Bulls, Bears, Pigs » macro

Liquidity vs. Solvency – What’s the difference? Why does it matter?

bbp — Tue, 16 Dec 2008 05:33:10 +0000

As more and more people become bullish on this market and the economy, I think it is a great time for a sanity check. Will the economic environment be a lot better or worse 12 months from now? Bulls will tell you that we put in a market bottom in November and that all the indicators of fear were near or at all-time highs, a good sign of a bottom. They will also argue that, with all the stimulus being poured in around the world by governments and central banks, the world economy will stabilize in the coming year and the stock market is rising in advance of that. Bears, on the other hand, argue that the economic situation is bad and only getting worse. Employment, consumption, and industrial production are falling off a cliff. They claim that corporate earnings in 2009 will be worse than 2008 and there will be no V-shaped recovery in 2010 if there is any at all. So, who’s right?

First, I think it’s important for all to understand two key terms: liquidity and solvency.
From Merriam-Webster:

Main Entry:¹liq·uid

Pronunciation: \ˈli-kwəd\

Function: adjective

Etymology: Middle English, from Middle French liquide, from Latin liquidus, from liquēre to be fluid; akin to Latin lixa water, lye, and perhaps to Old Irish fliuch damp

Date: 14th century

1: flowing freely like water
2: having the properties of a liquid : being neither solid nor gaseous
3 a: shining and clear liquid eyes> b: being musical and free of harshness in sound c: smooth and unconstrained in movement d: articulated without friction and capable of being prolonged like a vowel liquid consonant>
4 a: consisting of or capable of ready conversion into cash <liquid assets> b: capable of covering current liabilities quickly with current assets
— li·quid·i·ty \li-ˈkwi-də-tē\ noun

Main Entry:¹sol·vent

Pronunciation: \-vənt\

Function: adjective

Etymology: Latin solvent-, solvens, present participle of solvere to dissolve, pay

Date: 1630

1 : able to pay all legal debts solvent company>
2 : that dissolves or can dissolve <solvent action of water>

Now, let’s examine a liquidity problem and a solvency problem separately.
Company A lists as assets a warehouse worth $50,000, inventory worth $20,000 and $10,000 in cash in their bank account. Furthermore, Company A lists as liabilities only a $35,000 loan maturing next month. Clearly, we can see that Company A has more than enough assets to cover its liabilities. In fact, Company A has a positive net worth of $45,000 (80,000 – 35,000). However, they are going to run into a problem raising the money they need to pay off the loan because their warehouse and inventory are not liquid assets i.e. easily convertible to cash. You’ll also notice that there are degrees of liquidity for assets – inventory being more liquid than real estate. This is a classic liquidity problem. Sometimes, a solution can’t be found and a company may be forced to liquidate assets. Usually, a workaround (such as a temporary loan using the warehouse as collateral) will allow the company to remain in business. If this sounds a lot like what the Fed is doing.. well, it is. They are accepting all sorts of new collateral from banks for cash. The cash allows banks to continue on with their business. Actually, the Fed and central banks around the world have essentially drowned the world in a sea of liquidity. Cheap money is available for all at low rates. Our problems are solved, right? Not so fast.
Let’s look at Company B. For simplicity, Company B has the exact same balance sheet as Company A. Let’s say that Company B had bad risk managers and didn’t buy insurance and last week a flood washed away their warehouse and most of the inventory. Well, now Company B has $10,000 in cash left and a $35,000 loan to pay. This is a solvency problem and it’s bad. Generally, companies that are insolvent are forced into bankruptcy.

If you didn’t understand why Lehman went under despite having access to the Fed’s funding sources, well now you know. They didn’t have a liquidity problem; they had a solvency problem. All the assets on their balance sheets were essentially washed away in a flood and they could no longer cover their debts. Every writedown you hear about in the news is the revaluation of assets on balance sheets at a lower level. It brings companies closer and closer to an insolvency position. The scary thing is that no one can really believe what anyone says about the value of their assets because they are all marking their books to fantasy valuations. Take for example Lehman Brothers and their magical loss of billions in value from the day before bankruptcy to the day after.

The TARP is attempting to address solvency problems by directly injecting capital into the banks to increase their capital ratios. The Fed, however, has only been providing liquidity through all their programs – TAF, PDCF, etc.

