Is This a Liquidity Crisis or An Insolvency Crisis?

by: Felix Salmon

Nouriel Roubini is a genuine expert on the difference between illiquidity and insolvency: he wrote a whole book on the subject, at least as it applies to countries. And now he's attempting to diagnose the present credit crunch as an insolvency crisis rather than a liquidity problem. The thing is, telling the difference is always more of an art than a science. And from my point of view, a lot of what Roubini considers to be insolvency is really "just" a liquidity problem. Liquidity crunches are bad, of course – but they're not as bad as insolvency. So the difference does matter, both in terms of the severity of the present crisis and in terms of whether injections of liquidity from the ECB and the Fed will be able to help.

So it's worth examining the Roubini list of insolvents, to see which ones ring true.

First on the list, of course, are homeowners:

You have hundreds of thousands of US households who are insolvents on their mortgages. And this is not just a subprime problem: the same reckless lending practices used in subprime – no downpayment, no verification of income and assets, interest rate only loans, negative amortization, teaser rates – were used for near prime, Alt-A loans, hybrid prime ARMs, home equity loans, piggyback loans. More than 50% of all mortgage originations in 2005 and 2006 had this toxic waste characteristics. That is why you will have hundreds of thousands – perhaps over a million - of subprime, near prime and prime borrowers who will end up in delinquency, default and foreclosure. Lots of insolvent borrowers.

No doubt there are insolvent subprime borrowers. They borrowed more than they could afford, at high interest rates, and their net worth is now negative. What about the Alt-A and prime borrowers? Delinquency rates are rising there, too, as Nouriel notes, at least on the ARM front. We haven't reached the worst of the resets yet, and so one can't take much solace in relatively low foreclosure rates right now, either. But these are individuals with good credit, in an environment where declaring personal bankruptcy is both very difficult and very harmful. I have some hope that they will manage to muddle through somehow. Just because you have a negative net worth doesn't mean you have to default on your mortgage. In general, though, I agree with Nouriel on this one: there is a lot of insolvency among homeowners with recent-vintage mortgages.

Next are the mortgage lenders:

You also have lots of insolvent mortgage lenders – not just the 60 plus subprime ones who have already gone out of business – but also plenty of near prime and prime ones. AHM – who went bankrupt last week – was not exposed mostly to subprime; it was exposed to near prime and prime. Countrywide has reported sharp losses not only on subprime lending but also on prime ones.

This one I disagree on. There were a few subprime lenders who went bust relatively early on because the banks put back to them a lot of the nuclear waste that they underwrote. Yes, those were definitely insolvent. But AHM, and many of the other mortgage-lender bankruptcies, I'd classify as more of a liquidity problem than an insolvency problem. If it's not owned by a big bank, a mortgage lender is always at the mercy of its own bank lenders. If and when they pull their credit lines, the lender goes bust, no matter how healthy its fundamentals. The lender bankruptcies – certainly the more recent ones – are due to liquidity being pulled, and are not due to insolvency.

Then come the home builders.

You will also have – soon enough – plenty of insolvent home builders. Many small ones have gone out of business; it is likely that some of the larger ones will follow in the next few months. Beazer Homes – a major home builder - last week had to refute rumors of its impending insolvency; but so did AHM a few weeks its insolvency. With orders for home builders falling 30-40% and cancellation rates above 30% a few will become insolvent over the next year or so.

Again, I think this is a liquidity problem more than an insolvency problem. If the homebuilders can simply access enough liquidity to be able to warehouse their stock of unsold inventory for as long as it takes to sell it, they should be fine. Insolvency only comes with serious double-digit house-price declines – and while those do exist in some parts of the country, those are still the exception rather than the rule.

Next come insolvent hedge funds – and I definitely agree with Nouriel there. The magic of leverage can and will wipe out more than a couple of Bear Stearns funds.

Finally comes the biggest and most contentious group of all: in a nutshell, everybody else. Easy credit has brought default rates down to unnatural levels in recent years: rather than declare bankruptcy, companies have been able to refinance. Absent the easy credit, default and bankruptcy rates are going to have to rise.

On this one, too, I agree with Nouriel. Default rates must rise from present levels, and even if they only go back to their historical levels, that's going to be a big rise. I'm not convinced that a higher-but-still-relatively-low corporate default rate will necessarily drive the US and the world into an apocalyptic recession. But I do agree that there are some areas of the economy where an injection of liquidity is not warranted, and might even be counterproductive over the medium term. Lenders have been irresponsible of late; they're going to have to pay the price at some point, and there's no reason why it shouldn't be a year or two from now when present loans mature and corporate bankruptcies start rising.