Mervyn King: “Systemic Insolvency Is Now The Problem”

I want to take you through how we got from the financial system’s "systemic insolvency" to bailouts to record profits and bonuses again in the span of two years.

From the WikiLeaks cables as published in the Guardian today regarding a meeting with the US Ambassador to the United Kingdom and the Bank of England Governor Mervyn King on 17 Mar 2008:

Systemic Insolvency Is Now The Problem


2. (C/NF) King said that liquidity is necessary but not sufficient in the current market crisis because the global banking system is undercapitalized due to being over leveraged. He said it is hard to look at the big four UK banks (Royal Bank of Scotland, Barclays, HSBC, and Lloyds TSB) and not think they need more capital. A coordinated effort among central banks and finance ministers may be needed to develop a plan to recapitalize the banking system.

Unblocking Illiquid Mortgage-Backed Securities

——————————————— –

3. (C/NF) King said it is also imperative to find a way for banks to sell off unwanted illiquid securities, including mortgage backed securities, without resorting to sales at distressed valuations. He said sales at distressed values only serve to lower the floor to which banks must mark down their assets (mark to market), thereby forcing unwarranted additional write downs.

What does this prove? That it was widely known in government circles by the time Bear Stearns went bust that the global banking system was effectively insolvent – and that banks’ unloading garbage assets at inflated prices was seen as critical in preventing the whole global economy from collapsing. It’s good to see this confirmed in writing.

Now if the U.S. Ambassador was told point blank by Mervyn King, the Governor of the Bank of England, that the banks were insolvent, then clearly everyone high in U.S. and British officialdom knew as well. New Labour under Gordon Brown certainly knew. The Bush Administration knew. The Obama Administration knew via Tim Geithner.

Here’s what I had been saying in the last two years:

  • The U.S. financial system is effectively insolvent (23 Sep 2008)

    I have said before that a systemic response is necessary to deal with the present banking crisis in the United States. This crisis has nothing to do with subprime assets and little to do with things like predatory lending. Those are issues that populists will use to prosecute the scapegoats we are likely to see down the line. The crisis has everything to do with low interest rates, zero regulation and a credit bubble of monumental proportions.

    The banking system of the United States is effectively insolvent. Buying up $700 billion in assets is not going to solve this basic fact. A systemic response is needed. If we do not address these issues, we may see significant dead-weight loss as many institutions fail.

  • It’s the writedowns, stupid (19 Mar 2009)

    So, it should be pretty clear that we have some serious losses still left to work through in the financial sector. I reckon the U.S. banking system is effectively insolvent. This is what Nouriel Roubini means when he says there will be $3.6 trillion in writedowns before this is all over. This means that banks do not have adequate capital to absorb the likely losses facing them later this year.

    To date we have addressed this problem by throwing more money at it — bailing out the banks and attempting to prevent asset prices from falling. I predict this solution will lead to another panic if continued indefinitely. (Remember, between now and the summer or fall, the unemployment rate could reach 9-10%, while home prices would still be falling and default rates rising.) American citizens would realize the system is insolvent and would cease to trust that a reasonable solution was in the offing.

    Confidence in America’s banking system is already lacking, especially in the large banks and large regional banks. This confidence can only be restored if banks are adequately capitalized now and in the future. Were we to suffer another round of major writedowns and capital injections into major institutions, I expect all confidence would be lost and bank runs would begin in earnest. This must be avoided at all costs.

    Given the lack of capital the banking system now has and the likely level of writedowns, many institutions are fundamentally insolvent. They must, therefore, be liquidated or nationalized BEFORE confidence in the system is lost and bank runs occur.

  • The Fake Recovery (13 Apr 2009)

    I last posted on Thursday before the Easter Holidays in two posts very much at odds with one another.  The overall thrust of the first post was that the financial services industry in the United States was due to gain from some very advantageous circumstances in 2009.  Meanwhile, the later re-post pointed out the continued fragility of the U.S.  economy and banking system and focused on liquidity and solvency as unresolved issues.  I would like to bring these two posts together here because I believe the concept behind the dichotomy is best described as the Fake Recovery.

    Why ‘Fake’?  This is a fake recovery because the underlying systemic issues in the financial sector are being papered over through various mechanisms designed to surreptitiously recapitalize banks while monetary and fiscal stimulus induces a rebound before many banks’ inherent insolvency becomes a problem.  This means the banking system will remain weak even after recovery takes hold.  The likely result of the weak system will be a relapse into a depression-like circumstances once the temporary salve of stimulus has worn off.  Note that this does not preclude stocks from large rallies or a new bull market from forming because as unsustainable as the recovery may be, it will be a recovery nonetheless.

