Solvency and Liquidity: Non-Identical Twins
“It’s not a solvency problem; it’s a liquidity problem.” So many people say regarding some financial firms that are on the ropes. I’ve never liked that way of expressing the problem. Let me explain why.
When does a firm typically default? When they run out of liquidity. True, some firms voluntarily file for bankruptcy when they see that their assets are worth less than their liabilities, and don’t see any way out. Some firms are forced to file for bankruptcy when they trip a debt covenant. But most firms that find their net worth slouching into, or slouching deeper into negativity don’t file for bankruptcy. They play for time.
They hold an option with an uncertain expiry date. When will we run out of cash? Any way to conserve cash or sell off assets could lengthen the time to expiry, and maybe, just maybe, the economy will turn, or the pricing cycle will turn for the products, or enough other firms will fail, that the remaining liquidity lowers financing rates enough that the company can re-liquefy and survive.
The thing is, a company’s liquidity only becomes an issue when its ability to generate cash flow adequate to service creditors is questionable. A company can say all it wants, “But we have valuable assets. We’re not near insolvency!” Fine. Sell some of those valuable assets and generate liquidity. “But it’s a bad market, we don’t want to hit low bids.” This explains why the solvency as well as liquidity is questioned. The assets aren’t worth as much as previously imagined. Perhaps on a fair value basis, during the period of stress, net worth is negative.
Will the banks extend short term loans against unencumbered assets? Can the firm do a private placement with some prize asset as security? No? Perhaps the assets are worth considerably less than thought. A healthy premium of the value of assets over liabilities will almost always be able to attract financing. But when you are close to the line in a bad environment, any small premium will seem like an illusion to lenders.
So, in a large majority of cases, if there are liquidity problems, it is because there are solvency problems as well. Here’s one more test: if a firm is suffering from low liquidity, but has valuable assets, why not sell out to another public firm, or go private, and let private equity solve the liquidity problem? After all, they would like to buy valuable assets at a discount, right? Right?!
Well, I would hope so, but during bad periods in the credit cycle, that doesn’t happen often. So, the way I think is this: Most hard liquidity problems are solvency problems, and vice-versa. They are non-identical twins that don’t stray very far from each other.
Okay, that was theory, now for practice. Credit sensitive financials have been getting whacked lately, and deservedly so. Here are the examples:
- AIG: a complex organization that needs to become less complex. What are the assets worth versus the liabilities? Incalculable.
- The bond spreads of a lot of regional banks are deep in junk bond territory even if their ratings are not. Will some large banks default? I hope not, but I think so.
- El-Erian of PIMCO comments on the same phenomenon in an interview with Bloomberg. (Much more is talked about in the interview. Bright guy, what can I say?)
- Another way of viewing the problem is that bank holding companies are often dependent on dividends from their downstream operating bank subsidiaries. At this point in time, it is difficult for those subsidiaries to upstream cash to the holding companies. No surprise then, that many banks are facing higher borrowing costs as they try to roll over maturing bonds.
- Since a large amount of recent investment grade corporate debt issuance has been from financial companies, it is no surprise that the spreads on default swap indexes are near recent highs. To have a truly diversified corporate bond portfolio now, one would have to underweight financials in a significant way.
My examples should confirm to you that insolvency and illiquidity are closely related. In my investing, I like owning companies that are not playing it too close to the line. In bad economic environments, the line moves, and companies that thought they could survive can’t. A warning to all of us who invest, and to those who manage companies: Play it safe. Never take risks that could endanged the franchise, and don’t invest in companies that do so.
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This article has 4 comments:
- bcncv
- 18 Comments
Aug 20 01:42 PM- fatcat
- 442 Comments
Aug 20 02:34 PM- gramps2
- 108 Comments
Aug 20 02:58 PMAirlines do not fly with barely sufficient fuel - they always have a bit extra "just in case". What if the airport is backed up and the plane has to circle? What if the weather turns bad and the plane is forced to divert to another airport? Clearly, having a little extra cushion of fuel is the difference between a *safe* airline, and an airline that is playing with people's lives. Customers are absolutely justified in not trusting an airline that refuses to have a cushion of safety.
Why would you trust a bank who's solvency is "right on the line"? What competent manager assumes the economy will never face a little bad weather? We have had recessions (and worse) for 6000 years of recorded history -- it is insane to figure another recession will never happen.
If a bank is solvent and has some extra "cushion room" to survive an economic downturn, then its pretty easy to quash a bank run. This has happened, and in each case the bank survived.
If a bank is operating so close to the line that markets question its solvency -- its exactly the same as a airplane with no extra fuel cushion. Its only a matter of time before there is a disaster -- when, not if.
- Bonanza36
- 28 Comments
Aug 20 05:08 PMThis is like me saying that I am liquid because I borrowed a $100,000 off my Visa card and put it in my checking account, while at the same time my assets are exceeded by my liabilities by a million dollars.
I am insolvent, but liquid. I am hoping that my creditors are not smart enough to figure that out and come asking for their money back.
This is where the banks are: they are praying for a miracle.
I know lots of folks who are solvent but not liquid. Times are tough for them.
I also know folks who have money in the bank but a negative net worth.
Right now, you need a solid balance sheet and plenty of cash to survive, something the banks have lost sight of.
The banks are "liquid" only because they have used Uncle Ben's pawn shop to hock their most toxic loans, but they are not solvent.
We are simply putting off the day of reckoning when the banks are bailed out by taxpayers. Right now, they are just playing the game of "hide the sausage" and are hoping we don't notice.
More by David Merkel