Insolvency is philosophy, illiquidity is fact

Take a look at a snippet of GM’s last-quarter balance sheet (courtesy of Yahoo! Finance). It’s the part that contains what accountants quaintly call “Shareholder Equity”:

Yes, the accounting value of the firm’s equity is negative 41.7 billion dollars. Now, answer me this. Is GM insolvent?

There is no definitive answer. It’s a philosophical question, a matter of opinion. The market says GM’s equity is worth $15B dollars. All we can say with any confidence is that GM is liquid, it has not yet failed to pay its bills, it is capable of borrowing to finance its operational needs despite a balance sheet with no vital signs. The patient walks and breathes, so it is not dead. Somehow.

There is a meme going around the blogosphere, and now the mainstream-press-o-sphere, that the Fed is helpless in the current crisis because the problem is one of solvency, not liquidity. Here’s Paul Krugman (hat tip Mark Thoma):

In past financial crises… the Fed has been able to wave its magic wand and make market turmoil disappear. But this time the magic isn’t working… Why not? Because the problem with the markets isn’t just a lack of liquidity — there’s also a fundamental problem of solvency.

Here, here, Dr. Krugman. And you too, Dr. Roubini. And Michael Shedlock. And Kevin Drum. I agree with you all. From the tiny legal entities known as asset-backed securities, way up through to a couple of large money center banks, there are a lot of entities out there which, by my Victorian standards, are simply insolvent. But by those standards, GM oughtn’t be able to fog a mirror, let alone borrow money from people. It’s the living dead, a zombie, to use a term fashionable when discussing Japan but never, ever appropriate to the hypercapitalist U.S. of A.

Can a determined central bank “wave its magic wand” and make insolvent entities solvent? I have no idea. But I do know this. A central bank can keep almost anything liquid for a long, long time. And as far as financial markets are concerned, only liquidity matters. The little theory called solvency is only relevant to the degree that it predicts liquidity, or illiquidity. Central banks can undo that relationship, if they wish to. Perhaps they wish to.

I have no idea how “aggressive” the U.S. Federal Reserve will become in trying to resolve the present crisis in credit markets. There are in norms of accounting, regulatory frameworks, laws, that might constrain it. But, central bankers have been remarkably candid in describing their willingness to circumvent these constraints in a crisis. (See here or here for examples.) With the new Term Auction Facility, the US Fed has just given itself a tool by which it can ensure the liquidity of “insolvent” assets, at prices the bank itself determines, indefinitely. Some commentators (e.g. Yves Smith) have wondered how a temporary facility, loans with a fixed term of one month, can make much difference one way or another in the liquidity of assets. The answer, of course, is that they can be rolled over (via new auctions, which are already announced for January, or by other means). The same logic that impels the initial extension of credit suggests that loans will be rolled over, must be rolled over, for as long as “crisis” continues. The Fed has bent over backwards to help out financial institutions. Once it has direct loans to those institutions on its balance sheet, it will own their problems in a way it has not until now. Will the Fed pull the plug and demand payment of a bank that says it cannot pay? Will it force a bankruptcy, as private creditors might, if the bank was in default? Is that even conceivable? The day that happens to a bank of any scale is the day you can be sure the credit crisis is no more.

I’m going to end with a bit of a cheap shot, because really, nothing is beneath me. Remember this?

The aide said that guys like me were “in what we call the reality-based community,” which he defined as people who “believe that solutions emerge from your judicious study of discernible reality… That’s not the way the world really works anymore. We’re an empire now, and when we act, we create our own reality.”

Worrying about “insolvency” is a defect of the reality-based community. For everyone else, all that matters is the price at which assets can be sold or borrowed against. The Fed can set that price, if it acts with sufficient, um, determination. Analyzing underlying cash flows is for pansies.

The latest financial innovation cooked up by the banking system might be described as “postmodern pricing”, whereby the exchange/collateral value of assets is intentionally unmoored from quaint ideas like “true” or “fundamental” value. All for the benefit of struggling homeowners and hard-working ordinary Americans, of course. If you are among the macroeconomic mainstream that has nodded along with Fed interventions to support “liquidity”, but you find this brave new world troubling, well, good. Better late than never, and you are welcome among us. Expect to be mocked. Bear it with pride.

Update History:
  • 14-Dec-2007, 5:39 p.m. EST: Replaced the awkward “I want you to take a look at…” with just “Take a look at…”
  • 14-Dec-2007, 6:15 p.m. EST: Cleaned up some wordiness (unnecessary “thus far”), added some wordiness (“help” to “help out”), inserted a missing verb to be.

6 Responses to “Insolvency is philosophy, illiquidity is fact”

  1. Andrew writes:

    Steve: I think this can be reconciled without invoking the “smoke and mirrors” (or perhaps “shock and awe”) approach of the infamous aide.

