Punchinello’s Chronicles

September 29, 2008

Liquidity and Solvency

Filed under: Word of the Day — Punchinello @ 3:21 pm
Tags: , , ,

I’m not an economist, I just really like words and language. It happens that at the moment I’m reading some books about economics. I like to read a lot, too. This latest spate of economic information has got me thinking a whole lot about globalization, what causes business changes, history, and so forth. It’s also just weird that we’re having such huge economic turmoil at the same time.

Two words we hear a lot about in relation to banks and corporations, are “liquidity” and “solvency.” These relate to “assets.” An asset is a thing you can own. It has a value in that others will exchange value for that asset. Assets can be tangible or intangible, meaning you can drop it on your foot or you can picture it in your imagination. A house is an asset, but a software license is also an asset.

So-called human assets are people who are valuable in some way. Employees in a company are valuable because they do work. Sadly, using the term “asset” to describe living human beings has led business accountants into some pretty scary places.

Being “liquid” means that an asset can quickly be sold in the current marketplace. When sold, it also holds pretty much the same value. It’s easy to convert one thing into something else of equal value. In a lot of ways, bartering works on liquid assets and liquidity. If you have a peanut butter sandwich and don’t particularly want it, but someone else has a ham sandwich, you can exchange the two sandwiches.

If you’re at lunch and everyone in the cafeteria is hungry, then sandwiches are liquid assets. There’s a market for food at that time, and people will exchange one asset for another. The only qualification is that you have to own a sandwich or other food asset. Big problems show up if you own an asset and there isn’t a market for that thing. That’s what’s going on at the moment in the real estate business.

Solvency, on the other hand, has to do with borrowing and how much you’re worth. In theory, the value (worth) of the stuff you own has to equal or be more than the amount you’ve borrowed. This works the other way too, in that the amount of money and assets in a bank must equal the amount of loans they’ve made.

“Collateral” is something of value that you own, for which you’re willing to sign over ownership rights in exchange for money (a loan). It’s a “security.” You’re saying that the money and your promise to pay it back is secure because if you fail to pay it back, the lender can take your collateral and sell it. Another real estate problem is that houses that used to be liquid collateral, now aren’t liquid. They’re not easy to sell, so if you don’t pay back your loan, the bank can’t exchange your house for cash.

In many ways, being solvent is a lot like having credibility — being believable. That’s why people are talking about this bail-out program being necessary to “maintain credibility in America’s banking system.” To be solvent, a bank or company should have enough liquid assets that they can give all depositors their money at any given moment.

Banking laws allow banks, these days, to keep in the vault only a fraction of the amount of real money they’ve been given to store. If I deposit $100 in the bank, they need only keep maybe a couple of bucks and can lend out maybe $85 when it’s all finagled around. When I show up and ask for my $100, the only reason they can give it to me is because YOU and forty other folks have also put money into the same bank.

Banks hope that at any given time, only one or two people will want their money out of the vault. They shift money back and forth between depositors, to cover the “demands” of one or two who want to withdraw money. A “run” on a bank is when everyone shows up wanting their money at the same time.

When a bank is insolvent (not solvent), they simply don’t have the money to cover all their financial obligations. At that time, they shut down or the FDIC insurance company steps in and gives small depositors their money.

You’re solvent when you sell more than you buy and store up money. You’re insolvent when you buy more than you can pay for. Right now, America (as a store) is insolvent for the most part. Thankfully, America is NOT a store in the normal sense. And so we can live on debt for a long time. The problem, though, is that all that debt is starting to catch up with us (and the rest of the world). The banks are only a sign of the problem, like the tip of an iceberg.


1 Comment »

  1. You just saved the day. Just what I was looking for – all in 1. thanks a lot.

    Comment by kikky — October 29, 2008 @ 1:11 pm | Reply

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