“It’s not a solvency problem; it’s a liquidity problem.”  So many people say regarding some financial firms that are on the ropes.  I’ve never liked that way of expressing the problem.  Let me explain why.

When does a firm typically default?  When they run out of liquidity.  True, some firms voluntarily file for bankruptcy when they see that their assets are worth less than their liabilities, and don’t see any way out.  Some firms are forced to file for bankruptcy when they trip a debt covenant.  But most firms that find their net worth slouching into, or slouching deeper into negativity don’t file for bankruptcy.  They play for time.

They hold an option with an uncertain expiry date.  When will we run out of cash?  Any way to conserve cash or sell off assets could lengthen the time to expiry, and maybe, just maybe, the economy will turn, or the pricing cycle will turn for the products, or enough other firms will fail, that the remaining liquidity lowers financing rates enough that the company can re-liquefy and survive.

The thing is, a company’s liquidity only becomes an issue when its ability to generate cash flow adequate to service creditors is questionable.  A company can say all it wants, “But we have valuable assets.  We’re not near insolvency!”  Fine.  Sell some of those valuable assets and generate liquidity.  “But it’s a bad market, we don’t want to hit low bids.”  This explains why the solvency as well as liquidity is questioned.  The assets aren’t worth as much as previously imagined.  Perhaps on a fair value basis, during the period of stress, net worth is negative.

Will the banks extend short term loans against unencumbered assets?  Can the firm do a private placement with some prize asset as security? No?  Perhaps the assets are worth considerably less than thought.  A healthy premium of the value of assets over liabilities will almost always be able to attract financing.  But when you are close to the line in a bad environment, any small premium will seem like an illusion to lenders.

So, in a large majority of cases, if there are liquidity problems, it is because there are solvency problems as well.  Here’s one more test: if a firm is suffering from low liquidity, but has valuable assets, why not sell out to another public firm, or go private, and let private equity solve the liquidity problem?  After all, they would like to buy valuable assets at a discount, right?  Right?!

Well, I would hope so, but during bad periods in the credit cycle, that doesn’t happen often.  So, the way I think is this: most hard liquidity problems are solvency problems, and vice-versa.  They are non-identical twins that don’t stray very far from each other.

Okay, that was theory, now for practice.  Credit sensitive financials have been getting whacked lately, and deservedly so.  Here are the examples:

• AIG: a complex organization that needs to become less complex.  What are the assets worth versus the liabilities?  Incalculable.
• The bond spreads of a lot of regional banks are deep in junk bond territory even if their ratings are not.  Will some large banks default?  I hope not, but I think so.
• El-Erian of PIMCO comments on the same phenomenon in an interview with Bloomberg.  (Much more is talked about in the interview.  Bright guy, what can I say?)
• Another way of viewing the problem is that bank holding companies are often dependent on dividends from their downstream operating bank subsidiaries.  At this point in time, it is difficult for those subsidiaries to upstream cash to the holding companies.  No surprise then, that many banks are facing higher borrowing costs as they try to roll over maturing bonds.
• Since a large amount of recent investment grade corporate debt issuance has been from financial companies, it is no surprise that the spreads on default swap indexes are near recent highs.  To have a truly diversified corporate bond portfolio now, one would have to underweight financials in a significant way.

My examples should confirm to you that insolvency and illiquidity are closely related.  In my investing, I like owning companies that are not playing it too close to the line.  In bad economic environments, the line moves, and companies that thought they could survive can’t.  A warning to all of us who invest, and to those who manage companies: play it safe.  Never take risks that could endanged the franchise, and don’t invest in companies that do so.