After thinking about it, it seems clear to me that no amount of liquidity solves the solvency problems in our economy. Banks are insolvent. Consumers are insolvent. Corporations are insolvent. This is what happens when there is too much leverage in the system and your equity cushion gets wiped out. Mainly for this reason, I think we have a lot more pain to endure on the downside in the stock market and I think the economy will end up being much worse than people would like to believe. The only solution as far as I can tell is allowing bankruptcies to occur and not bailing everyone out and pushing judgment day into the future. Government can provide stimulus to attempt to stabilize the economy but they shouldn’t allow the zombie corporations to live on. It will be painful but when the dust settles, we will be a lot stronger for it.

Let’s Get Something Straight

bbp — Tue, 11 Nov 2008 04:19:10 +0000

“Persecution is the first law of society because it is always easier to suppress criticism than to meet it” – Howard Mumford Jones

Over the past year, there has been an outcry from company executives and the investing public about short-selling. Short sellers have been blamed for reaping profits from the downfall of good companies with their “bear raids” and “rumor mongering” while John Doe is left to suffer the losses. And if you believe that, you probably think that Bear Stearns and Lehman were fine institutions that would have prospered if not for those nasty bears. In an effort to educate the general public, I am going to discuss the mechanics of a short transaction, the rationale behind a short transaction, the benefits provided by short sellers to the markets, and why blaming short sellers for your losses is simply “passing the buck” and not taking responsibility for your own poor investment analysis. (See my article on taking control of your money and your life.)

1. Mechanics of a short transaction
The first question I always get is “How can you sell something you don’t own?” Well, let’s take a step back and examine a regular buy and sell transaction. First, assume that every share of XYZ stock is issued on a stock certificate. When you buy 100 shares of XYZ at $10 in the market, you send $1,000 and in exchange 100 XYZ stock certificates are sent to you. The following week XYZ is selling for $15 and you decide to sell your stock certificates. You send your 100 XYZ stock certificates to the buyer in exchange for $1,500 (nice trade!) This is not only pretty easy to understand it is also what happens when you buy stock except that the stock certificates are usually held at your broker. So, now let’s look at a sell short and buy to cover transaction. XYZ is trading at $25 in the market and you feel that the price is too high. You go to your broker and ask them if you can borrow 100 shares of XYZ that you will return to them at a later date. IF, and only IF, your broker is in possession of someone else’s stock certificates, they can lend them to you. Once you are lent the shares you can sell them (the shares you have borrowed from your broker) in exchange for $2,500 cash which goes into your account. The next week, XYZ is trading at $15 and you go back to the market and spend $1,500 to buy back 100 shares. You return the 100 borrowed shares to your broker and pocket the $1,000. This is how it works. As for “naked” short selling (shorting without first finding someone to borrow shares from), this has been illegal for years and continues to be illegal. I do not endorse it and no legitimate short seller practices it.

2. Why do it?
This is a personal preference question mostly. However, my answer is that it provides flexibility. If a stock is not cheap enough to buy, it may be expensive enough to short. You have effectively doubled your pool of investment options in equities. Oftentimes, the best shorts are companies that are frauds (think Enron), fads (Crocs and Heelys), and failing business models (Sirf, Sierra Wireless, Novatel). If you a smart enough investor to do the homework and realize that the value being ascribed to a company is fair beyond its intrinsic value, why shouldn’t you be allowed to profit from it?

3. What’s the benefit?
Short sellers provide a few benefits. First, they act as a check on promotional/fraudulent management. They make Dick Fuld and Jimmy Cayne back up their comments that their firms are fine (Lehman and Bear were fine the day before they went under.) Second, they provide liquidity that would otherwise not exist. This point is easy to make in the current market circumstances where the lack of bids and offers is making trading much more difficult. Third, short sellers provide natural future buyers. If you remove short selling from a market , you can effectively remove all bids. If you want proof, ask China. They saw their market go down 75% from the peak in a straight line essentially and they didn’t allow short selling either. I blame Christopher Cox and the SEC for creating an air pocket in September by banning short selling in financials that exacerbated the fall in October.

