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September 23, 2008

Illiquidity versus Insolvency

Some people out there need to spend more time in remedial finance. There are two things going on in the financial sector, and while they are linked, they can and should be usefully separated, at least for discussion.

We have illiquidity and we have insolvency, and they're neither always in the same places, nor necessarily at the same time. We have illiquid paper -- CDOs, RMBS, etc. etc. -- that is being marked to a non-existent market, thus creating damaging prices. There are various ways of dealing with it, one of which is goosing the market into action by purchasing some of that paper from balance sheets where it currently languishes.

Turning to insolvency, we have institutions that do not have a strong enough balance sheet to fund operations. Fannie, Freddie, AIG, Bear, Lehman, etc. Pick your favorite FDIC list failed bank of the week. These institutions are insolvent. They are, in a parrot sense, no more. Now, illiquid paper can make banks insolvent -- via the wonderful feedback loops of credit rating agencies, default swaps, etc. -- but they are not the same thing.

So, could you have a bailout in which some toxic paper is bought from some (currently) healthy banks? Of course you could. Get over it already and let's be adults about this stuff. We're trying to deal with illiquidity and insolvency, and intelligent people should be able to tell the difference, and act accordingly. We are going to have to deal with both issues repeatedly, so let's get on with it.

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