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angusthermopylae (38.67)

Liquidity vs. Solvency

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March 12, 2008 – Comments (6) | RELATED TICKERS: CFC , FNMA , FMCC

Liquidity vs. Solvency is probably a good subject at this point, and one that brings a certain confusion to this humble layman.

Now, as I understand it, liquidity is (at its most basic) the ability to move around assets.  For example, having cash on hand means that you have a certain amount of liquidity.  You can spend/trade it for a wide variety of goods, from a can of Coke at Family Dollar to a new car or house, if you have enough.   Seems simple enough, right?

Solvency, then, is your basic balance sheet:  Do you have more assets than debts?  In a strictly budgeted scenario, if you have more debts than assets, you are not (very) solvent; all your income goes to servicing those debts.  You can't move around assets easily because everything is tied to a debt (or the Repo Man is knocking on your door.)  You are insolvent, frozen, unable to move through the tides of money.

Examples

You have a neighbor named John.  He's a cattle farmer.  Beef prices have been going up, and for the last few years, he's managed to keep ahead of the debts.  It's mid-winter, and he's got hay in the barn,  feed-corn seed in the shed, and 1,000 pregnant cows.  Because he's has more unencumbered assets than debts, he's solvent.  However, none of those assets can be quickly turned into cash (hay might sell to other farmers, but the corn has to grow, and the calves are still only en potentia.)  He can have $1 million in assets, with the potential to make $500,000 in the coming year, but he can't move it around.  Therefore, he has very little liquidity.

Your other neighbor, Bill, has had a run of bad years, and he sold all his cattle to pay off debts, feed his family, and pay his taxes.  He has just walked out of the bank with a $500,000 cash loan, mortgaged on his land.  (The banker, a friend and a business man, decided that it was worth the risk.)  Bill has very few assets, but a lot of cash.  He's very liquid, but practically insolvent.

Which one would you rather be?  John, who might have to starve a little now, but reap the rewards in a few months; or Bill,  who can spend his money on anything, but has a 30-year mortgage hanging over his every move?

The Problem

So here's where I get confused.  Today, the Fed announced that they are putting out $200 billion to help ease liquidity problems with major banks and lenders.  Markets were overjoyed!  Brokers cheered!

But why the celebration?  Helping liquidity doesn't mean the debt has gone away.  It simply means that you can now shuffle around money to keep the banks open.  If banks start closing, it will directly hurt the consumers and the economy.  But if a bank stays open by tap-dancing on the waves, its fall could be that much harder when it finally comes.

The basic, fundamental problem is still there--production is off; spending is high; and many of the supposed assets our economy has have been over-valued.  To be incredibly simplistic, too much money has been floating around.  Everyone has tried to get a piece of it (or had to without realizing it).

CAPS, for example, illustrates this perfectly.  How do you get a high score in the CAPS system?  By beating the market!  If the market rises 10% in a year, and your picks have only risen 9%, you're losing!  Likewise, if there is more money in the economy, you have to get a larger volume of it just to stay even.

On the other hand, if the market drops 10% in a year, and your picks only drop 8%, you're winning!  Not because you have more, but because you have more relative to the market.

Simplistically, this is how the money supply works. 

Here's some math:  If the Fed pumps in $200 billion into the market,  and there are about 350 million people in the US, every man, woman and child has to come out of the year with at least $571 more dollars than they would normally have...to stay even!  If you have a family of four, and only one bread winner, then he/she has to come out with $2,280 more dollars out of thin air.  Every single person who doesn't have that extra money is at least that much poorer than before, even if they show a perfectly balanced budget.

So, John and Bill?

With the Feds action today, John's real profits are going to get cut.  Since everyone is going to working to get their $571 to stay even, John's going to pay more at the pump, the feed store, the grocery store, and the tax office.

Bill, on the other hand, has it much worse.  That 30-year mortgage has just gotten a little steeper, and he's going to have to work harder and harder to just stay even.  Like sand in the gears, this will wear a little faster, run a little rougher, and make it that much easier to simply collapse under the weight of it all. 

