Is This A Liquidity Crisis Or A Solvency Crisis? It Matters To Fed (#GotBitcoin?)
If central bank is too concerned about getting its money back, it may shun weaker companies. Is This A Liquidity Crisis Or A Solvency Crisis? It Matters To Fed (#GotBitcoin?)
Is the economy facing a liquidity crisis, or a solvency crisis? The distinction will determine how important the Federal Reserve is to returning the economy to health.
In a liquidity crisis, otherwise healthy firms collapse because they can’t access credit. The Fed can resolve such a crisis because it can print and lend unlimited amounts of money. In a solvency crisis, companies can’t survive no matter how much they can borrow: they need more revenue. The Fed can’t solve that.
Fed Chairman Jerome Powell underlined the distinction Wednesday. The central bank had directed aid to sectors “where we have never been before and…quite aggressively,” he said at a news conference after the central bank’s policy meeting.
“Nonetheless these are lending powers. We can’t lend to insolvent companies. We can’t make grants.”
Is that lending enough to save the economy? The stock market seems to think so. The S&P 500 Index is down just 13% from its pre-pandemic level. By preventing illiquid companies from going bankrupt, the market seems to believe the Fed has set the stage for a brisk economic recovery once the coronavirus pandemic eases.
Investors may have conferred more power on the Fed than the Fed believes it has. Mr. Powell urged Congress to appropriate more money to aid potentially insolvent firms and the unemployed. “This is the time to use the great fiscal power of the United States to do what we can to support the economy,” he said.
The Fed was created to deal with one specific type of liquidity crisis: runs on banks. A bank in need of cash to meet deposit withdrawals could borrow from the Fed. In the 2008 global financial crisis, the Fed made itself “lender of last resort” to a much wider range of financial institutions and markets. It made money on those loans, which shows the recipients were, in fact, solvent.
In 2012, the European Central Bank’s then-president Mario Draghi provided history’s most vivid demonstration of central bank power by promising to do “whatever it takes” to save the euro. Investors correctly inferred that meant lending to heavily indebted countries such as Italy and Spain, which were being locked out of bond markets. Investors quickly resumed buying Spanish and Italian debt, before the ECB had spent a penny.
The Fed’s response to the coronavirus pandemic has been similar. When yields on Treasurys and mortgage-backed bonds spiked, the Fed brought them down with a flood of buying. When investors started to shun corporate debt, the Fed promised to buy it through special programs backstopped by the Treasury department. The spread on yields between investment-grade corporate bonds and Treasurys has since shrunk by about half, without the Fed buying any corporate bonds.
“It’s not just the actual lending we do,” Mr. Powell explained. “We build confidence in the market, and private market participants come in, and many companies that would have had to come to the Fed have now been able to finance themselves privately.”
Still, the companies able to issue bonds are those that are widely seen as solvent. A much bigger challenge looms: the many companies that were profitable before the pandemic and should be again when the pandemic has passed, but may not survive that long. Providing them with cash should pay economic dividends in terms of protecting jobs and incomes, but such a move is complicated by the question of whether the firms are illiquid or insolvent.
For small business, Congress chose to ignore the distinction by offering $660 billion in loans that don’t have to be repaid if they meet certain conditions. By contrast, the Fed’s Main Street loans, to which $600 billion has been allotted, are supposed to be repaid. If the Fed is too concerned about getting the money back, it may shun the weaker companies where the money will make the biggest difference. Congress provided the Fed with $454 billion of capital, presumably to make it easier to make potentially money-losing loans. Asked how much risk the Fed was willing to take with that money, Mr. Powell demurred: “That is really a question for the Treasury.”
Difference Between Liquidity Crisis And Solvency Crisis
What Is The Difference Between A Liquidity Issue And Solvency Issue?
A liquidity issue (crisis) occurs when a firm (or country) has a temporary cash flow problem. Its assets are greater than its debts, but some assets are illiquid (e.g. it takes a long time to sell a house. A bank can’t suddenly demand a mortgage loan back) Therefore, although in theory assets are greater than debts, it can’t meet its current payment requirements.
