Yes, the accounting value of the firm's equity is negative 41.7 billion dollars. Now, answer me this. Is GM insolvent?
There is no definitive answer. It's a philosophical question, a matter of opinion. The market says GM's equity is worth $15B dollars. All we can say with any confidence is that GM is liquid, it has not yet failed to pay its bills, it is capable of borrowing to finance its operational needs despite a balance sheet with no vital signs. The patient walks and breathes, so it is not dead. Somehow.
There is a meme going around the blogosphere, and now the mainstream-press-o-sphere, that the Fed is helpless in the current crisis because the problem is one of solvency, not liquidity. Here's Paul Krugman (hat tip Mark Thoma):
In past financial crises... the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn't working... Why not? Because the problem with the markets isn't just a lack of liquidity — there's also a fundamental problem of solvency.
Here, here, Dr. Krugman. And you too, Dr. Roubini. And Michael Shedlock. And Kevin Drum. I agree with you all. From the tiny legal entities known as asset-backed securities, way up through to a couple of large money center banks, there are a lot of entities out there which, by my Victorian standards, are simply insolvent. But by those standards, GM oughtn't be able to fog a mirror, let alone borrow money from people. It's the living dead, a zombie, to use a term fashionable when discussing Japan but never, ever appropriate to the hypercapitalist U.S. of A.
Can a determined central bank "wave its magic wand" and make insolvent entities solvent? I have no idea. But I do know this. A central bank can keep almost anything liquid for a long, long time. And as far as financial markets are concerned, only liquidity matters. The little theory called solvency is only relevant to the degree that it predicts liquidity, or illiquidity. Central banks can undo that relationship, if they wish to. Perhaps they wish to.
I have no idea how "aggressive" the U.S. Federal Reserve will become in trying to resolve the present crisis in credit markets. There are in norms of accounting, regulatory frameworks, laws, that might constrain it. But, central bankers have been remarkably candid in describing their willingness to circumvent these constraints in a crisis. (See here or here for examples.) With the new Term Auction Facility, the US Fed has just given itself a tool by which it can ensure the liquidity of "insolvent" assets, at prices the bank itself determines, indefinitely. Some commentators (e.g. Yves Smith) have wondered how a temporary facility, loans with a fixed term of one month, can make much difference one way or another in the liquidity of assets. The answer, of course, is that they can be rolled over (via new auctions, which are already announced for January, or by other means). The same logic that impels the initial extension of credit suggests that loans will be rolled over, must be rolled over, for as long as "crisis" continues. The Fed has bent over backwards to help out financial institutions. Once it has direct loans to those institutions on its balance sheet, it will own their problems in a way it has not until now. Will the Fed pull the plug and demand payment of a bank that says it cannot pay? Will it force a bankruptcy, as private creditors might, if the bank was in default? Is that even conceivable? The day that happens to a bank of any scale is the day you can be sure the credit crisis is no more.
I'm going to end with a bit of a cheap shot, because really, nothing is beneath me. Remember this?
The aide said that guys like me were "in what we call the reality-based community," which he defined as people who "believe that solutions emerge from your judicious study of discernible reality... That's not the way the world really works anymore. We're an empire now, and when we act, we create our own reality."
Worrying about "insolvency" is a defect of the reality-based community. For everyone else, all that matters is the price at which assets can be sold or borrowed against. The Fed can set that price, if it acts with sufficient, um, determination. Analyzing underlying cash flows is for pansies.
The latest financial innovation cooked up by the banking system might be described as "postmodern pricing", whereby the exchange/collateral value of assets is intentionally unmoored from quaint ideas like "true" or "fundamental" value. All for the benefit of struggling homeowners and hard-working ordinary Americans, of course. If you are among the macroeconomic mainstream that has nodded along with Fed interventions to support "liquidity", but you find this brave new world troubling, well, good. Better late than never, and you are welcome among us. Expect to be mocked. Bear it with pride.
- 14-Dec-2007, 5:39 p.m. EST: Replaced the awkward "I want you to take a look at..." with just "Take a look at..."
- 14-Dec-2007, 6:15 p.m. EST: Cleaned up some wordiness (unnecessary "thus far"), added some wordiness ("help" to "help out"), inserted a missing verb to be.
|Steve Randy Waldman — Friday December 14, 2007 at 12:34pm||permalink|