Sunday, September 14, 2008

Insolvency vs Illiquidity

So what is the difference between insolvency and illiquidity? Say you have a credit card, and you owe $1000, all due on the next payment. The payment is overdue. Your car is for sale, and as soon as you sell it you will have the money to pay the $1000 on the credit card.

If the Fed loans you $1000 and puts a lien against your car, they've solved your liquidity crisis. You can take the Fed's money and pay your bill. Once the car sells, the Fed gets its money back.

But now repeat the above exercise and remove the car. That is a solvency crisis. You owe $1000 and have insufficient assets to sell off.

The problem with AIG, Merrill, WaMu, and the former Lehman is not one of liquidity.
It is solvency.

Here's the kicker: You can't loan your way out of a solvency crisis. There is no other means available then to unwind the bad debt. This is exactly what happened with Lehman today. Merrill's day of reckoning was postponed, and will instead happen when Bank of America performs the unwind.

AIG is staring down the barrel this moment. Will they unwind?
Sooner or later, they will.

So in conclusion, we should make the Treasury write 100 times on the blackboard:

Insolvency is not solved by M&A.
Insolvency is not solved by M&A.
Insolvency is not solved by M&A.

Public Service: Click HERE for up-to-the-minute S&P futures overnight.


Anonymous said...

Thanks. Good explanation. Nice blog.

Anonymous said...

good explanation of terms
Bad prognostication, in regards to BofA and ML. ML is both cash and balance sheet solvent, BofA, I'm not so sure