cover maturing debt.
The commercial banks were
then faced with selling their “liquid” assets in order to fund the lines of
credit.
The money markets faced a
downward spiral of prices as participants wondered about where prices should be
set in the commercial paper market and in the market for short-term Treasuries.
This, to me, is a classical
example of what a liquidity crisis is all about.
How does one combat a
liquidity crisis? This is where the
central bank comes in. A central bank
combats a liquidity crisis by providing sufficient liquidity to the financial
markets so that selling assets, like Treasury securities, ceases and order is
restored to the pricing process.
Historically, the vehicle
used to accomplish this outcome has been the discount window of the Federal
Reserve. In the case of the Penn Central
crisis, the Federal Reserve threw open the discount window and stated that any
bank needing liquidity to cover draw-downs on their backup lines of credit could
come to the discount window and borrow what they needed.
The caveat on this opening of
the discount window was that the borrowings were only to last for a short time
until the crisis past. It was generally
expected that the situation would resolve itself within about four weeks.
A liquidity crisis is a
short-term phenomena! A liquidity crisis
occurs because market participants, on the buy-side, do not have sufficient
information to set prices…hence, the demand-side of the market is extremely weak.
I have constantly argued over
the time that I have been writing this blog (started February 2009) that
government officials were wrong to consider the sovereign debt crisis in Europe
and the ensuing banking crisis as a “liquidity problem” and not a “solvency
problem.”
The problem has been that the
market may not know exactly where the prices of financial assets should be, but
they do know that these prices are below the value at which governments and
banks carry the assets. The owners of
the assets will not sell them because it would bankrupt the institution. But, this is not a “liquidity problem” in the
classical sense. The problem is
connected with the solvency of the institutions.
The officials in Europe (I
will not call them leaders) have attempted to treat their problems as a
liquidity problem. Their responses to
the financial markets has constantly been to provide troubled governments and
financial institutions sufficient liquidity to work their problems out thereby
“kicking the solution to their problems down the road.”
Now, even the “liquidity
solutions” are coming back to further weaken these institutions. Note the description in the New
York Times about the liquidity provided to European banks by the ECB.
“At the
root of Spain’s crisis has been a drastic flight of foreign capital from the
country — one that, paradoxically, has been accentuated by the European Central
Bank’s program of providing low-cost three-year loans to European banks so that
they might buy their governments’ bonds.
When the central bank created that
program late last year, and dispensed two rounds of loans within a few months,
it was credited with having done much to ease Europe’s crisis.
In the case of Spain, while the
program bought time, it has made the country’s underlying problems worse.
Spanish banks have by far been the most aggressive participants in the
cheap-loan program, having borrowed more than 300 billion euros from the
central bank. And much of that money was spent on Spanish government bonds.
In the short term, those bond
purchases helped the government by bringing down interest rates — by reducing
Madrid’s cost of borrowing. But as a result, Spanish banks now own a larger
share, about 67 percent, of their own government’s debt than the banks of any
other country in the euro zone, according to research by BNP Paribas.
Now the value of those bonds is
declining — prices fall as yields rise — and further weakening Spanish banks.”
In my experience in working with
failing institutions, those running the failing institutions continue to deny
the reality of their problems by ignoring the reality of their insolvency and
by pointing their fingers at any other possible cause of the failure in order
to hang onto their illusions.
We hear, “the problem is caused by
greedy speculators”; “the problem is just a problem of liquidity”; “the problem
is the Germans”; and so on and so forth!
Just having returned from two weeks
in Rome, I can’t get the image of Nero playing the fiddle while Rome burned out
of my mind. The fiddle-playing of the
European officials has allowed them to suppress the real issues that have to do
with the solvency of their governments and their banking institutions and the reform
and restructuring that needs to be gained in their cultures. As long as this denial continues the issues
will not be resolved.
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