    The real situation. In truth, the U.S. banking system as a whole is probably insolvent.

  • What If It’s All A Lie? (27 May 2010)

    I have argued consistently for two years that the U.S. is experiencing a solvency crisis in the overleveraged financial sector. Many companies would be effectively insolvent were they required to mark their assets to market.

    Most policy makers understand this point. However, many, including the past two Treasury secretaries, have argued that this is a liquidity crisis masquerading as an insolvency crisis. With enough loan forbearance, capital injections, and time, the banking system will eventually be restored to health and the American economy will be back on its fundamentally sound path.

The key in the chain of events in America came between posts two and three above. It was the changing of accounting rules to hide insolvency (and the stress tests to raise more capital certainly helped). Without this accounting gimmick, we would have seen GD2 already. Credit Writedowns = Depression; No credit writedowns = fake recovery.The systemic crisis has been halted so far because the credit writedowns are no longer being taken. If the credit writedowns re-appear, so too will the systemic crisis.

Here’s the Obama Administration’s view:

GEITHNER: I spent most of my professional life in this building. Watching the politics of the things we did in the past financial crises in Mexico and Asia had a powerful effect on me. The surveys were 9-to-1 against almost everything that helped contain the damage. And I watched exceptionally capable people just get killed in the court of public opinion as they defended those policies on the Hill. This is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives. We’ll be judged on how we dealt with the things that were broken in the country. We broke the back of the worst financial panic in three generations, more effectively and at a much lower cost than I think anybody thought was possible.

So, you see, "this is a necessary part of the office, certainly in financial crises. I think this really says something important about the president, not about me. The test is whether you have people willing to do the things that are deeply unpopular, deeply hard to understand, knowing that they’re necessary to do and better than the alternatives."

Got it?


  1. I have been pounding on this for some time. The cables confirm knowledge of it by Western governments and central banks. (How could they have not known?)

    The proper response at the time was government (cb) provision of liquidity, resolution of insolvent institutions as required, and restructuring of debt. That this did not occur then strongly suggests that it will not take place until the next crisis, when a bailout will be politically impossible.

    While no one can predict when this will transpire, a strong shock could easily provoke a panic that engulfs the US, UK, and EZ simultaneously, which would go viral and threaten other economies with very high private debt to GDP ratios. This puts the world is at serious risk of another depression.

    The situation is dangerous, and governments are acting irresponsibly in trying to deal with it with wallpaper and bailing wire instead of biting the bullet and acknowledging the obvious — debts that cannot be paid in full will not be paid in full or maybe at all if restructuring does not occur in time and debt deflation gets out of hand.

    Governments are also forcing austerity on their populations in a vain effort to preserve the neoliberal model of free market capitalism in the name of the sanctity of property and contracts. There is already rioting in Europe and the UK, and political gridlock in the US both between the parties and in the GOP, as the Tea Party threatens to primary anyone not pure enough for them. Bad economics is spilling over into incendiary politics.

    Indications are that this is not going to turn out well staying the present course.

  2. When you can see how poorly ‘Main Street’ is doing(10-20% unemployment depending how one views it) and then view the financial sector bonuses, then the disconnect is obvious. Funny how Geithner can see the need to take actions that even though they are unpopular need to be done but…. his point of view is so skewed toward the needs of the financial sector that he cannot even propose dealing with the insolvency issue. Nothing that is unpopular on Wall Street has been carried out or even proposed by Geithner. I think ‘they’ knew much before. I don’t think it is any coincidence that former head of Goldman Sachs leaves his lucrative position to move to Bush’s Treasury just in time for him to be in place for the meltdown. I don’t think it is any coincidence that Bernanke, who studied the depression, is picked to replace Greenspan before the meltdown becomes apparent.

  3. Bank of America nervous about their turn in spotlight…

    Systemic insolvency for all to see??

  4. The entire strategy of all the main economies has been extend and pretend on a massive scale. The banks have not had enough earnings since the crisis strike to have earned their way out of trouble, and if they have they have given it away in bonuses. The banking crisis is not over. We are probably not even half way through yet all the pundits are talking about recovery. You need new jobs to have a recovery.

  5. Pre-crisis, I was quite adamant in saying banks were insolvent. I am less so now because they have been pumped so full of money. At this juncture, it’s hard to say how many of the most under-capitalized banks remain open only as a result of regulatory forbearance. Certainly the medium-sized banks that still haven’t paid back their TARP money are effectively insolvent. These are the regionals in excess of $75 billion in assets that are too big for the FDIC to unwind since it would mean the FDIC would need to tap it’s line of credit from the Treasury.

