Liquidity or Insolvency?

The current mayhem in the credit markets raises an interesting issue about the nature of the problem underlying the liquidity crisis. Throughout Thursday and Friday last week the ECB and the FED began pumping the financial system with liquidity in order to try and stem the credit seizure within the banking system. The banks are currently reluctant to lend to each other because they are fearful of taking on hidden subprime exposure, something which has been cropping up in all sorts of surprising places. Consequently, the overnight lending rate has been opening much higher, thereby obliging the central banks to engage in repo activities to push the rate back down towards the target rate.

The issue is whether this policy will actually work. From a fundamental perspective it is difficult to see how it will because the underlying problem is not one of liquidity but one of insolvency. If the only problem were liquidity then this policy would probably work because the provision of liquidity would allow market participants to roll over their obligations. Unfortunately, many of the mortgages in issue in America were predicated on 10-15% house price appreciation, something which is obviously behind us now. So now we have large numbers of actual insolvencies emerging.

I therefore believe that the FED and the ECB have a very difficult task at hand. Providing liquidity to the system is not going to solve the underlying problem. The seizure of credit is not simply a result of risk aversion, it reflects an underlying real debt and insolvency problem. My guess is that they have calculated (hoped) that the true scale of the problem is less than the bears are fearing. They will provide liquidity for just long enough so that all the exposure and the mess is out in the open. The provision of liquidity should stop the crisis spilling over into other financial asset classes such as equities, thereby limiting the scale of real economy effects. We can only hope that the true scale of the exposure is less that is widely feared...