Is it a liquidity or solvency crisis?

May 5th, 2008

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As you would have read by now, Warren Buffett declared that

The worst of the crisis in Wall Street is over. In terms of people with individual mortgages, there’s a lot of pain left to come.

As this Bloomberg article, Buffett Says Credit Crisis Ebbs for Wall Street Firms (Update4), reported,

Warren Buffett, chief executive officer of Berkshire Hathaway Inc., said the global credit crunch has eased for bankers, and the Federal Reserve probably averted more failures by helping to rescue Bear Stearns Cos.

Clearly, the market is in agreement with Warren Buffett, with the stock market rallying in the belief that the worst of the credit crisis is over. So, could the credit crisis be just a liquidity problem? Or is it a more serious solvency issue? What is the difference between the two?

Well, let’s use the pawnshop analogy from our previous article, Central banks and pawnshops. Let’s suppose that Tom had a big mortgage debt, recurring bills to pay and a nice well-paying job and no savings. Let’s say he resigned from his job to take up another well-paying job. The only catch is that in between these two jobs, there was a period of 2 months where he would draw no wages. Since he had no savings, this will mean that he would be unable to pay his bills and his mortgage debt repayments. Not to worry, Tom went to the pawnshop and pawned his gold jewellery for cash to pay his bills and mortgage debt. Then when his new job starts, he will draw out his salary to repay his loan from the pawnshop and redeem his gold jewellery. Tom had a liquidity problem. Fine.

What if, Tom was retrenched from his job and for the next 12 months, could not find another job? He could pawn his gold jewellery, but as long as he did not have a job, he would not have any hope of repaying his loan from the pawnshop in order to redeem his gold jewellery. The next month arrived and he had to pay that month’s bills and mortgage repayment while his gold jewellery was still stuck at the pawnshop. Tom is getting more desperate. Perhaps he can pawn his silver jewellery? Fortunately, the pawnshop was as willing as the Fed. It accepted Tom’s silver jewellery for the same amount of cash as the previous loan. Tom was saved for another month. Obviously, Tom had a solvency problem. That’s bad.

So, is the credit crisis a liquidity or solvency issue?

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