Is financial crisis matter of solvency or liquidity?

By Clytie Bunyan

Published: March 23, 2008

Last week's government-sponsored bailout of Bear Stearns was shocking. It rocked world markets at a time when they're desperately seeking any indicator that would push stocks higher.

The idea that one of the world's largest investment banks had to be rescued in what amounted to a fire-sale deal was not widely expected. What made it so surprising was that, despite Bear Stearns' continued decline in the stock market, the company consistently denied it was in trouble.

And it's not clear other large banks and investment houses won't follow this pattern. Thursday, the Federal Reserve said companies are taking advantage of its emergency loan offer to the tune of an average $13.4 billion in daily borrowing. That's in just one week.

Frankly, I'm surprised Bear Stearns was the first to hit the deck. Merrill Lynch would have been my first guess, after its former Chairman Stanley O'Neil's exit and $22 billion in writedowns.

Or perhaps an investment house with a wider global reach. We've all been focused on the subprime fallout in the United States, but friends in Europe tell me signs of people not being able to meet promised obligations to sophisticated loans they borrowed are also present there.

One friend described a situation where banks not only had been offering 100 percent mortgages but also "free” money to furnish the house.

Perhaps what's saving some of these companies is their early approach to finding solutions.

Citigroup, for example, for about a year has been shedding thousands of jobs worldwide as it seeks to eliminate redundancies.

What's concerning is whether the financial crisis is a matter of solvency or one of liquidity.

If what we're seeing is a liquidity issue, investment firms only are looking at a short-term problem and the $13.4 billion borrowed from the Federal Reserve last week should relieve the stranglehold on available cash.

But if these firms don't have enough cash to cover long-term operations, that's a solvency issue, and all those billions still won't help.

For about a year now we've been hearing homeowners slammed for taking subprime mortgages, blamed for the current crisis. There's no bailout offered homeowners who, in some parts of the country, are forced to walk away from their homes because there's no means of readjusting their adjustable rates to a fixed mortgage as they watch their homes devalue. Yet there's no hesitation to throw billions at the folks who supposedly were lots smarter then the subprime home buyers and securitized those mortgages for their own gain.

Money managers constantly counsel people about putting money away for unforeseen events, such as sickness, divorce or death — that dramatically change a family's cash flow. There've been hundreds of riches-to-rags stories of people falling on hard times after such life changes.

It's beyond my comprehension why Wall Street saw securitizing people's mortgages — many packaged as sophisticated lending products such as adjustable-rate, interest-only signature loans — would not be a high-risk practice. The big banks and investment firms are getting help for their failings, but the folks who took advantage of those mortgage products, for what some may argue were more basic human reasons, are faced with foreclosure.

Hopefully Fed Chairman Ben Bernanke and his colleagues at the Federal Reserve are smarter than the folks who run the big investment firms, and the $75 billion it will make available to companies this week will begin to help the financial system operate as it should.

The Fed's efforts are aimed at saving not just one company but the entire financial system from collapse. Too bad efforts to help people avoid losing their homes haven't been as aggressive.

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