Liquidity or Solvency?

The equity markets sold off hard on Monday on the news of the collapse of the bailout deal. No doubt the authorities will try to cobble together another rescue package soon.

There is no shortage of suggested solutions. For me, the key issue of evaluating the next deal is how the power shifts between investors, bankers and taxpayers.


Fed and other central banks desperately injecting liquidity
Right now, the credit markets have seized up. In response, the world’s major central banks are desperately trying to inject liquidity into the financial system.

Is it enough? Some have even suggested that a bailout isn't needed.


...but the system is insolvent
Brad Setser summarized the issues best in when he questioned whether $700b is enough. The issue is what price any bailout fund pays for the distressed securities, book value or market value (however you define it):

If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

Paying a high price (likely book value) for the toxic paper bails out investors and bankers, but does little for taxpayers. Paying discounted market value is favorable for taxpayers but leaves the financial system insolvent.

Book or market value for the toxic paper?
I heard that the calls, emails and faxes to Congress were running at about 200 to 1 against the defeated deal. The predominant feeling among the electorate was that it wasn’t fair for taxpayers to be bailing out big investors and investment bankers. With an election not that far away, Congress listened.

Many have suggested that the key component of any deal be the payment of a highly discounted value for the toxic paper clogging up the system. If that is done, then the financials would have take massive writedowns which would render them insolvent (see John Hussman’s analysis here). John Berry has suggested that this would be the granddaddy of all carry trades. Buy high yielding assets (at 10-12%) and finance it at 3-4%. The key issue, in that case, is what is the “hurdle” default rate that makes the Treasury money?


How will foreigners react?
I have indicated before that many of the components of the failed deal, which seemed to favor investors, was quite likely the result of Chinese pressure. Yu Yongding, a former advisor to the Chinese central bank, recently acknowledged the pressures on China and on the US by stating that Asia needs a deal to prevent panic selling of U.S. debt. However, China wants something in return:

Yu said China is helping the U.S. ``in a very big way'' and added that it should get something in return. The U.S. should avoid labeling it an unfair trader and a currency manipulator and not politicize other issues, he said.

``It is not fair that we are doing this in good faith and are prepared to bear serious consequences and you are still labeling China this and that, accusing China of this and that,'' he said. ``China knows what to do. We don't need your
intervention.''

He also indicated that this may be a tectonic shift in China’s future policies:

``Our export-growth strategy has run its natural course,'' he said. ``We should change course.''

China should stop intervening in the foreign currency markets and thus allow rapid appreciation of the yuan, he said. While this would cause pain for exporters, China could ease the transition by using its strong fiscal position to aid those who lose their jobs. It also should stimulate domestic demand to offset lower income from overseas sales.

Without yuan appreciation, China will continue to accumulate foreign reserves, which means further accumulating ``IOUs from the U.S.,'' said Yu. ``This is paper and it may default and it will not increase China's national welfare.''

In other words, China stands ready to help the US through this crisis. However, there is a political price to be paid. Moreover, this may signal the beginning of the end of the US Dollar as the premier reserve currency in the world.


Not just Big Bad China making waves
Before anyone jumps on Big Bad China, understand that China has been the most vocal of the foreign lenders. No doubt others, such as the oil producing states in the Middle East that are big holders of USD paper, are thinking along the same lines. For instance, Germany's Finance Minister Peer Steinbrück was quoted in Der Spiegel as saying:

There will be shifts in terms of the importance and status of New York and London as the two main financial centers. State-owned banks and funds, as well as commercial banks from Europe, China, Russia and the Arab world will close the gaps, creating new centers of power in the financial world.

In addition, the Washington Post recently reported that:

Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.

IMF mandated adjustments would be extremely painful for America. Note that these last two comments were from America's closest allies. In addition, an opinion piece in the Telegraph in the UK notes that a default by the US government is no longer unthinkable.

Years ago when I managed international equity portfolios, our international and emerging markets teams used to irk our US colleagues with the comment that the US is only 1 of 50 markets. That comment is now coming true in more ways than one.