4. Caveat Emptor
The worst consequence of all this “shoot the messenger” talk is that people feel comfortable blaming short sellers for their losses in the market. Instead of taking responsibility for their losses or poor analysis, they feel they can attack those that have actually done some work. That is capitalism at its worst. Short sellers are providing a service to everyone by keeping markets honest – Warren Buffett has said as much if you need me to appeal to a higher authority.

I leave you with this thought: Of all the CEOs that have publicly complained about short sellers driving their stock price down, how many of them had a real business when the truth was finally out? Here’s a list to start your research with — LEH, BSC, ENRN, OSTK. If a company has an intrinsic value and a real business model, short selling can do nothing more than temporarily distort the value. So whether you choose to employ short strategies or not, please understand that it’s nothing personal. It’s valuation at work.

Of debts, deflations, and depressions

bbp — Wed, 05 Nov 2008 03:11:36 +0000

In 1933, Irving Fisher, possibly the first celebrity economist, published his paper titled “The Debt-Deflation Theory of Great Depressions. ” A thorough reading of which should be required by anyone who wants to talk intelligently about our current crisis. I believe that not only does it address the causes and effects of depressions but also discusses possible solutions.

As for causes, Fisher believes there are two major factors that lead to a major depression as opposed to a run-of-the-mill slowdown in the business cycle: over-indebtedness and deflation. He believes that other factors can play a role in business cycles but they are basically secondary factors when it comes to real economic upheaval. Over-indebtedness and deflation are the main players in any extended economic downtown. He cites 1837, 1873, and 1929-1933. (I encourage you to read about these periods in history on Wikipedia.) He then lays out the effects, which an astute reader will see are quite applicable to today.

Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress setting and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a ” capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to (7) Pessimism and loss of confidence, which in turn lead to (8) Hoarding and slowing down still more the velocity of circulation.
The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.
Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

Now, it shouldn’t take very much to see that our over-indebtedness during this past cycle arose from expectations of large increases in the price in real estate. A broader statement would be that over the past ten years investors of all types (individual, corporate, government) have been willing to leverage their balance sheets in expectations of a better return on their investment. However, these same investors were not being adequately compensated for the risks they were taking. And now, we find ourselves in the midst of a massive deleveraging. And of his list of nine items, we can pretty confidently say that most, if not all, are playing out.

So, are we screwed? Is The Great Depression II about to begin? Well, let’s look at what Fisher views as the solution.

Unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-33 (namely when the more the debtors pay the more they owe) tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost universal bankruptcy, the indebted-ness must cease to grow greater and begin to grow less. Then comes recovery and a tendency for a new boom-depression sequence. This is the so-called “natural” way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.
On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.

Fisher’s solution is simply reflation. If this sounds a lot like the playbook that Bernanke and the Fed are using, that’s because it is. It’s no secret that Bernanke has a profound understanding of the Great Depression. He has already lowered interest rates to 1% and provided liquidity to the markets in creative ways. He and Hank Paulson are trying to incentivize banks to lend again so that we can rebuild confidence in the system. With all that being said, it remains to be seen if any of this will work. Fisher wrote his paper in 1933 and thought we were emerging from the Depression then but it took a few more years. There is still a lot of pain to come for this economy in the near term. There are many years of excesses to be wrung out but we can take some solace in the fact that policy makers are studying their history books.

A View on the Recapitalization of Banks

bbp — Sun, 12 Oct 2008 23:48:01 +0000

After a tumultuous few weeks in the credit and equity markets, it seems that the US Treasury and Federal Reserve are finally on the right track. After some ridiculous jawboning about buying toxic mortgage securities above market prices, they have decided to use the Swedish playbook from the 1990s banking crisis in Scandinavia. This involves several steps:

1. Injection of equity capital into the banking system

2. Providing confidence in the banking system to investors by providing transparent marks to illiquid securities

3. Taking equity stakes in firms that are strong enough to survive and liquidating those that aren’t – this helps to remove moral hazard because there is a serious price to pay if you want to remain in business and you are a financial company

4. Providing incentives to banks to lend their newfound capital

For more information, I will point you in the direction of the Fed’s paper located at this link: Cleveland Fed Policy Paper

I think that investors, and the public in general, should breathe a sigh of relief. We have yet to deal with the recession that is coming but our policy makers are, for once, doing the right things to keep the foundation of our economy strong.