    So is this a big extend and pretend game? Yes, David Lazarus is right. This is the game being played everywhere. Ireland has come clean the most and look at them – on the verge of national insolvency. Policy makers in other countries are very afraid of meeting a similar fate.

    I will have some retrospective posts but my view is this: we are in the recovery phase of a depression. Another dip is coming and it is likely that when it does, that’s when the solvency issues will re-appear. If anyone has comments or wants to make a different argument, I’d like to hear it.


  6. As David Lazarus said the root causes of this crisis have been only postponed and piled up, Massive liabilities have transferred effectively from left pocket to right pocket. Bailing out failed companies “to prevent market freeze” hasn’t really solved anything. To me it’s quite the same where the next explosion of bursting bubble happens: in Hong Kong’s housing markets, in Europe thanks to the bloating banking sector or even in the US due to T-notes sell-offs.

    But there will be no jobs. Under the current system we have got the first thing to run a company fumbles on the first hurdle: there must be good profits. It is the very same if Chinese or Bangladeshian (textile industry) produces almost free goods. “Almost free” is not low price enough for the unemployed Western people. Therefore the demand will stay lower.

    And for mr. Harrison’s view there will be another dip I am not entirely sure how this, in my view inevitable, collapse will end. As I see all this will simply have got bad and really bad end-games. All the Western economies may end-up in protectionism with huge trade barriers to stimulate local production. As if we suppose “internal devaluation” meaning Western economies lower their salaries to the Chinese and Indian levels (neverminding the Bangladeshian wages, approximately $40 a month) it simply means there will be no million-dollar-condos anymore and mortgage documents have only the value depending on how well they burn in fireplace. Creditors won’t survive this.

    But, as long as people have faith (and faith alone) for the values and real worths and is not questioning the current system (see for what blind faith does) we will be creating bubbles and re-evaluating everything around. There will always be losers and winners, as if life itself would be a race or a competition.

    Paying prices mean accepting the system as it is.

    • John Mauldin was arguing this week that the extended and pretend of the 1980s worked in eliminating insolvency. I don’t buy it. We are only storing up problems for later. If the economy goes into a multi year recovery it will embolden recklessness that will see more bloodletting in the next downturn.

  7. I do not think that we are even close to recovery. I think that we have another big leg down in all asset markets to come. I see it coming from a sovereign default. That will cause billions to be lost in credit default swaps, that will wipe out some big banks.

    The central banks flooded markets with liquidity to prevent the collapse of the too big too fail banks. We still have a lot of losses in the banks to be exposed. The US prime residential market is in a worse condition than people realise. I feel that the UK property market is still way over valued by more than 40%. In 2004 the OECD felt that the UK residential was over valued by 34%. Add in three more years of bubble activity and then a 15% drop and we are still way overvalued.

    The banks are still insolvent if you take away all the hidden support that they have been given. The changing of accounting standards has not changed the fact the real value of many of the banks assets are considerably lower than they are being reported as. Nothing has really changed there.

    Ireland have not come clean. The government tried to brazen it out, and the markets called their bluff. I still think that they will default. It might take another eighteen months before it happens. I see Portugal (early 2011) and Spain (mid to late 2011) eventually having to be bailed out but it all it does is defer the date that German banks have to face their losses.

    The stock markets have priced in full recovery yet it is only because of massive cost cutting that their figures look so good. I am waiting for the US and UK stock markets to realise they are overpriced, by around 40% on fundamentals. Future business will be tougher than they think.

    I am not so worried about a Chinese property bubble as it is wholly contained within China, and the secondary effects will be minimal outside China. Though it will trigger a crash in Australia, whose markets are dependant on cheap chinese money. If there are problems in China, that money will leave Australia leaving its banks and over valued property markets high and dry.

    The nature of a crisis is that it comes out of left field. So it could be sovereign default or a stock market crash or a revolution, that cause the panic.

    As for solutions that is easier said than done. The politicians being depending on the big banks for election finance will block any sensible reforms till the economy collapses again. What is needed and what will be done is very different.

    The big banks are a drain on the rest of the economy. Ultimately until the banks are broken up, and shrunk as a proportion of the economy, there be no recovery, or a very weak recovery. Overall the global economy will recover but the big indebted western economies will struggle until that debt burden is lightened, either through defaults or growth. So it will be a two tier economy. Asia, the middle east, Africa and Latin America will do quite nicely. Though with the UK and Europe in austerity mode they will find the road tougher than they expected with no real growth, and millions more joining the labour force to find no work.

