Bridging the solvency/liquidity split

I have long argued that the split between solvency and liquidity is a false dichotomy in the current market. Decreasing liquidity can of itself and without changes in expectations of default depress the price of an asset and hence create a solvency problem. Similarly institutions that whose insolvency is rumoured find their liabilities illiquid. The FED's actions recently would, I suggest, support this view. They have been creating liquidity - as Alea notes by selling treasuries and repoing in illiquid assets, primarily ABS - in order to support asset prices. This explicit management of liquidity premiums is as important a factor as interest rate cuts. The early signs are that the two effects are working, especially now the primary dealers can assess the FED too. We'll see.

Update. The argument above broadly motivates my concerns with the positions of those, like Willem Buiter, argue that central banks should repo in ABS collateral, but should do so at aggressive haircuts. (See here for Buiter on Radio 4's today programme - be warned that that link might not persist for long however.) In purely financial terms Buiter is correct: this is the prudent approach. However it is seriously unhelpful in meeting the broader policy objective of reducing soaring liquidity premiums. If the Bank takes risk on the collateral it is much more likely to be effective in ensuring that it does not take as much risk on its counterparties.