Insolvent or Illiquid? That is the Question.

The pessimist says: Those mortgage values were artificially inflated as part of a housing bubble.  Housing prices will never get back to their pre-crash levels so banks should take a haircut on their mortgage-backed securities and move on. That's insolvent.

A "haircut" sounds benign, doesn't it?

So, if banks are illiquid, we just have to wait, during which banks have limited capital to lend and businesses have trouble growing.  If they're insolvent, they need to fix their balance sheets, maybe close some banks, and definitely send a lot of financiers into bankruptcy.

Illiquidity means we have to suffer through a two to three years of a slow economy and a wait for people to get their confidence back.

Insolvency means painful bankruptcies, even more loss of confidence and maybe even a bank run or two.

The billions the Federal Reserve Banks have already pumped into the nation's banks have just bought us time before we have to really answer this question. As part of TARP-2, Treasury Secretary Tim Geithner has created a "stress-test" for banks to determine whether or not their assets are insolvent or illiquid. It's an important first step towards unraveling the mess we're in.

The trouble is, what happens once the Treasury and the Fed know which banks are insolvent or illiquid? The moment that information hits the public, the bank in question would suffer a bank run and a total lack of confidence.  The last time this happened, with Illinois Continental Bank in the early 80's, the bank had about 200-times less assets than Bank of America has today, currently our nation's largest bank. Continental was nationalized over a weekend (in a time before easy electronic funds transfers) and it took 200 Fed employees to do it.  Would we nationalize Bank of America?

If we have to nationalize Bank of America, what would that say about the next largest bank, Citibank? Would their be a run on Citibank? What about Wells Fargo? J.P. Morgan Chase?

There just aren't enough trained people around for the Fed to mobilize for nationalizing these banks, let alone the 16 other large banks in America.

Meanwhile, banks know that they have some amount of bad, or "toxic" assets, but their either too scared to find out how much, or they're not letting on.  If they knew how much was bad, they'd have to do a balance sheet writedown, possibly driving many large banks into insolvency and bankruptcy.  So, they hold onto the capital the Fed gave them, in order to protect themselves from possible bankruptcy.

The Fed money, rather than being lent to businesses, is really propping up these big banks.  If they lend it to businesses, they won't have the capital needed to stay open their their toxic assets are proven to be as bad as they fear. 

So then we're back to the Toxic Asset idea first floated back in September - the Fed would buy all the bank's worst mortgage-backed securities (good luck figuring out which is good and which is bad!) at some discount rate and then determine which can be sold, and which just have to be junked.

Let's imagine the Fed bought these toxic assets - maybe as much as a trillion dollars worth (yes, a "T"). What then?

First we'd have to value the assets. A huge job, since most of it is in home mortgages. Someone would have to visit the millions of houses around the country to report on each house. Does someone still live there? Is it in good shape? Is it a good neighborhood? How do you value each of those things on a scale of millions?

Then, we'd have to find buyers for the securities.  Maybe we break them up into "good homes" and "bad homes". "Chicago homes" and "West Palm Beach homes". Whatever. But either way, the Fed ends up selling most of them at a loss.

Well, that's good news, because through this process we've finally restored some confidence to the system: A house is priced and sold at the value it's really worth.  But the bad news is that millions of houses are going to end up being priced for less than what the homeowners bought them for.

So, if we go through the Toxic Asset Relief Program 2 (TARP-2) process, we have a number of levels of pain we still have endure:

1. Banks and their investors have to take a loss on the many billions of dollars of toxic mortgage-backed securities they bought when they unload those securities on the Fed.
2. The Fed has to resell those securities - probably over a many-year process - at a discount again, because the Fed will likely have to overvalue the securities when they buy them from banks, just to make sure banks don't get driven too deep into a hole.
3. The securities - really bundled up groups of home mortgages - will be finally priced at their true value by new buyers and homeowners will find they have $400k mortgages on houses that are valued by their mortgage owners at about $350k.  Lucky homeowners with fair new mortgage owners will have an option to refinance, but either way the housing market will be down. What happens to all the equity they paid for? If the home value goes down $50k, does the homeowner take the hit? I'd guess yes.

To get through this whole process? I'm betting it'll take four to five years. In the meantime banks will hold off on lending until they get the toxic assets off their books. And consumer purchasing will be down because homeowners will be anxious to find out how much home they really own.

Regardless of how well the process is managed by Geithner, Obama and the Fed, everyone's going end up poorer in a few years.