This is a re-post that I hope serves as a reminder that although we are NOT talking about a liquidity crisis in the financial sector, but rather a solvency crisis, liquidity remains very much a concern. This post, despite being 6 months old, should highlight this issue in terms that are equally true today.

The original post follows.

The Credit Crisis has clearly entered a new phase. This is the most critical phase of the crisis to date because it hinges, not on solvency, but on liquidity. How well policy makers lead us through this period will decide whether the United States enters a deflationary spiral akin to the Great Depression.

The crux of the matter is that our financial system has been so shredded by the leverage that was allowed to be created and the bad debts that resulted that lending has slowed to a halt. We are experiencing credit deflation. And it is no longer a case of companies’ fear of lending to other companies. It is now a case of fear for one’s own solvency. Credit liquidity must return.

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Early last month I wrote a post warning that credit crises are dangerous because of the deadweight loss that results from a lack of credit.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

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That’s clearly where we are now. And I am not just talking about financial institutions here. I am talking about every company and every person that relies on credit to fund operations. Anyone could potentially be dragged down into bankruptcy because of the lack of credit availability. And this is a vicious cycle because companies realize that credit is unavailable. They do not want to get caught out. Therefore, they refuse to part with their own cash, making less cash available to lend.

This is called deflation. This is exactly what happened in the Great Depression, this is why Greenspan lowered interest rates to 1%, and this is what Ben Bernanke is desperately trying to avoid. Unless Bernanke can do something creative to stop this train wreck, companies are going to fall victim to this. Lehman Brothers chairman claims this is what happened to his firm. Northern Rock claims this is what happened to them. While those claims are debatable, it is clear that Fed Chairman Ben Bernanke understands this threat. This is one reason the Federal Reserve has intervened in the Commercial Paper market.

The Federal Reserve announced a radical new plan on Tuesday to jump-start the engine of the financial system. 

The Fed said in a statement that it would begin to buy large amounts of short-term debt in an effort to stimulate the credit markets, which have all but dried up.

Under the program, the Fed said that it would buy the unsecured short-term debt that companies rely on to finance their day-to-day activities. “This facility should encourage investors to once again engage in term lending in the commercial paper market,” the Fed said Tuesday in a statement. “An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.”

While the move will put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has stalled. The Commercial Paper Funding Facility, “will complement the Federal Reserve’s existing credit facilities to help provide liquidity to term funding markets,” the Fed statement said.

The Fed said it was creating a new entity to buy three-month unsecured and asset-backed commercial paper directly from eligible companies. It hopes to have the program running soon.
NY Times

Bernanke can’t get this thing running soon enough. The thing we want to avoid is solid, well-run businesses being forced into bankruptcy because no one will lend to them or because they can not roll over their debt. Certainly, one might feel well-run companies should not get into a position where they are beholden to their lenders for survival. Fair point, but it is still clear that there are companies which would be able to operate normally under normal credit conditions, which are suffering in these credit conditions. That is a dead-weight loss to the economy and is what ultimately leads to the vicious spiral of deflation.

I hope as much as anyone else that we can avoid deflation. However, I have to be realistic – it’s not looking very promising at this point. But, maybe Bernanke can pull a rabbit out of his hat.

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Fed Announces Plan to Buy Short-Term Debt – NY Times

Originally posted 7 Oct 2008 at 1252ET

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