Liquidity vs. Solvency: What's the Difference and Why Does it Matter?

As more and more people become bullish on this market and the economy, I think it is a great time for a sanity check. Will the economic environment be a lot better or worse 12 months from now? Bulls will tell you that we put in a market bottom in November and that all the indicators of fear were near or at all-time highs, a good sign of a bottom. They will also argue that, with all the stimulus being poured in around the world by governments and central banks, the world economy will stabilize in the coming year and the stock market is rising in advance of that. Bears, on the other hand, argue that the economic situation is bad and only getting worse. Employment, consumption, and industrial production are falling off a cliff. They claim that corporate earnings in 2009 will be worse than 2008 and there will be no V-shaped recovery in 2010 if there is any at all. So, who’s right?

First, I think it’s important for all to understand two key terms: liquidity and solvency.

From Merriam-Webster:

Main Entry: 1liq·uid

Pronunciation: \ˈli-kwəd\

Function: adjective

Etymology: Middle English, from Middle French liquide, from Latin liquidus, from liquēre to be fluid; akin to Latin lixa water, lye, and perhaps to Old Irish fliuch damp

Date: 14th century

1: flowing freely like water

2: having the properties of a liquid : being neither solid nor gaseous
3 a: shining and clear <large liquid eyes> b: being musical and free of harshness in sound c: smooth and unconstrained in movement d: articulated without friction and capable of being prolonged like a vowel <a liquid consonant>
4 a: consisting of or capable of ready conversion into cash <liquid assets> b: capable of covering current liabilities quickly with current assets
— li·quid·i·ty \li-ˈkwi-də-tē\ noun

Main Entry: 1sol·vent Pronunciation: \-vənt\
Function: adjective
Etymology: Latin solvent-, solvens, present participle of solvere to dissolve, pay Date: 1630 1 : able to pay all legal debts <a solvent company>
2 : that dissolves or can dissolve <solvent action of water>

Now, let’s examine a liquidity problem and a solvency problem separately.

Company A lists as assets a warehouse worth $50,000, inventory worth $20,000 and $10,000 in cash in their bank account. Furthermore, Company A lists as liabilities only a $35,000 loan maturing next month. Clearly, we can see that Company A has more than enough assets to cover its liabilities. In fact, Company A has a positive net worth of $45,000 (80,000 - 35,000). However, they are going to run into a problem raising the money they need to pay off the loan because their warehouse and inventory are not liquid assets i.e. easily convertible to cash.

You’ll also notice that there are degrees of liquidity for assets - inventory being more liquid than real estate. This is a classic liquidity problem. Sometimes, a solution can’t be found and a company may be forced to liquidate assets. Usually, a workaround (such as a temporary loan using the warehouse as collateral) will allow the company to remain in business. If this sounds a lot like what the Fed is doing... well, it is. They are accepting all sorts of new collateral from banks for cash. The cash allows banks to continue on with their business. Actually, the Fed and central banks around the world have essentially drowned the world in a sea of liquidity. Cheap money is available for all at low rates. Our problems are solved, right? Not so fast.

Let’s look at Company B. For simplicity, Company B has the exact same balance sheet as Company A. Let’s say that Company B had bad risk managers and didn’t buy insurance and last week a flood washed away their warehouse and most of the inventory. Well, now Company B has $10,000 in cash left and a $35,000 loan to pay. This is a solvency problem and it’s bad. Generally, companies that are insolvent are forced into bankruptcy.

If you didn’t understand why Lehman (LEHMQ.PK) went under despite having access to the Fed’s funding sources, well now you know. They didn’t have a liquidity problem; they had a solvency problem. All the assets on their balance sheets were essentially washed away in a flood and they could no longer cover their debts.

Every writedown you hear about in the news is the revaluation of assets on balance sheets at a lower level. It brings companies closer and closer to an insolvency position. The scary thing is that no one can really believe what anyone says about the value of their assets because they are all marking their books to fantasy valuations. Take for example Lehman Brothers and their magical loss of billions in value from the day before bankruptcy to the day after.

The TARP is attempting to address solvency problems by directly injecting capital into the banks to increase their capital ratios. The Fed, however, has only been providing liquidity through all their programs - TAF, PDCF, etc.

After thinking about it, it seems clear to me that no amount of liquidity solves the solvency problems in our economy. Banks are insolvent. Consumers are insolvent. Corporations are insolvent. This is what happens when there is too much leverage in the system and your equity cushion gets wiped out. Mainly for this reason, I think we have a lot more pain to endure on the downside in the stock market and I think the economy will end up being much worse than people would like to believe. The only solution as far as I can tell is allowing bankruptcies to occur and not bailing everyone out and pushing judgment day into the future. Government can provide stimulus to attempt to stabilize the economy but they shouldn’t allow the zombie corporations to live on. It will be painful but when the dust settles, we will be a lot stronger for it.