The other “i” word in the financial crisis

It is likely that some holders of large amounts of mortgage backed securities ("MBS") are not only illiquid, but will also be insolvent if (as they are required to do) they mark their MBS holdings down to "market value" in their quarterly financial statements. No doubt there is a great deal of anxiety about how to value illiquid assets, especially because, under Section 302 of Sarbanes-Oxley, CEOs and CFOs have to sign personal certifications of quarterly financial statements.

Many financial institutions have quarters ending September 30, but investment banks (and others?) traditionally have fiscal years ending in November and for them the third quarter ended August 31. Reports to the SEC are due 40-45 days after the end of a quarter and many companies have a track record of announcing earnings sooner. Thus, early October and early November are critical periods in the financial crisis.

Incidentally, when I Googled "Paulson Plan insolven" all of the top hits were in foreign media and blogs, for example this hard-hitting piece in Rupert Murdoch's The Australian. Two US economists frankly call it a "solvency crisis" and propose a solution that addresses insolvency as well as liquidity, but their excellent piece appeared in the Financial Times blog, not mainstream media.

Update on Friday, September 26, 2008 at 09:31PM by Skeptic

I guess this doesn't really count because it's a blog post, but Bruce McF reports that the EVP of the New York Fed called it an insolvency crisis in May.  However, neither he nor anybody else could bear to discuss it as other than a liquidity problem.  The Fed EVP called it "balance sheet pressure."  Naming the problem of course tends to constrain how you think about solutions.  Bruce's post is quite good at explaining the difference between liquidity and solvency problems and the different solution types that are required for each.  I recommend it. 

Update on Tuesday, September 30, 2008 at 10:50AM by Skeptic

Paul Krugman illustrates a typical bank balance sheet here and shows why buying "troubled assets" at "market value" under TARP does not cure an insolvency problem or make a solvent bank stronger.