Certainly there will be some outright losses, but it seems (at least to my non-expert eye) that the greatest concern is that, with all the complex derivatives and various counterparties, no one really knows what the result of unwinding would be. And even a bank may not be able to determine its own result, as such is dependent upon other parties, whose results are dependent upon still other parties, and so on.

But one possible result of unwinding everthing could be losses that are manageable by at least the majority of financial institutions. Of course, it is also possible that such is not the case, and there are gigantic losses waiting to wipe out large numbers of financial institution. But it seems that there is insufficient information for a compelling argument either way.

I’m sorry for the Icelanders. Some of their problems are their own creation; they’ve had their own little bubblete. But it’s tough to manage a small country with limited resources in a world with big financial dogs. Don’t lease that genetic base folks, some things aren’t for sale.

There may be a brief day when the net worth of Sigur Ros and Bjork together exceeds that of their country. *eeekk*

You asked a big question, and I am afraid I can give only a short answer,

It is true that illiquidity can lead banks and companies to fail, But there is strong evidence to suggest this is a solvency problem, bigger than the CDO problem you mention, although that is an important piece.

As you know, banks carry only a small amount of equity. 8% is a good rule of thumb. European banks carry even less (some are geared as much as 50 times).

Banks (and we can include investment banks) engaged in riskier and riskier lending. Just look at how the profile of credit card borrowers has changed. Banks have been out to create heavily indebted, chronic borrowers, though the use of teaser introductory offers. Before, they used to price their products so they made money off everyone (in fact, in the old days, the best customer was someone who paid the annual fee but used the card little or not at all); now their profits depend on the heavy borrowers.

Since the early 1990s, but at a greatly accelerated pace, consumers have taken on more debt relative to income. The ratio of consumer debt to income rose by 50% from 2000 to 2007. That is simply stunning.

Banks were also discouraged from building up loss reserves in good years. It was seen as a way to smooth earnings and frowned up on by regulators (talk about perverse).

So we have a lot of deadbeat borrowers, due to over leverage. Some were destined not to make it, some might have but will be taken down by bad luck or a deteriorating economy.

European banks didn’t have as much latitude to take risk, but were brought down by buying US product and also by exposure to the markets where consumers went wild (England, Ireland, Spain, the Baltics).

Does that help?

The Liquidity case (from above post) :

“This is a liquidity crisis,” Ohmae said at an investor forum hosted by CLSA Asia-Pacific Markets, the regional broking arm of Credit Agricole SA, in Hong Kong yesterday. “The liquidity has to be so big that people won’t get panicky.”

The Solvency Case (from Richard Kline, yesterday).

“This isn’t a crisis of confidence, it’s a crisis of solvency, and that isn’t addressed at all by bloating liquidity. The Fed keeps stacking bricks o’ bills on the Liquidity Wall, while the Solvency Wall has collapsed and the zombies are inside the City.”

I think “solvency” wins easily, especially when one considers style and presentation.

I love this blog. I have been heavily involved in subprime over the last six months.

I have been having a debate with a co-worker:

He believes that the bank failures are a result of a liquidy problem.

I believe that these banks have on their books tier-three assets such as CDO’s which are falling in value.

I am wondering if you could clarify what is at the heart of the failure of banks in the U.S. and EU.

Thanks

The record salaries at the newly privatized banks, the ridiculous housing boom in a country of only 300,000 people, world sales record for most LandRovers …. It was very clear that Iceland was headed for a cliff. Surely the government was in a position to say, no, especially given the country’s history of destitution under foreign interests as a Danish colony.