The Federal Reserve and the US government together have injected more than $6 trillion into the economy. The US government’s spending directly puts money in the hands of its citizens either by creating government jobs, or by sending out paychecks (UBI). The Federal Reserve, on the other hand, lends money to the government and big banks, who then lend it out to others. In addition to printing and injecting money into the economy, the Federal Reserve dropped the interest rates to near zero, which incentivizes people to borrow money. For example – The reason why there are so many home buyers right now is because of low interest rates; it’s cheap to borrow money. The low interest rates push asset prices higher, as money is drawn away from the low yielding bonds to other higher yielding riskier investments. In other words, low interest rates and abundant liquidity is the reason why the stock market (equities) is soaring, the home prices (real estate) are rising, commodities (such as gold) are becoming more expensive, etc. Now, an average Joe might look at this and say that his investments are going up in price, so the US Economy got past the shutdown, and came back roaring again. Far from it. While the Federal Reserve can help wither the liquidity crisis, it can not do anything about the solvency crisis. In this week’s blog post, I will talk about solvency crisis, and why the worse might be yet to come.
First off, let’s quickly go over the difference between liquidity crisis and solvency crisis. A company is said to be in a liquidity crisis when it does not have enough current assets (cash, receivables, etc) to service its short term obligations. A company is said to be in a solvency crisis when its liabilities have grown so much larger than its assets that the company is unable to pay back the debt it owes, and bankruptcy is the likely outcome. A company can be in a liquidity crisis, and still be solvent – this would happen if that company is running low on cash and can not meet its near term obligations, but still has more assets than liabilities; it will just take time for that company to sell off those non-current assets (plants, properties, equipment, etc) and convert them to cash. So, in such a situation, Federal Reserve / banks can step in and provide the much needed liquidity (cash) to get past the near term obstacle. However, the Federal Reserve or the government can not replace the company’s revenue void created by loss of demand. In a way, the Federal Reserve is postponing the inevitable solvency crisis (defaults, bankruptcies) for some zombie companies.
If this previous paragraph confused you, don’t worry. I’ll provide an example that’s more applicable to an individual setting. Assume that your income is $5000 per month (analogous to business’s revenue). You have assets such as your car (worth $15,000), house (worth $100,000), and cash/savings ($2,000). You have liabilities such as your car that you financed (still need to pay back $10,000) and your house (still need to pay back $85,000). So, your total assets are worth: $15,000 + $100,000 + $2,000 = $117,000. Your total liabilities equal to: $10,000 + $85,000 = $95,000. Assume that you lost your job i.e. lost the $5,000 monthly income, and your monthly loan payments due is $2,500. You only have $2,000 in your bank account. Uh-oh, you are short $500; this is precisely what a liquidity crisis is. You are still solvent because you can liquidate your assets, and get $117,000 – $95,000 = $22,000. However, it would take a long time to sell those assets and generate the much needed cash. The Federal Reserve / banks / credit cards can come in and provide you the much needed $500 to get through the month, and prevent that liquidity crisis for the time being.
What would a solvency crisis look like? We can use the 2007-08 housing market bust example here. So, back to the previous example, instead of your house being worth $100,000 (asset), when you try selling it, you only get $50,000. What would your total assets and liabilities look like now? Total assets: $15,000 + $50,000 + $2,000 = $67,000. Total liabilities: $10,000 + $85,000 = $95,000. Your liabilities are greater than your assets. You are in a situation where even after liquidating all your assets, you can not pay back your liabilities (debt). Suppose you ran out of all your cash i.e. $2,000. In order for you to continue living, you decide to finance yourself via credit card debt, with the rational that once you get a job, you’ll start paying it all back. This is exactly what companies are doing right now as their revenues have dwindled; they are taking on debt to finance their existing operations. As long as liquidity is abundant, these zombie companies can continue meeting their near term obligations. However, it is important to understand that just because a company is able to survive through the economic shutdown does not mean that it’s a great company. In fact, the company probably took on large amounts of debt to keep going and get to the other side. So, in reality, the debt ridden company is in a lot worse shape now than before, when it did not have a lot of debt.
Can the Federal Reserve help resolve the solvency crisis? No, it can not. However, the Fed can certainly help delay the crisis, and make it worse (by allowing companies to take on more debt). For analogy – assume you lost your job, and are now living on your credit cards. Right when you were about to get to your maximum credit card limit, your credit card company decided to increase your limit. Your credit card company has undoubtedly saved you from declaring bankruptcy/default. However, it has not canceled all your debt – you still owe them money. Said differently, your credit card company has helped delay your solvency crisis. At the same time, it has made the situation worse because now, you owe an even greater sum than before. Lastly, by allowing you to continue taking on more debt, a larger amount of capital is destroyed when you eventually default and declare bankruptcy.
The only way to resolve a solvency crisis is by increasing your assets, and decreasing your liabilities i.e. by having greater assets than liabilities. This can happen by increasing sales, cutting costs, saving excess revenue, and paying off debt (liabilities). If you are interested, you can watch former Federal Reserve chairman, Ben Bernanke, talk about financial panic, liquidity crisis, and solvency crisis here (video clip 31). He talks about how despite access to liquidity, Lehman Brothers came under intense pressure as it could not find any buyer to its assets, and had to eventually declare bankruptcy. Lehman Brothers was a classic example of a company in solvency crisis, which ended in bankruptcy.
Hope you learned a little and found this blog post helpful. We talked about liquidity and solvency crisis. We saw how the Federal Reserve is helping push the solvency crisis farther down the road. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions. Please review the Disclaimer and Terms and Conditions.
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