    Capital controls will kill off many of the speculative markets finally allowing long term investment to take place, with prospects of real wage increases and a drop in unemployment. It could trap billions in the wrong countries and open up markets at home when multinationals find that they cannot repatriate their billions languishing in a tax haven.

    Also central banks will need to take notice of overall debt levels and step in to cut credit when debts climb to fast to too high. The simplest way of achieving this is to have banks use simple reserve asset ratios and scrap risk based capital ratios. Banks even with all their experts mismanaged risk and so risk based ratios have been discredited. If the maximum lending is twelve times tier one capital then it is much easier for everyone to assess the banks. Using risk analysis hides the fact that they do not have a clue what they are doing.

    A simple way of stabilising the property market is to ban banks from residential mortgages and leave it to mutual savings and loans or building societies that are completely separate from the wholesale capital markets. That means they will have to raise their money solely through deposits and lend solely through mortgages. This will stabilise savings rates for individuals and slow down any chance of a property bubble as it will need to be funded by savings. if this were the case in 2000 when the Fed lowered rates to 0.5% that mortgage rates would not have fallen so far as they would still need to attract depositors. Also fixed rules on lending such as minimum deposits and maximum ratio of loan to income would have muted the property bubble rather well.

    Also by extending capital gains to all assets at the marginal income tax rate will be a way for governments to fill their coffers with cash, shrinking their deficits. Though I cant see it happening till government finances deteriorate a lot further.

    I do not see a need for protectionism, but capital controls will stop countries like China artificially lowering the value of their currency and raising the value of every other currency in the same move.

    • If we really wanted to see where the wealth fundamentally comes from we would solely focus on production. This is where Western economies are lacking severely. There are less factories manufacturing goods, instead there are a whole bunch of importers, retailers, marketing divisions and all similiar kinds of “industries” which do not produce anything but they all take their cut and push the prices up.

      It all shows on GDP. How reliable is it? I recall quite hilarious example from Californian airport where a gardener got caught up setting security alarms. He had three jars of some substance and both the FBI and anti-terrorist sqaud kept interrogating whole day this poor gardener. They expected he had got bombs. After laboratory tests it turned out that the jars contained what the gardener claimed beforehand: honey. Even though this is a single example, but seeing how this works on GDP-wise we can sum it up how much there was production and how much did this all cost. Following the same pattern we could agree that two friends shaking hands would be declared as a high-paying job, all tax free. Salary could be like $10 grands per hour. As two friends shake hands their bills cancel each other but GDP would go up $20 000 per hour.

      Even though that just might be too extreme but the truth is we have got so much artificial work, which does not produce anything yet we rely on decifits based on annual GDP. As of how serious this misleading demographics really is we don’t need to look but Ireland. Most of Ireland’s production is agricultural. Then they went on to the banking. Boom and ka-boom. In Europe it’s not just German banks involved, it’s also so many major banks in Spain, the UK, France and Switzerland entangled in this mess. When we do compare their market values to their balance sheets we immediately see this will not end well.

      As of China’s problems I am not sure how sterilised the property bubble bursting would be. Does it scare investors? I haven’t done much research on that front, but I assume it just could rock the boat that much it could trigger the chaos elsewhere.

      About revolution, this current system cannot work under current circumstances. The change will be hard to achieve, because there will always be power behind the current one. Power that is reluctant to face any change. We can extend current system and pretend everything’s ok. But as already seen in Europe the demonstrations have turned violent and the approval for current system is finite. This may well get out of hands. Then again, it wouldn’t be the first time world goes into a global conflict that begins in Europe.

      • I agree that emphasis should be on production. The example that you gave just showed activity, not wealth creation. It is also why all the stimulus measures have been poor. They were for tax cuts rather than actual stimulus. Longer term the measures of the economy need to change as permanent growth is impossible on a finite planet.

        I will accept that Germany are not the only lenders to Ireland. The UK has $46 billion on loan there. German banks are involved in ALL the PIIGS. The fact is that all the PIIGS have debts from the core countries, UK; France; Germany and Belgium. All will take big hits if any of the PIIGS default. They must default because the alternatives are a decade of depression just paying these debts back. Even the creditor countries will not be free to invest properly until they have been paid in full. Such is the risk of a default blowing a hole in their balance sheets. So all these sovereign bailouts are really yet more bank bailouts. Yes it will not end well. One UK bank that has already been taken over by the state has billions at risk in Ireland, which means the UK tax payer will lose if there is a default.

