Liquidity vs. solvency

September 23, 2008 at 5:41 am | Posted in credit, Housing | Leave a comment
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I think the response to the credit crisis has to be dictated by a determination of whether the crisis is principally one of liquidity or of solvency. So here is a basic attempt to clarify what this means.

A liquidity crisis basically means that firms have enough assets, but they cannot be easily converted to cash in time. This is a temporary problem and can be tided over relatively easily. An example of a liquidity crisis for an individual could be – You have $50,000 in a bank CD or savings account, $500 in your checking account, and your car needs major repairs over the weekend. You have the money to cover the repairs, but not right now. You need credit – Of course, you could put it on your card. But suppose you couldn’t? Or didn’t have a card. You would need to borrow from a friend or family member – Just for 2-3 days, till you can get your own money into cash.

A solvency crisis means you just do not have the money or other assets to meet your liabilities – your borrowings and your other obligations (taxes, condo fees etc). Borrowing from someone won’t help you much. Say what you owe on the house and car and cards etc. all came to $400k, but the value of the house and car and furniture and savings all add up to $350k. Maybe you still keep making your payments, but if those debts needed paying (say you had to sell your house to move for a new job), you would come up short, and borrowing from somewhere else will still leave you just as short.

In the financial institution context: The FI has borrowed some money (direct borrowing or securities issued or public deposits), has put in its own money as well, and invested the whole amount, buying shares and/or lending money to various borrowers. Say some of the depositors want their money back, and the FI doesn’t have that much cash handy. They would either need to borrow from someone else to pay off the first guys, or sell some of the investments to get the cash. But what if the investments are hard to sell, like an individual mortgage or individual loan to a small business owner? Or, what if they can be sold, but selling too much all at once can cause the price to drop, forcing the firm to take a loss? This is a classic “Its a wonderful life” scenario, and borrowing from someone for a few days or months until some of the investments come due is a ready (though not always easy solution) to the liquidity problem.

With a solvency problem, the assets / investments may have gone bad, and so are now worth a lot less than the firm paid for them. Some borrowers may be out of business, others are struggling, and their assets, which were offered as security when they borrowed the money, may not be worth as much as you thought they were (housing is a prime example).

There is no easy way out of a solvency problem.

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