Liquidity vs. Solvency In The Financial Crisis

from the jumpstarting-the-economy dept

There's been a fair amount of interest in my last few posts on the financial crisis and The Insight Community has been providing some great analysis on how the financial crisis is impacting small businesses. You can see some of the initial input over on American Express's OpenForum blog, as they're sponsoring that discussion. Some good posts to check out are Dennis Howlett's quick tips for small businesses and Zack Miller's concept of "black swan" contingency planning for small businesses. We'll definitely have more on the small business front coming up, but I wanted to go back to what's going on with the banks.

After my initial post, I got an email suggesting that I put too much emphasis on the liquidity problem, and not enough on the insolvency problem. There's been something of an ongoing discussion on this point on various websites, and even the Wall Street Journal got into the act a few days ago, talking to Milton Friedman's co-author on A Monetary History of the United States, Anna Schwartz, who makes the point that the problem absolutely is an insolvency issue, while it appears that much of the federal bailout is focused on dealing with a liquidity problem.

So, what's the difference? In simple terms (and, yes, I'm sure the super finance types may quibble over the specifics, but this should get the broad strokes correct), liquidity problems occur when an entity owes money but doesn't have readily available cash to pay off those debts. They may have other assets, and generally speaking, if they're facing a liquidity problem, they're likely to try to sell off those assets, potentially below cost, just to get the money they need to pay off their debts. Say, for example, you owe $100 for your car loan each month, but don't have the cash to make the payment. You might try to sell something else you own to get that cash, and if you're desperate enough, you may even sell something for less than it's worth, just to get the cash and avoid defaulting.

But much of the problem in the financial world over the past few weeks hasn't been a lack of liquidity but an unwillingness to lend. That is, the banks have a ton of cash on hand, but they're afraid to give it out to anyone, because they don't know if whoever they lend it to will still exist when it comes time to repay. So, instead of lending it out, they're dumping it into the safest of safe investment vehicles: US gov't treasury bonds, even though they pay almost no interest. As the good folks on Planet Money note, treasuries are about the equivalent of stuffing the money into your mattress. You won't lose the money, but you won't make any interest either.

Basically, many of the banks have liquidity (cash), but are so afraid that the others they lend to are insolvent (unable to pay back loans) that they won't loan. That's why you may have heard more and more people talking about the (until recently) obscure "TED spread," which basically represents the difference between the interest rate at which banks are lending to each other (the LIBOR -- or London InterBank Offered Rate) and the interest rate on US treasuries. It's a quick measure to determine how secure banks feel about lending to each other vs. putting money in the proverbial mattress. In normal times, this is pretty small, because lending short term money out to other banks is considered pretty damn safe -- almost as safe as lending to the US government. So, it's usually well below 1%. Over the past few weeks, it's been sitting above 4%, on many days -- which basically means that banks are simply sitting on their cash because they don't trust other banks at all. This week, it finally started dropping, representing at least some easing of concern (though it's still pretty high).

So, as you can see, there's plenty of money in many of these banks, suggesting that they're not so worried about liquidity, but the solvency of everyone else they deal with. Of course, the two things overlap a bit. A bank that doesn't have liquidity may then be considered insolvent as well. On the good side, it looks like the federal government is finally recognizing the difference between liquidity and solvency and is trying to deal with the solvency issue by effectively agreeing to buy up commercial paper from money market funds. Basically, the issue here is that the commercial paper market has been standing still. As we described in our earlier post, this is the short-term lending that goes on between companies all the time, and is important for their liquidity. But with the money market managers afraid of insolvency, they're unwilling to lend money out, if there's not enough evidence they'll get it back. So, now, the government is basically saying, "go ahead and lend it out, and we'll make sure that it gets paid back." That could present a huge risk in terms of pushing the market to do bad loans and stick them to the US government, but as a short-term measure it can certainly help in kick-starting the market. Unfortunately, there are already some complaints that the rules are way too confusing.

That said the real problems touch on both liquidity and solvency, so the real solution needs to deal with both. If we don't deal with the worries over solvency, then we'll have a much bigger liquidity problem across the economy. Because the banks are afraid to lend money out, lots of companies are unable to then get the money they need for daily operations -- and then they become insolvent, creating a disastrous domino effect. Those with money are afraid to lend it, because they're afraid they won't get it back -- and their unwillingness to lend is making it so that others really can't meet their obligations. So, while there's some argument about solvency vs. liquidity, a solvency problem at one part of the chain can create a liquidity problem elsewhere, which in turn leads to solvency problems. This is why it is rather important to get those with money to get it moving again, or it very much is like an engine running out of oil. Just dumping money into the market can help somewhat, but until recently, it was mostly going to banks who already had cash, but weren't lending it.

So, what's it all mean? Well, as of today (and these things are changing pretty quickly), the past few weeks showed that no one was lending to anyone as they all seemed to fear that the folks on the other side wouldn't be around or able to give the money back within the next three months or so. That created a pretty significant risk of limited cash flow problems. The initial moves by the gov't with the bailout didn't seem to do much to deal with that problem, but its more recent moves suggest it now recognizes the real issue and will do what's necessary to fix it. My fear, at this point, is that in typical government fashion, it turns the spigot too far, leading to a situation where, in order to force liquidity into the rest of the market, we end up encouraging and paying for bad loans.

Needless to say, this is still a pretty complex situation, and while it looks like we may have (so far) avoided the worst case scenario, there's reason to be afraid that in all the knob spinning the Fed is doing, we're going to end up overshooting in both directions at points, and that can be just as dangerous in simply delaying inevitable pain.

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