Time to bury the liquidity theory
Just as people in the financial markets thought they were starting to put the crisis behind them, a slew of regulatory reports has brought the early days of the crunch back into focus. They make clear that solvency, not liquidity, was the key issue all along.
The New York bankruptcy court’s examiner report of Lehman Brothers kicked off a period of unhappy credit crunch reminiscence, with its eye-popping tales of hidden leverage and questionable valuations. This week three more reports have been released, prising apart the corpses of failed banks in the US, the UK and Iceland. None of them make pretty reading.
Cast your mind back to the summer of 2007 and remember the refrain that the crisis then — and in the first three quarters of 2008, before the financial malaise had fully spread to the wider global economy — was essentially a liquidity crisis rather than a solvency crisis, at least outside of US subprime.
For instance, consider this, a typical comment from a EuroWeek report just after Northern Rock used the Bank of England’s emergency lending facility in September 2007.
"What is interesting is that from a Basle II perspective, Northern Rock is a fantastic buy,” said one senior financial institutions debt capital markets banker. "They have very low cost-income ratios, originate quality assets and this shouldn’t have happened. However, by funding so much over one to three month markets, they have come unstuck and a big bulk of rolling paper is due in the coming weeks."
Most of the banks and other firms that failed in these early months, so the theory goes, went under because fearful or even aggressively speculative markets picked off the weakest participants — those most vulnerable to a liquidity squeeze.
The recent reports make clear that this is not the case, although credit risk fears in some asset classes such as covered bonds and European prime RMBS do seem to have been overblown. The reports lay out how the banks in question were getting into trouble long before funding markets froze up completely in late 2008. In many cases they misrepresented their asset quality, their leverage and/or other key indicators of credit quality.
Poison in the river
Today, the FSA fined two former executives of Northern Rock, the first big casualty of the crisis, for their involvement in the misreporting of arrears between 2005 and 2007. Under pressure to keep the firm’s reported arrears below half the UK average, Northern Rock’s debt management unit effectively disappeared 1,917 loans in long term arrears from the accounts — at the peak outnumbering loans publicly disclosed as in repossession by more than 100%.
Meanwhile, the special investigative commission of the Icelandic parliament has published its report on the collapse of the banking system, which argues that the sector may have been insolvent before foreign funding dried up and the government stepped in. A valuation by Deloitte of the banks’ domestic assets, conducted when they were taken over, showed that their largest loan exposures were vastly overvalued, despite the fact that the banks held extremely low loss provisions against them. These revaluations were so startling that, according to the report, they forced the government to throw out its initial restructuring plans.
Finally, the US Senate’s Permanent Subcommittee on Investigations is holding hearings on Washington Mutual, the largest bank failure in US history. The committee published preliminary findings yesterday, based on internal documents, with the committee chair accusing WaMu of “dumping poison into the river” of the financial system through its underwriting, controls and disclosure practices.
Together these reports show that credit risk was far more of an issue in the early stages of the crisis than was commonly acknowledged at the time — except by the investors who refused to blindly provide funding. Investors were right to be concerned about these institutions and given the nature and scale of accounting shenanigans that have been uncovered, you can hardly blame them for extending that concern to the rest of the market.
The tragedy is that it is hard to see how, in a future crisis, investors will be able to distinguish between those institutions who are accurately portraying their low credit risk and those who are merely bluffing. Even the strictest accounting regime relies heavily on managerial judgement, and so reading accounts becomes, to a large degree, an exercise in trust. And in a crisis, trust is in short supply.