    The market value ascribed to GM shareholders represents, as I understand it, the discounted value of future cash flows accruing to shareholders. If you take the view that GM as an entity is a going concern, then provided that the future cash flows have an expected value north of zero, the shares which represent claims on this future stream of cash flows have value.

    Now, if the company were to be liquidated today, the amount of value available to shareholders would be negative (not obvious to me that anyone could require shareholders to pony up, but that’s another story). So long as there’s no precipitating event that forces the company into liquidation, the balance sheet can be brought over time into the black by translating positive future cash flows into retained earnings.

    So the question is, what manner of precipitating event might act as an insuperable obstacle between moving from the current “negative equity” position to the future restoration of financial health? For many financial institutions, it’s the demand for collateral beyond their means to stand surety for declining assets (representing declining future cash flow streams). In GM’s case, the negative retained earnings amount is related to deferred taxation, and my understanding is that this doesn’t give rise to any immediate demand for company-breaking resources from Uncle Sam.

    Still doesn’t mean GM are going to design and build great cars anytime soon though.

  2. skeptonomist writes:

    “…all that matters is the price at which assets can be sold or borrowed against.”

    True under some circumstances, such as a bubble. But the bursting of a bubble represents a return to the “reality-based” world. There is nothing new in this. Supporters of the Fed think that it can redefine reality – we will see if this can be done.

  3. dissent writes:

    How does this magic wand ‘disappear’ the foreclosure problem?

    People can’t refinance because the home is worth less than the mortgage on it. At this micro scale, busted is busted. You can keep the game going (perhaps) for banks and such, but the issue of collapse at the bottom will trickle up.

  4. All — Sorry for delayed responses!

    Andrew — I think it’s pretty hard to make a case that GM’s valuation is simply the discounted expected value of future cash flows under an “ordinary” probability distribution. Why? I haven’t done a full cashflow analyisis, but, as I recall, looking at net income as an imperfect proxy, GM earned roughly $10B during the “good” years of the 1990s. Supposing (again, imperfectly) that we can add a forward-looking cash-flow valuation to the book value of equity to come up with a “reasonable” market value, if GM could do as well as it did in the 1990s in perpetuity, it would only have a market value of 0 if the market-required real return on its stock is ~2%. That’s more like a real return requirement for government bonds than stocks. That’s particularly extraordinary for a firm that, by ordinary accounting metrics, should be liable to an illiquidity event, so the market should demand a high risk premium. The only way I can make sense of GM’s stock price is to view the downside risk as somehow capped, in which case GM’s stock might be viewed as a reasonably priced option. GM’s asset base is huge — if the world changed and it could somehow generate a strong (but unprecedented in its recent history) ROA, it’s stock would be very valuable. If you believe GM is an ordinary firm whose equity could go to zero, taking a chance on that upper-tail event is a pretty dumb idea. But if you think GM’s downside is somehow limited, that it is too big or connected to fail, then a lottery ticket with small downside and high upside might be valuable. So, the core question is, does a firm that depends upon creditors to lend more than $100B with accounting book value of -$40B face or fail to face risk of what you call a “precipitating event”. Any smaller, less-storied firm with this balance sheet (proportionally) would have already faced such an event. If you think it won’t happen, why not?

    skeptonomist — Regardless of whether we are in a bubble or its bursting, I think it is true that “…all that matters is the price at which assets can be sold or borrowed against.” Ordinarily, though, during the crash this price quickly falls. My conjecture is that the Fed, if it wishes to, can support asset prices, and thereby hold the bubble in suspended animation. I’m with you that the Fed can’t redefine reality, the damage to the real economy has been done and is ongoing. But it can target financial prices as it wishes, and help certain players (at the hidden expense of others). That’s all I’m suggesting it may do.

    dissent — “How does this magic wand ‘disappear’ the foreclosure problem? ” It doesn’t, and I agree that, “the issue of collapse at the bottom will trickle up.” But, the Fed will say, “the foreclosure crisis will be worse if there is freeze-up of the financial system because of it”, and act to forestall the former. The whole US financial system has been like a kind of anaesthesia to the US economy, making the world seem okay and pleasant while imbalances and misallocations caused great harm underneath. Bailing out banks only keeps the anaesthesia going a few minutes longer. But, the bankers don’t see it that way, if the numbers on their screens look good, the world is good, by definition, efficient markets and sophisticated financial institutions and all of that. So, they will target the numbers on their screens and ignore the rest, until they no longer can.

  5. The term “zombie” was used in the US between 1979 and 1983. It referred to the “zombie thrifts” that the Office of Thrift Supervision refused to close even though they were clearly insolvent.

  6. IA — Good to know, and very a propos!