Illiquidity and Insolvency

Someone asked how the bailout is supposed to work:

I'd say it this way, there are two problems.

1. Financial firms are stuck holding securities they can't sell and can't borrow against. Since these firms borrow short and lend long, that's a killer. The problem is that there are hidden bombs in their asset portfolios, and nobody knows which securities will blow up (so everyone tries to get rid of their securities causing prices to fall rapidly [and this leads to the "paradox of deleveraging", see Krugman's description]). By having the government trade for these frozen assets (some of which are perfectly fine) and replace them with safe, low risk or risk free assets, the firms ought to be able to sell the assets and/or borrow against them again (since there will now be buyers willing to take them), prices will stabilize, and credit will resume flowing.

That's an illiquidity problem. It's caused by toxic assets, the hidden ones freeze up the whole system since nobody wants to end up with them. Why give up cash unless the interest rate is really, really high, too high?

2. The other problem is solvency. Now, some people think that if you solve the illiquidity problem, that's enough, it will allow the firms to borrow within the private sector (perhaps internationally) and recapitalize themselves.

Others think the solvency problem can only be solved with additional injections of safe assets - say cash or bonds - solving the illiquidity problem alone won't be enough.

I don't want to take chances, so I say (1) get rid of the toxic stuff, that helps the liquidity problems and gets credit markets moving again (they froze up severely after Lehman was allowed to collapse, that was a mistake), (2) add additional capital to help with solvency, this is extra insurance in case freeing up credit markets by solving the liquidity problem isn't enough by itself, and (3) give taxpayers a stake in all of this for their troubles. The exact form of that stake isn't as important as the fact that they have one.