…It’s Always about Liquidity!
Since Silicon Valley Bank’s demise, many of the usual suspects have been yapping and editorializing about the importance of capital and capital ratios, but it’s never about capital. It’s always about liquidity!
Consider a firm with $X in liabilities, and let X be as large as you want…billions, trillions, go for it. If the firm has $X+1 in cash, it is liquid and can pay its bills. A “run” on it, where, say, all debtholders demand immediate repayment, leaves it with $1. (Given that strong position, it’s less likely that anyone would panic and demand repayment. More on this later.) Ignoring noncash assets, if $X is extremely large, then, the firm’s capital ratio, 1/(1+X), is extremely small, yet it can still pay its obligations, immediately.1
When the firm’s assets aren’t all in cash, it’s easier to talk about capital (or, roughly, assets – liabilities) than it is to talk about liquidity because, like water, a single asset’s liquidity can have multiple states or phases. (If you’re thirsty, it’s hard to drink ice and very unpleasant and dangerous to drink steam.) However, unlike water, the state of the asset—be it a loan, bond, security, or other investment—is often hidden and, therefore, unknown or uncertain to an outsider. Still worse, that hidden value changes with time and circumstances.
What determines the value of a “liquid” asset?
If the firm needs to sell a noncash asset, that asset may be in a useful, “liquid” state, where someone is willing to pay an acceptable price for it, or not. When no one wants it at the price that the firm will accept it’s because:
- the asset is more important and valuable to the firm than it is to the prospective buyers, or
- prospective buyers know that the firm needs to sell it and can be patient and wait for a better price in anticipation of the firm’s increasing desperation.
Now, I tried hard to make the above as short as possible, but the preceding two paragraphs are much longer to write and harder to explain than the tired bromide, “they need more capital.”
The problem exists even when the book value of all of the firm’s assets substantially exceeds the value of all of its liabilities, because noncash assets, their values, and their salability are unknown or uncertain and change with circumstances. This means that no one really ever knows what that stuff might be worth in a crunch; claim holders don’t have enough information to evaluate the assets; so, they panic.
So, what’s the solution?
We’ll explain more in a future post, but a good start would be increased transparency—similar to how Fannie Mae provides its (anonymized) mortgage portfolio data to the public.2 When investors, bondholders, or depositors ask the equivalent of, “What does it got in its pocketses, Precious?” they should have the data that they need to get a clearer answer.