My Magic 8-Ball prediction is that this is just a band-aid.  The underlying problems of the economy are only going to get worse, and, in a fit of economic Darwinism, over-priced and over-extended businesses are going to come tumbling down like, well, the legendary brokers of the Great Depression.

6 Comments – Post Your Own

#1) On March 12, 2008 at 2:25 AM, Zakrooster (68.31) wrote:

Thanks for the lesson

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#2) On March 12, 2008 at 2:52 AM, LordZ wrote:

Dude the feds didnt pump extra money in the market, what they simply did was allow what otherwise was frozen assets ~ bonds that no one was interested in picking up ~ because their valuation were uncertain and no one was ready to have their money get frozen in this bond area ~ to become liquid they allowed them to get converted into treasury bills. Imagine if all the sudden you couldnt sell stocks or you couldnt access your credit. Imagine if you had 200 billion in the bank, but you couldnt get at your money, what the Fed along with all the other countries financial institutions and markets agreed to was allow access to these fund by way of loans of treasury notes. Its not like they gave someone something for nothing.

Instead of simply giving big banks free money, they finally did something smart and cleared this otherwise dead money. The markets reacted positively, havent you ever forgotten your wallet and found yourself vulnerable ~ once I accidentally left my wallet at home when I went to work and I found it rather disturbing to be without my money ~ fortunately I was able to go to my bank and withdraw some cash without my id.

Its not like the market is blind to the facts, yeah jobs are harder to come by etc etc, this isnt new, finally rather than continuing to devalue the dollar, the Government finally did something smart and created liquidity in an otherwise crazy market.

Its not up to the Fed to fix the economy, everyone knows this.

However if you have a situation where a good portion of capital that otherwise was trading suddenly and for a good period of time become untradeable your going to have all markets tank.

The first rule in saving any patient is you stop the bleeding and then you start the breathing...

WHat we had for many many months was severe bleeding, and no matter how much blood the fed pumped into this patient, it wasnt until they finally noticed that big gapping hole pouring out blood that the patient finally was able to get medical treatment on.

Its so simple, but dont take my word, just look at how the market will perform in 7 hours....

 

 

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#3) On March 12, 2008 at 10:09 AM, floridabuilder2 (99.24) wrote:

this dove tails with a lot of what i am stating about banks being benevolent to builders.... most builders are insolvent because their true book is less than their debt.............  builders own assets that are not liquid............. in other words they have the worst of both worlds

so now as a bank you have on your balance sheet loans to builders and developers that are both insolvent and holding illiquid assets................  the only thing you can do to prevent your bank from going bankrupt is to put a band aid on it, hope for a bottom, and work with the builders / developers that can stay breakeven or better...........  you cannot put a fork into the builders and developers because that would cause one massive implosion...

nice post

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#4) On March 12, 2008 at 12:52 PM, QualityPicks (52.17) wrote:

Our economy has problems of solvency which are causing liquidity issues. The Fed is trying to solve the liquidity issues. But because we are not solving the solvency issues, liquidity issues will keep poping up again. The Fed will "try" to help the solvency issues by lowering the rates, hoping the banks can make bigger profits on their good customers, since banks are not passing along the lower interests. Bank customers get screwed by paying high interest and by earning little interest in their savings. So, who's helping the average Joe? The average Joe is at the root of all the problems. If Joe is insolvent, he can't pay his mortgage or his credit card, which makes banks insolvent, which causes liquidity problems :) Liquidity issues are simply a simptom of our problems. To really fix liquidity for good we'll have to fix solvency. This is a hard process that will take time. The Fed is helping in some ways and obstructing in other ways.

 

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#5) On March 12, 2008 at 8:34 PM, hall9999 (99.26) wrote:

Angusthermopylae - In your example of which neighbor is better off - the solvent one or the liquid one - it really just depends on what happens going forward.  John is solvent but if he suddenly has a major expense like medical bills, or he is forced to pay back some of his debt (as Thornburg Mortgage was forced to do) then, being illiquid, he would have to sell what assets he could at a huge discount.  That would reduce his future earning potential.  Also, because his assets were sold for less than their worth (below book value) he has become less solvent.

