A while back I asked: Is there still any disagreement over whether the current subprime crisis is rooted in liquidity or solvency?
We get the answer today with Lehman Brother filing for bankruptcy and Merrill Lynch sold to BofA and AIG apparently teetering on the brink:
Tim Duy: To give the Fed the benefit of the doubt, earlier this year they likely saw the financial crisis as primarily a liquidity event. Thus, they could make the analogy that market participants just needed a “slap in the face,” and some rapid rate cuts and fresh sources of liquidity would give confidence that much needed boost. By now, however, officials probably realize this is a solvency crisis. Too many debt instruments hinge on the state of the US housing market, and too many homeowners took on loans that are simply unaffordable.
I had also suggested in the same post:
Assuming that the same institutions who invested in these securities can classify them as toxic or possibly non-radioactive then a workout perhaps similar to the Resolution Trust for S&L can be created for the toxic securities (and its underlying assets -- again assuming these can be identified).
Again, Tim Duy: Still, despite the Fed’s creative efforts to date, the crisis is moving to a stage that is simply too big for the Fed; Congress needs to step up and define the parameters of any mass bailout of the financial sector. Some version of the Resolution Trust Corporation is the most likely outcome. I suspect that taxpayers will ultimately absorb significant losses, but it will be a crime if such a bailout does not entail a radical reevaluation of financial regulation.
Update: Continued calls for a RTC like solution from a link on Economists View.
My comment regarding financial regulation:
Some differing opinions are here. I believe that it was financial regulation that led to financial "innovations" in the derivative markets. One of the basis of "innovations" such as the use of Special Investment Vehicles and Special Purpose Vehicles as conduits for securitization was to avoid regulation of capital. (This applies more to banks but perhaps also to investment banks.) Another reason is to accelerate earnings for financial reporting purposes. (For instance, see Chapter 4 of Introduction of Structured Finance by Frank Fabozzi, Henry Davis, and Moorad Choudhry.)
The authors note, not unadmiringly, that with structured finance, "The market for asset-backed securities is large and therefore access to this source of funding will enable a bank to grow its loan books at a faster pace than if it were reliant on traditional funding sources alone. For example, in the U.K. a former building society-turned bank, Norther Rock plc, took advantage of securitization to back it's growing share of the U.K. residential mortgage market." (pg. 77) Of course, we all know what happened to Northern Rock.
At the risk of sounding flippant, we don't need more regulation but more effective regulation. As Tim Duy notes, this crisis will probably lead to a "radical reevaluation of financial regulation" - no s**t.