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Solvency vs Liquidity

You can't treat solvency problems with liquidity solutions...

IT'S NOT easy investing in a post credit bubble collapse environment. It's not enough to comprehend the direction of economies and the profitability of the companies that are trying to make a profit in also need to comprehend the thinking of central bankers and politicians. That, we can safely say, is an impossible task, writes Greg Canavan for the Daily Reckoning Australia.

Betting on a bailout is easy money. But being fully invested on the assumption a bailout will float all markets higher is idiotic. Bailouts don't work. They create moral hazard, distort price signals and cause deeper structural issues. To make money from them, your timing needs to be very good.

The central banking fraternity's latest efforts at 'providing liquidity' does take some pressure of the global banking system, so markets should remain supported in the short term at least. There's a high probability that one of the large European banks was on the brink of bankruptcy in the past few days. The Euro banks have been starved of short term funding as the market's confidence in their solvency has diminished.

Specifically, the US money market funds that invest in short term bank paper have pulled their funding in recent weeks. Because banks 'borrow short and lend long' the evaporation of short term funding obviously caused major distress for Europe's banks.

If a major European bank was in trouble and its demise threatened to trigger billions of Dollars' worth of credit default swap insurance written by major US banks, is it any wonder the Fed stepped in to provide a source of cheap US funding.

But in 'saving the day' – again – the Fed is simply creating even greater distortions...and as we'll explain in a moment, much of this is related to the distortions they created a few years ago.

Let's join the dots on what is really going on here. US money market funds start to dump short term European bank paper*. That means less US Dollars flowing through the Euro banking system. And, if you read the definition we included below, you'll see it means less rolling over of short term debt.

When that happens, alarms bells go off in the corridors of power. The Fed realizes there is a potential systemic banking problem and provides the funding that the private market has decided is too risky.

Once again, the Fed is distorting the signals the private market is trying to send. The market is saying there is a solvency problem and the Fed is saying it's just a matter of liquidity. And don't forget, one of the reasons US money market funds are hunting around Europe for a decent return is because interest rates are so low in the US...thanks to the Fed and it's flawed attempt to 'kick-start the economy'.

If this is just a liquidity problem, the Fed is right to act. But that's the question – liquidity or insolvency. The Fed's US Dollar swap lines – whereby it swaps US Dollars for Euros with the ECB – have been open for a while, but as of 30 November, they were only drawn to US$2.4 billion, a piddling amount.

Yesterday's announcement that the Fed would lower the cost of accessing these US Dollar swaps by 50 basis points seemed to get the market all excited. If it's because it has delayed/avoided the bankruptcy of a major global bank then the bullish response is hardly surprising. Nor is it comforting.

If the banks in question were simply suffering from a short-term liquidity problem, 50 basis points should not be that big a deal. Walter Bagehot, author of Lombard Street (a definitive book on money market operations) said in a liquidity crisis central banks should provide plenty of liquidity at a high cost against good security.

But the Fed is providing plenty of liquidity at low cost against collateral of uncertain value and quality. And that's the problem with the global banking system these days. Debt has become so pervasive that formally 'good' collateral – sovereign debt – is not good at all.

And treating solvency problems with liquidity solutions only creates larger problems down the road. That's why Greece is in such deep trouble. The IMF has provided Greece with plenty of liquidity to keep it afloat. Meanwhile, its economy continues to contract and its debt situation worsens.

If you're unsure of the difference between solvency and illiquidity, here's an easy example:

You have an unexpected tax bill from some dazzling investments you made, the proceeds of which you gave to your bank to extinguish the mortgage on your house. The tax bill is due in three months but your current cash reserves, plus saving out of income, won't cover the expense. Your problem is one of liquidity – plenty of net assets, just not in liquid form. So go to your bank, borrow a small amount using your home as security, and pay the sponging tax man.

Now for insolvency. You bought a house in Sydney's eastern suburbs in 2007, putting down only 10 per cent equity. You spent the remainder of your cash and borrowed from other creditors to renovate the shoebox in the hope someone else would come along and pay more for it.

A few years later, following lay-offs at various investment banks and other finance related industries, prices are falling and the bigger fool (from that theory you heard about prior to purchase) has failed to show up.

You're just scrapping by paying the mortgage, but your other creditors see you are in trouble and want their cash back. You're in a bind because you have negative net assets. In the absence of a loan from the Fed, using the purchase price of your home as collateral, you are insolvent.

A loan might help you out in the short run, but you then must hope/pray your income increases substantially or the value of your assets rise. In a deleveraging environment, that is not likely. Going further into debt in the 'hope' that growth in income or assets will come to the rescue is a bad strategy. It just creates more bad debt that you'll eventually have to deal with.

European banks (and the US banks that have written insurance against them) are in, or close to insolvency. Because banking is all about confidence, near enough is good enough. When the market gets the hint that a bank is in trouble, that hint is enough to create a run on the bank and push it into insolvency anyway.

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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