  Bill on the other hand, having few assets, isn't generating income.  But if he invests that $500K in cattle and feed he could have enough assets to generate an income that would service the debt and then some.  He might even be able to get a really good price on that stuff from John.  In addition, he could hold on to a portion of that $500K so that he remains liquid and won't be forced to sell assets before they have a chance to bear fruit.

 

  QualityPicks - It seems to me that the larger problem is the liquidity issue.  In fact, lack of liquidity is causing the solvency problems.  As floridabuilder has pointed out most homebuilders are falling more and more in the red but if they have enough cash to get through the hard times then they will survive.  If their assets were more liquid then book value (and thus solvency) wouldn't fall as much.  In Thornburg's case for example, their assets are mortgages which hold their value unless the mortgagee doesn't pay and the underlying asset is worth less than the mortgage when they go to forclose.  Thornburg's customers almost always pay their mortgage and since they almost always have lots of equity in their homes the asset is rarely worth less than the mortgage.  Thornburg's problem was that, being illiquid, when the market for mortgage backed securities seized up they couldn't get a fair value for their assets.  That forced them to write down their book value and thus sell assets at a discount to maintain their debt/equity ratio.  Same situation as farmer John.

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#6) On March 13, 2008 at 3:45 AM, angusthermopylae (38.67) wrote:

You've come up with some great comments, so I thought I'd write back to respond, and (perhaps) clarify.

I agree with both LordZ and hall9999 on the bigger picture.  The Fed is not the one you can or must rely upon to fix the economy, and both Bill and John are going to be subject to all sorts of outside influences that 1) are completely beyond their control (weather, overall market, emergencies) and 2) can turn their fortunes around (good or bad) without warning.

I hope that, in my post, I was able to maintain a neutral tone about the money going to the banks.  Whether the $200 billion is being spent wisely or not, having banks go under will bring everything crashing down.  The Fed is doing something, but I don't believe it's the best course.

Lordz is probably correct in the respect that the money will allow "frozen" or "dead" assets to be moved around.  This may stave off an immediate collapse of many larger institutions, and that will protect the people who depend on those institutions, both big and small.

Here's an example that seems to prove both LordZ's point and, possibly, mine:  The Carlyle Capital Corp. is fully expecting that their creditors are going to seize all their assets.  Their situation is exactly what LordZ described.  They needed money, couldn't get it, and now are in a world of hurt.   Imagine that situation becoming more widespread among banks and mortgage companies.

It also illustrates my point in that, while they have a severe liquidity problem, they are also victim to becoming insolvent; what they have wasn't nearly as valuable as they thought it was. You can argue that it was bad timing, bad judgement, or bad luck; according to the article, they are both insolvent and illiquid, and mere survival is going to be tricky.

My reference to Darwin wasn't happenstance.  Economies are like ecologies, and new businesses (life) emerge, grow, and evolve in response to history, environment, and future possibilities.  Because land and home values were overpriced, a lot of companies got weak and sloppy, thinking it would last forever.  For whatever reason (and I bet there are a host of subtle causes that haven't been factored in), this financial scaffolding is beginning to crumble.

floridabuilder points out that it's an intricate web, and everyone is trying to hold on as long as possible, hoping to make it through the bottom (just like an ecology.)  Banks are dependent upon developers who are dependent upon banks.  Everyone is smart enought to see the Mutually Assured Destruction hanging over them, but  no one can  take the steps necessary to extricate themselves.

And that's just developers.  We still have food, gas, clothing, autos, computer manufacturing, fast food, drugs, health care, Social Security, military, and a million other factors that are all tied in to this.  History will probably say the mortgage crisis kicked it all off, but I believe that the real problems are deeper, more fundamental, and have been in the works for many years.

With that in mind, I still hold the opinion that the US economy is going to go through some major retooling (and associated pain) before we see the light at the end of the tunnel.  All you can do as the little guy is get rid of your debt, hang on to your job, and be prepared to take up another career if it all goes completely fubar.

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