* A solvency crisis occurs when a country has debts that it can’t meet through its assets. i.e. even if it could sell all its assets, it would still be unable to repay its debts.
* To be insolvent is much more serious because even if you have access to temporary funds it can’t solve the underlying problem of excess debts.
Definition Of Liquidity: Capable Of Covering Current Liabilities Quickly With Current Assets
Definition Of Solvency: Ability Of A Business To Have Enough Assets To Cover Its Liabilities
Example of Solvency Crisis
When Lehman Brothers went under, its debts (liabilities) were much greater than its assets. Therefore, even though it had access to temporary funds from the Federal Reserve, this access to liquidity couldn’t solve the underlying problem that it couldn’t meet its liabilities.
Example of Greece – Insolvency
Arguably, the debt Greece faces means that it is insolvent. It’s debt to GDP is so large that there is little chance Greece could pay off its debts from current tax revenue. Therefore, it will have to default on at least part of its debt and receive bailout funds.
Another example could be a country which faces a liquidity crisis. For example, suppose a country in the Eurozone has debt to GDP ratio of around 60%. With positive economic growth, this kind of debt should be manageable; they should be able to pay it off.
However, if there was a fall in confidence in bond markets, one month the country may be unable to sell sufficient bonds. The country might have some illiquid assets (e.g. islands, national treasures it could sell) but the problem is that in the short term, it can’t gain sufficient finance to meet its current expenditure. Therefore, it is experiencing liquidity issues.
In 2012, there was a crisis of confidence in the Eurozone. It started with evidence Greece was insolvent. Investors no longer wanted to hold Greek bonds and so the yield on bonds rose rapidly – getting close to 30% – indicating it was seen as ‘junk bond’ with little hope of getting money back.
Because of uncertainties over Greece and recession in rest of Eurozone investors became nervous of holding debt in other Eurozone economies, such as Ireland, Portugal and Spain. These countries were not insolvent, but they had no Central Bank to print money and buy bonds.
Central Bank Can Provide Liquidity
A country like the UK can easily avoid liquidity issues by having a Central Bank who is willing to print money and buy bonds where necessary. This means that if the UK sold insufficient bonds one month, the Central Bank could intervene to provide liquidity.
A Central Bank can help avoid temporary liquidity shortages, but it wouldn’t be a solution if debt levels were fundamentally unsustainable and the country was insolvent.
For example, in 2008, the Zimbabwe economy was bankrupt by falling demand and shortages of goods. In response, the government printed more money – but this only caused hyperinflation and did not solve the fundamental problem
Liquidity crisis can cause solvency issues
Arguably, if countries face liquidity shortages (e.g. no access to liquidity in the Eurozone because there is no Central Bank to buy bonds) this could lead to solvency issues in the long term. Because markets fear illiquidity, bond yields rise. This causes:
Higher interest payments making it harder to repay actual debt.
It also forces governments into austerity measures which lead to lower growth and can make it very difficult to achieve a positive rate of growth and repay the debt in the long-term.
Therefore access to liquidity can help, but it can’t solve a fundamental situation of insolvency.
Speaking of Insolvent…..
A Nation of Zombie Borrowers Isn’t Inevitable—Even With More Debt
Governments and central banks are correct in trying to extend credit to companies that were already loaded up.
Can you cure a debt problem with more debt?
Governments and central banks everywhere are in the process of trying to do exactly that: extend more credit to companies that were already loaded up with plenty of it. With some caveats, they are right to do so—and truly radical action being tested in Europe could overcome even these drawbacks.
This sounds like it makes no sense. Put simply, a company that generates less cash than it has to pay in interest is bust, and adding more debt means adding on still more interest. If a company can’t repay a loan when it matures, it is also bust, and more debt means a bigger amount to repay at the end.
