Illiquidity and insolvency and the takeover of WaMu

A bank can be illiquid and insolvent.  This is a nasty end-game.

It can be insolvent but not illiquid – when it has plenty of access to deposit funding but the loans it has made are heavily bad.  In this case continued operation risks further losses to depositors and the organisation SHOULD be regulated or confiscated.

It can be illiquid but not insolvent (such as when a perfectly good bank has a run).

The purpose of lender-of-last-resort things in bank regulation are to ensure that banks which are subject to runs don’t fail because they are illiquid but not insolvent.  If a bank which is solvent has a run the right thing for the government to do is to front the run – make it go away – and let the bank sort itself out over time.

The problem of course is that when a bank is illiquid it is very hard to tell whether the liquid bank really is insolvent. 

If the government were perfect at telling this they would know precisely who to bail out and who not to.  Nobody serious thinks they know that.  If I knew that I would be a much better stock picker than I am.

Anyway the reason for a bank confiscation is that the bank is UNSOUND meaning the capital is inadequate.  Illiquidity is NOT a reason for a bank liquidation. 

This comment was made by the FDIC:

Federal regulators said WaMu has suffered an exodus of $16.7 billion in deposits since Sept. 15, leaving the Seattle thrift “with insufficient liquidity to meet its obligations.” As a result, WaMu was in “an unsafe and unsound condition to transact business,” according to the Office of Thrift Supervision. 

What is strange about this is that this is precisely the reason you SHOULD NOT take over an institution – certainly without consulting it about alternative forms of liquidity (such as pledging its loans).  The whole point of government intervention is to nationalise insolvent institutions and to keep solvent ones liquid.  Now I suspect there is more to this story than this blog post.  But for the moment the explanations are inadequate...

Two weeks ago WM put out a press release that said this:

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank's operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

If this release was not a direct lie - and there is no reason to believe it was - then the OTS thought only two weeks ago that WaMu did not require additional capital.  Very strange indeed.