Sunday, March 11, 2012

Crisis Basics: Solvency Crisis Vs. Liquidity Crisis

Let us understand what a solvency crisis and liquidity crisis are.

A Liquidity Crisis
Here is a popular example that was given in past few years. “A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 deposit back to the tourist.” This is a liquidity crisis.

Point to note:
  1. All people were in debt. The size of debt is immaterial. The hotel manager could have had debt of $1million to various vendors.
  2. The debt was used to create value. That, is the most important aspect of this debt.
  3. The value dominoes were stalled because of lack of liquidity which the tourist provided.
A solvency crisis
Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

Points to note:
  1. Debt was created just as in previous case.
  2. Debt was deployed to non-productive ventures. In this example Madoff drank-off all the wine. It means value was destroyed.
  3. The debt domino does not stall easily in this case unless doubt creeps into the mind of the restauranteur.
Therefore
  1. Now clearly solvency crisis seems bad one. If only we had someone who could tell the restauranteur that Madoff was a crook. That someone, in many cases, should have been the ratings agency.
  2. Whenever there are debts, there are also bad debts. Good debts are deployed towards creating value higher than the value of the debt. 
  3. This begs further explanation. Let us assume an entrepreneur takes $100 of debt @ interest rate of 10% per annum. This debt is employed to do work that ideally produces output greater than $110 in one year. Thus, debt of $100 creates, let us say, $130 of value. Then we say that debt of $100 create $10 of value for the creditor and $20 value for the entrepreneur. 
  4. From the creditor's perspective, let us say the creditor makes 100 such loans. So the total debt is $10,000. Potential value it should create for the creditor = $1000. 
  5. Now imagine one entrepreneur fails and loses everything. 
  6. From the creditor's point of view there is not yet a problem as other 99 loans are good. The creditor will lose $100 of capital and $10 of interest. Thus, the creditor will earn $890 in that year. In technical parlance we would say, the creditor had write-off of $110.
  7. Solvency crisis happens with size of bad debts is higher than the value created by good debt.
The problem of misdiagnosing a solvency crisis as a liquidity crisis
The authorities tend to pump in more money to solve what they term, rightly or wrongly, as a liquidity crisis. The money often goes to Madoffs of the world who disappear with the money. The problem gets compounded when a solvency problem is thought to be a liquidity problem.  This actually increases the level of bad-debts in the system.

The way out of the solvency crisis 
There are various ways out of solvency crisis, each dependent on the size and structure of the problem. 
  1. One way out is to write off the debt and start afresh. Everyone takes a hit and blames their naivety and goes back to work. 
    • This is relatively easy when the size of the problem is relatively small, as in our example above. 
    • There is a problem with relative size of bad debt is colossal. In such cases, creditors need to be wound down in a systematic manner. At the same time, the resulting recession has to be managed by promoting employment and counter-recession measures.
  2. Textbook way is a little different. Technically, it is possible to increase the level of the good debt to such an extent that the bad debt can be written off without any problem. There are two ways to create good debt. 
    • First, by reducing interest rate marginally bad debt can become good debt. It is interesting to note that the first approach works only if the amount of bad loans is uncomfortable but not catastrophic like we had in 2007. In other words, the difference between good and bad debt has a bearing on effectiveness of this approach. Monetarist do not agree with this pre-condition. They believe this approach can work for any difference between good and bad debt.
    • Second, by pumping in additional money into the system. The additional money, ideally, will create value that will dwarf the losses from bad debts. This is like making a line smaller by drawing a longer line beside it. The second approach only works when you have body of projects that can absorb the new capital and still be classified as good debt. The gains from these projects must be quick and substantial. For example, if by some stroke of policy we can quadruple the exports then debt required to fund that policy can become this text-book solution.
  3. The third way of escaping a solvency crisis is what I call the Chinese-bank way. In this mechanism, you combine all bad debts, distressed assets into a special purpose vehicle. This cleans up the balance-sheet of corporates holding those assets in first place giving them room to borrow and invest in their businesses. The special purpose vehicle is then backed by government whose solvency, ideally, is not a problem. Over a period of time as industry grows back into a healthy state, government offloads its stake in SPV to the markets which digest these debts. 
    1. Naturally, these bad debts are a little different from other bad debts. These bad debts must be productive under some conditions, which are denied because of the impending crisis and may return when the crises abates.
    2. If government is holding really bad bad-debts then it can write-off the SPV investment and claim the debts as taxes either from public or corporates at later date.

In sum
We can notice that quite a few ways for countering this crisis have been tried. We haven't had much success. As stated, half-hearted attempts to solve the problem compound this problem, thus, we are in a bigger soup. Let us hope, further solutions are better managed.