Michael Pettis: When do we call it a solvency crisis

In a very interesting column, Michael Pettis looks at how there can be a bank solvency crisis going on for years before the banks and regulators are willing to publicly acknowledge that there is a bank solvency crisis.

The example that Mr. Pettis focuses on is the handling of loans to Less Developed Countries (LDC).

Regular readers know that your humble blogger has written about the LDC experience extensively.  The key takeaways were market participants knew that from a book value perspective the banks were insolvent, this did not matter and banks can operate for years while rebuilding low or negative book capital levels.

Why did market participants know the banks had negative book capital levels as a result of the LDC loans?

Because the banks disclosed the size of their exposures to each Less Developed Country.  By simply taking the price that the loans traded for in the market, market participants had a way of approximating the value of these exposures and what the true book capital level was for each bank.

Compare and contrast this with the current situation where banks do not disclose their exposures.

There is no way for market participants to know just how negative the true book capital levels are for each bank.

To take one possibly illuminating example, I started my trading career during the Latin American debt crisis, which officially began in August 1982. 

I joined the market in 1987, when bankers and policymakers were still assuring everyone that the problem Latin America was facing was a liquidity problem.

Nobody believed them nor because of disclosure of the LDC loans did anyone have to believe them.

I have referred to the handling of the LDC loans and the Savings & Loans as Fed Chairman Paul Volcker's regulatory legacy.  He believed in handling solvency issues behind closed doors.

This philosophy ultimately resulted in what I refer to as the policy of financial failure contagion and its corollary, the Geithner Doctrine (via Yves Smith:  do nothing that will harm the profits or reputations of big and/or politically connected banks).

This policy is built on the notion that financial contagion is minimized by hiding the truth behind closed doors.

As discussed above, this policy was absolutely the wrong conclusion to draw from the LDC loan experience.

The conclusions to have drawn are that markets understand that banks can operate with low or negative book capital levels and that markets can handle the truth.

As long as we could keep rolling loans over, they earnestly explained, the problem would eventually resolve itself at little to no relative cost (well, Latin America was struggling with unemployment, capital flight, hyperinflation and political turmoil, but I guess that doesn’t really count). 

It wasn’t until 1990 that the first formal debt forgiveness took place – known as the Mexican Brady Bond restructuring – and before the end of the decade nearly every country except Chile and Colombia had their own Brady bonds. 

Even those two countries, and all the others, had managed to obtain for themselves a significant amount of informal debt forgiveness through debt-equity swaps and debt repurchases at huge discounts from face value (some legal and some not quite legal). 

Why did it take so long for bankers and policymakers to recognize the truth – that this was not just a liquidity problem? 

Actually it didn’t. Most bankers knew by 1985-86 that the region was actually suffering from a generalized solvency problem, and among the big banks JP Morgan had been taking substantial provisions all along. 

No one could formally acknowledge the possibility of insolvency, however, because to have done so would have required that all of banks take much greater provisions than they already had. 

This would have created a problem. Of the top ten banks in America, only JP Morgan would not have been technically insolvent had the banks been forced to mark their LDC loan portfolios to market.

Mr. Pettis is confusing having negative book capital levels with being technically insolvent.

The banks all were technically insolvent as the book value of their liabilities exceeded the market value of their assets (the definition of technical insolvency).

Recognizing their losses would have had two impacts.  First, it would have in fact made the banks reported book capital levels negative.  Second and far more importantly, it would have hammered banker bonuses.  These bonuses couldn't be paid when banks have low or negative book capital levels.

In May 1987 Citibank, after many years of replenishing its capital, was able to announce suddenly and to the great surprise of the entire market that it had decided to take a huge amount of provisions against dodgy sovereign loans.

When it did so, Security Pacific became the poster bank for everyone knowing that its "true" book capital levels were massively negative.

However, everyone knew it would not be closed as it had a franchise that was capable of generating a significant amount of earnings even with a negative book capital level.

By 1989-90 the rest of the big American banks were also able to accept the write-offs without becoming technically insolvent. That is when everybody formally “discovered” that in fact the LDC debt crisis was a lot more than just a liquidity crisis.

No, this is when the regulators and bankers were willing to formally acknowledge the LDC debt crisis was a solvency crisis. It was well known by the market that it was a solvency crisis since 1982.

This is the key point. The American bankers weren’t stupid. They just could not formally acknowledge reality until they had built up sufficient capital through many years of high earnings – thanks in no small part to the help provided by the Fed in the form of distorted yield curves – to recognize the losses without becoming insolvent.

American bankers were not stupid.  They knew that formally acknowledging reality would end their lucrative bonuses.

This is exactly what has happened globally during our current bank solvency led financial crisis.  

And this matters to Europe. There is simply no way European banks, especially in Germany, can acknowledge the possibility of sovereign insolvency until they, too, have built up enough capital to absorb the losses. 

They have, unfortunately, been painfully slow to do so, even with yield-curve help from the ECB, and so I suspect that this is going to remain a “liquidity” problem for many more years. 

While it does, the debt-burdened countries of peripheral Europe are going to suffer a decade of weak growth, high unemployment, and contentious politics, all the while the debt growing faster than the economy.

Mr. Pettis re-iterates a series of points that your humble blogger has previously made.  These points boil down to two simple observations:

1. when bankers are allowed to pay themselves bonuses, banks cannot rebuild their book capital levels quickly; and
2. when banks are not required to recognize their losses on the excess debt in the financial system, the real economy and the borrowers suffer as a result.