        As for revolution I actually suspect that it might take a couple of countries to fall before Europe and the US alter directions. This is a repeat of the thirties. It was the fear of a rise of communism that created many US institutions then. The efforts to create homeowners in the US to give people a stake in society worked right till 1980. I do not think that there will be a war as a result but there will be massive upheavals.

    • I have to disagree with you on two points. First, the US is in a technical recovery right now. Economic activity is increasing across a broad range of indicators: industrial production, capacity utilization, retail sales, wage growth, even employment. It is 100% clear that this is a technical recovery. Why these indicators are increasing (stimulus, regulatory forbearance) is beside the point. They are increasing.

      Second, you say “Ireland have not come clean. The government tried to brazen it out, and the markets called their bluff.”

      The Irish have come clean on much of the debt. Have they come 100% clean? No. Where the government tried to brazen it out is in sticking taxpayers with the bill – and that is where the markets have called their bluff. They have transfered bank losses onto the backs of taxpayers in such a large amount that the debts cannot be repaid. But a huge percentage – probably the majority – of writedowns in Ireland have been recognized.

      The same cannot be said in Spain, for example. There is a very big difference – and you will see this unfold in Spain in due course.

      • Mr. Harrison, how is exactly Spain different? I received a link which I can as well paste here:

        As the article refers to “hidden books” it’s the major contributor to my worries. If the books are clean, tidy and sound why not reveal the parts showing it to the rest of the world, as transparency is widely sought after the first wave of current crisis? If they are not hiding won’t solve anything.

      • It might be a technical recovery but it certainly does not feel like one. Unemployment is still rising in more than twenty states. Wage growth might be growing but which income bracket are getting it? If it is just the top 5% it will not help the economy.

        Ireland brazened it out on the solvency of the banks. The fact that there was a silent run on the banks lead to the rescue deal. Yes most of the losses are probably known about but the transfer of toxic debts to NAMA at inflated prices will inevitably be returned to the banks or else the taxpayer will find even more losses. Also austerity will create further losses as it bites and even sound loans become unviable.

        Spanish banks have not been guaranteed, yet. Though the problems in Spain are of the deficit from the high unemployment, and collapsing tax revenues.

        • Agreed. It may technically be recovery. But it doesn’t feel like one. And yes the Irish government also has tried to act as its banks were solvent when they were not. Ultimately, however, the majority of the losses have been recognized which isn’t the same in Spain.

          The other key difference between Ireland and Spain is that Ireland has already socialized its banks losses at great expense to taxpayers. The Spanish have not. They must resist doing so and it’s good that they have the Irish example to show what happens if they did try.

          • I totally agree that the Spanish should not protect the banks. The caja’s do have serious problems. Many have merged and closed. They had the same problems of trying to compete with banks with cheap wholesale funds. My idea of isolating the residential market from banks and wholesale markets would have protected them, and the public to a significant extent.

  8. Indeed.

  9. Lies squared do not equal a recovery, and it’s not just financial. We need to get down to the nitty-gritty on all the lies, deception, and blatant corruption that has occurred in the past 10 years including 9/11.

    Whatever happened to the missing $2.3 Trillion Rumsfeld announced on 9/10? A recent report discloses the part of the Pentagon that was destroyed held the accounting division, thus destroying evidence.

    The cabal continues in power. Now a former president and his chief of staff (Bush I & James Baker) have to broker a deal with Nicaragua to keep Dick Cheney from being arrested for corruption. Where’s the outrage?

  10. I have been thinking about the impact of systemic insolvency. If there is such a crisis and the big banks are allowed to crash what will be the impact? Will it really be as bad as Mervyn King hints at?

    Yes there will be significant problems for a few days, but it will wipe out the potential liabilities at the same time. It will mean that the FDIC will have a busy few weeks, but it opens up new options.

    The core bank branch networks could be reopened very quickly. This will mean little or no impact for most depositors. The investment banking side could be shut, with all traders blacklisted until they have been cleared from any involvement in the banks failure. Also taking any passports to stop any potential flight abroad. The FBI could then seize all the assets of any bankers and its traders who made reckless trades. This will be moral hazard of a kind that the public will relish. With large numbers of the investment banking sector out of commission either temporarily or permanently, it will mean that small boutique share dealers can operate without unfair competition from high frequency traders.

    It will allow a return to a world where investment and commercial banking are separated. Especially if the universal banks are destroyed by systemic insolvency.