There are three ways new lending can fix this, and all are being used: refinancing at a lower rate, deferring interest to repay in the future and extending debt or making it easier to get a replacement loan at maturity. The caveats are that more debt makes the entire economy more at risk from any rise in interest rates, and that companies might be saved only to turn into the living dead—zombies forced to use all their cash to service their debt.
Lower rates help immediately by reducing interest costs and come from a mix of direct Federal Reserve rate cuts, discounted lending directly to companies by both government agencies and the Fed, and the Fed’s planned purchase of corporate bonds, bringing yields back down.
Many banks are offering deferral of interest on credit cards, car loans and some small-business loans (along with some government-backed business loans). The interest still has to be paid, but not for several months, when, one hopes, the economy will be improving again. It’s harder in the corporate bond market, where only a handful of issuers gave themselves an option to roll up the interest and pay it at maturity. Such a “payment-in-kind toggle” was included in only $4.2 billion of new bonds last year, according to Dealogic. The rest need to renegotiate terms or turn to the government for support.
Finally, extending a loan is a classic tactic for a troubled business, while even healthy companies can rarely afford to pay off all their debt when it matures. This is one reason the Fed is intervening so aggressively to keep the corporate bond market open, as an inability to repay old debt with new debt would force large numbers of solid companies into the bankruptcy courts.
All of this helps keep companies alive. And lower rates do even more, turning Fed liquidity into corporate solvency: The interest savings translate into higher profits and so a stronger balance sheet for the troubled company.
The danger is zombies. Lower rates enough, and you might animate a dead company—but not so much that it’s actually alive. The result is a company using all its cash to pay interest. It will merely limp along, unable to invest for the future or ever repay its debts.
Zombification is a real risk, not just now but in any effort to save a company by cutting rates. Advocates of creative destruction argue it would be better to let the zombies die and reallocate their workers and capital to more-productive uses.
It is true that creative destruction is capitalism at its best—in normal times. These are not normal times. Allowing companies to limp along holds out the hope that when the coronavirus pandemic recedes their revenues will improve and they will be revivified, albeit with weaker growth prospects than before they were loaded down with debt. Frankly, we all have to get used to that after months of economic collapse.
Not every zombie can be saved. The retailer Neiman Marcus was already close to being one of the walking dead before its bankruptcy filing, loaded down with debt that consumed most of its income. It has only been a year since it restructured its debt to gain breathing space for a planned three-year recovery, strangled by the lockdown.
Undoubtedly all the new debt will create new zombies, which will eventually have to be dealt with. But spreading out corporate failures over time is better than having them all at once, because the economy can better reallocate resources when it is growing. The sudden shock of a mass of bankruptcies all at once would hammer demand and risk a downward spiral into depression. Banks are being encouraged to “extend and pretend”—giving borrowers more time to pay and pretending they are still creditworthy—precisely to avoid adding another shock to a struggling economy.
Central banks can go further. Lower rates improve the profits (or reduce the losses) of borrowers, but negative rates transfer money from savers to borrowers. So far only a few of the best-rated companies in Europe, the region with the lowest rates, can borrow at below zero, but the European Central Bank is already experimenting with the next step: borrowing rates lower than deposit rates.
For now the gap is small, with the ECB’s best borrowing rate under new term loans to banks being minus 1%, for those that meet certain conditions, compared with a deposit rate of minus 0.5%. It isn’t nothing: Italian banks’ profits will get a 10% boost from the rate inversion, according to Frederik Ducrozet, a global strategist at Pictet Wealth Management. A widened gap would help banks more, and if the ECB insisted on the lower borrowing rates being passed on it could help nonbank borrowers too. Liquidity would be transformed directly into solvency.
The danger is that central banks handing out money doesn’t just cure the zombies, but creates inflation. That’s not a problem for now, and as M&G fund manager Eric Lonergan says, it is easy to fix: “If by a miracle we do too much, it’s not a problem: you just raise taxes.”