When is a Financial Company Insolvent?

Every now and then, I see a stupid post saying that a financial company is solvent if it is still making timely payments on its liabilities.  That is the Ponzi definition of solvency.  So long as there is an unclaimed dollar in the till, the financial institution is solvent.

To this I say “hooey.”  Financial institutions don’t have all that much to them.  They are just a bundle of promises.  “Parties I have lent to will pay me more than parties I have borrowed from.”  They are a bundle of longer-dated accruals.  The value of assets and liabilities can’t be firmly fixed in the same way that those of an industrial company can.  In that same sense, the current value of assets versus liabilities in a financial firm correlates highly with the trading value of its equity.

So when a financial company has a negative net worth on a fair market value basis, the odds of the common stock being wiped out is high.  Could the market come back?  Yes, but the odds are less than even.

This is my way of saying that regulators should take control of operating financial companies when the fair value of their net worth goes negative.  Like a good technical trader, honor the stop-loss.

3 Comments

  • “Every now and then, I see a stupid post saying that a financial company is solvent if it is still making timely payments on its liabilities. That is the Ponzi definition of solvency. So long as there is an unclaimed dollar in the till, the financial institution is solvent.”

    A very good point.This view might explain why Ponzi Schemes seem like an unsolvable puzzle. They mimic working investments for quite a long time, in the sense that they are making payments, which is what many investors mainly care about, not looking under the hood. My only question about Ponzi Schemes is: Where is the hood?

  • Dan says:

    And I say ‘hooey’ to anyone who believes that we can accurately establish the ‘fair market value’ of something (a bank’s assets in this case) without an orderly market–or even a market at all. And we do not have any thing close to an orderly market here; one that can be used to value the asset side of the bank’s balance sheet. That said, why should we force a bank (Citi, BofA, you fill in the name) out of business because of our estimate of the value of their assets?

    Maybe an analogy would help: Let’s say I start an electric utility with $100 million in capital. I borrow another $400 million and build a power plant for a cost of $500 million. I generate electricity and sell at a price such that the cash flow from the my power sales covers my operating expenses, my debt service and provides a return on capital. All seems well.

    One day, however, my regulator notices that another power plant, similar to mine, has recently sold for $350 million. He compares the sale price of that plant with the $500 million book cost of my plant and he realizes that if I were to put my plant up for sale at its fair market value it could wipe out all of my capital. With intended prudence, he requires that I put my power plant up for auction to determine its fair value. If it’s worth the $500 million I’m carrying it on my books for, fine; if not, it might require swift regulatory action. My plant is put up for auction and sure enough–the regulator was on to something–the auction results in a high bid (the fair market value) on my plant of only $325 million. The regulator is right: my utility is insolvent, in fact I’m really running nothing more than a Ponzi scheme. He forces the sale of my power plant; all my capital is wiped out and the bond holders receive 81 cents on the dollar (maybe 70 cents after legal fees). But we have put an end to another Ponzi scheme. Nice work!

    Is this a good idea? Is the world a safer place for stock or bond investors now? Or for the consumers of electrical power? I certainly don’t think so. Not in the case of my utility, and not for Citi or BofA either.

    But we are talking about banks, not utilities, so maybe we should use a bank analogy. Let’s say I start a bank with $10,000 in capital. I open my doors to take deposits and make loans. On the deposit side, I offer a 5-year CD at 4% and sure enough, I get a $40,000 5-year deposit for 4%. Now I need a loan. I offer a 5-year car loan for 8% (with a 10% down payment) and, bam, a very credit worthy customer borrows $50,000 from my bank for a new car that costs $55,000. I’m in business, and what a business! My deposits cost me $1,600 per year and my loan earns $4,000. Before expenses, I earn $2,400 per year on my $10,000 capital investment. All seems well.

    Before I can take in any more deposits or make any loans, however, my regulator notices that used car prices are soft and he looks closely at the asset side of my bank’s balance sheet; he’s curious about its fair market value. He sees the car loan and he reviews the recent auction prices for similar cars. Yikes! The fair value of the car is only $35,000. Sure enough, the bank is insolvent, in fact this is nothing more than another Ponzi scheme. Fortunately it’s Friday and before I can cause any more harm he closes my bank. The bank’s assets are sold at fair market value ($35,000) which wipes out my capital. The $40,000 depositor is protected by FDIC insurance so they are made whole. Net cost to the public, only $5,000–all thanks to swift regulatory action.

    Fair market accounting doesn’t work without fair markets.

  • tc says:

    Dan says: “a very credit worthy customer borrows $50,000 from my bank for a new car that costs $55,000″

    And just how do you know that this guy is credit worthy? What if you got the loan from some broker who didn’t check the borrower’s income? What if you don’t have a whole loan, but a CDO assembled out of thousands of car loans based on a mathematical model that only physicists can understand? What if your borrower was expecting to repay you by flipping his car in a market that always went up?

    The banks should have all this information – if anyone does. If they want the market to regain confidence in their assets, then why don’t they reveal what’s in them, and make everyone understand that they are money good?