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Musings Report 2020-51 12-18-20 2021: The Difference Between Liquidity and Solvency Will Finally Matter
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2021: The Difference Between Liquidity and Solvency Will Finally Matter
2020 was another year of "nothing else matters except credit is cheaper and more available than ever."
That's what the financial media means by liquidity: money is freely available to all who wish to borrow.
(It also means the Federal Reserve stands ready to buy Treasury bonds from anyone who wants to trade their bond for cash, but that's another story.)
With credit cheap and plentiful, homeowners and corporations can refinance existing debts at lower rates, reducing their monthly debt service. This is equivalent to getting a raise / additional income, as the debtor's disposable income remaining after paying interest and principle increases as the monthly interest declines.
This has been the Federal Reserve's main trick for the past 12 years: by constantly reducing interest rates, the Fed has increased the amount of money left to borrowers after they pay debt, taxes and other essential expenses.
(Savers have been decimated by the Fed's zero interest rate policy, of course, as savings and bond yields are also near zero.)
Since the Fed can't boost actual revenues, earnings or profits, the only way it could boost disposable income was reducing the cost of debt.
With rates effectively zero and mortgages at all-time lows, there's no room left to extend this trick and keep the banking sector afloat.
One feature of liquidity is that it enables insolvent companies to stay alive by borrowing more, a.k.a. zombie companies. These are companies that don't earn enough to service their debts, but who stay among the living by borrowing more money which they use to service the interest and principle they can't pay out of revenues.
Solvency means being able to pay all expenses out of net income: for households, income after taxes, healthcare insurance, etc., and for companies, income net of production costs (materials, tools, utilities, labor, labor overhead, etc.).
If a household or company can't cover its expenses, it must draw upon savings (capital) to pay the bills. Eventually the capital is consumed and the household or business is unable to pay expenses, i.e. it is insolvent, and so it declares bankruptcy and its assets are liquidated to pay liabilities (debt, accounts payable, unpaid wages, etc.).
So an insolvent corporation can stay alive as a zombie as long as it can borrow more money to cover its debt service and other expenses. In this way, liquidity creates the illusion of solvency by covering up the reality that the business is only staying alive by digging itself deeper into debt.
Imagine a commercial office building owner whose tenants have stopped paying rent due to lockdowns and staff working at home. As long as somebody (the federal government, the Fed, etc.) is flooding the economy with liquidity and offering bailouts in the form of new loans, this business can continue to pay its enormous mortgage--not out of rents paid by tenants but out of freshly borrowed debt.
This illusion of solvency has been fueling an unprecedented bubble in stocks, bonds, real estate, bitcoin and pretty much everything else, as everyone expects the economy to reflate and every zombie to regain its previous revenue levels and become solvent.
The reality is the zombies have no way to service their existing debts except by borrowing more. Renters who are months behind in their rent payments have no way to make good on the rent that's owed and zombie companies have no way to service their debts, much less pay down their ballooning debt.
Creating the illusion of solvency has generated unrealistically rosy expectations of the real-world economy's ability to service existing debts without going deeper into debt.
The Fed has reached the limits of substituting liquidity for solvency, and the millions of households and thousands of businesses that are insolvent are lined up like dominoes awaiting the first domino to topple the entire line.
Many of the assets held by these insolvent households and companies are not worth the valuations listed on lenders' books. Taking our example of the commercial office building owner, what is that building worth if it cannot be rented at 2019-era rents? What is it worth if there is simply no demand for office space even at reduced rates of rent?
Based on the current income--near-zero--the building is a liability, not an asset, as the cost of ownership--utilities, insurance, maintenance, property taxes, business fees, etc.--are higher than the income.
In an economy in which asset valuations are based on phantom income, demand and solvency, defaults will shatter the illusion that liquidity can substitute for solvency forever. What an asset is worth will be affected by selling, both voluntary and forced liquidation.
No one knows what the value of any asset is worth in a revaluation based on solvency rather than liquidity, but it is likely to be an extreme reversal of extreme liquidity-based valuations.
Put another way: what goes up due to illusory solvency comes back down when financial realities replace illusions.
Highlights of the Blog
Podcasts:
Posts:
What Would Happen If the Fed Ceased to Exist? 12/18/20
Can 20 Years of Deflation Be Compressed into Two Years? We're About to Find Out 12/16/20
New Audiobook, New Song, Renewed Focus 12/13/20
Best Thing That Happened To Me This Week
It rained. That's good.
From Left Field
Human-made materials now outweigh Earth's entire biomass – study -- they should have included all the junk in landfills...
Quantity leads to quality (the origin of a parable) (via GFB)
How Hawaii became a playground for Silicon Valley tycoons -- Larry Ellison has moved to the island he owns 98% of, Lanai...Hawaii tax revenues will increase, though not right away, as California claims your Calif. residency lasts 18 months after you physically move away...
The Real Great Reset -- reality-based analysis....
The objective economy, part two -- follow the energy, that's what's behind the "money"...
The Social Life of Forests: Trees appear to communicate and cooperate through subterranean networks of fungi. What are they sharing with one another?
THE DARK SIDE OF SOLAR POWER -- have to add up total lifecycle costs, not just the fun part....
How North Sea Oil Shaped Britain’s Economy: 'Finance and the British state', she wrote, 'are mutually embedded to the point that it can be hard to tell where one stops and the other starts.' -- describes the US as well....
Megadrought invades the West -- the good news just keeps on coming...
This Stanford professor is confronting tech’s billionaire philosophers -- SillyCon Valley empty polo shirts and black turtlenecks....
Return of the city-state -- has the mode of production changed enough to obsolete nation-states? That's the question...
Facebook Is a Doomsday Machine (via GFB) The architecture of the modern web poses grave threats to humanity. It’s not too late to save ourselves. -- see below...
"The reason we feel alienated is because the society is infantile, trivial, and stupid. So the cost of sanity in this society is a certain level of alienation." Terence McKenna
Thanks for reading--
charles |
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