The liquidity trap
As the C-19 crisis progresses, it becomes more and more evident that the global economy is in a liquidity trap. Time to look at the distinction between liquidity and solvency and its implications for the AC (“after corona”) economy.
Liquidity refers to the ability of a business to make payments due. To make payments, a business either needs cash or assets that can be readily converted into cash.
Solvency, by contrast, is the ability of a business to meet its long term debts and obligations. From an accounting perspective, a business is considered solvent if its total assets are greater than its total liabilities, i.e. if the business has a positive net worth.
A company that is illiquid may not necessarily be insolvent given that its total assets may still be greater than its total liabilities. Yet, a company that cannot convert its assets into means of payment can be forced to enter bankruptcy even if solvent. As Perry Mehrling famously puts it, “Liquidity kills you quick.” Most importantly for our times, a company may have the liquidity to make payments due in the short term, yet, it may not be solvent because, for example, its revenue is unlikely to revert to BC (“before corona”) economy levels or its business model may be obsolete in the AC economy.
As an accountant, my dear friend Asgeir’s take on the matter is, “Liquidity is a fact. Solvency is an opinion.” Asgeir’s statement plays with the notion that auditors opine on the financial statements of a business. One of the underlying assumptions of such opinion may be that a particular business continues operating as a ‘going concern,’ which is a judgment that feeds directly into how assets are valued (at going concern or break-up value) and thus will determine whether a company has positive net worth, i.e. is solvent.
To establish whether a business is solvent, can be impossible in the current environment given the high uncertainty around the battle against the virus and the pace of the recovery. Look at Pizza Express, a casual dining restaurant with currently all of its 465 restaurants closed. In a consent solicitation statement Pizza Express let its bondholders know that its auditors are currently unable to sign off on its 2019 annual report because they are still deliberating whether it is appropriate for Pizza Express to report on a going concern basis.
Unsurprisingly, investors may be more optimistic about a company’s prospects than auditors! For example, the auditors of Merlin Entertainment Limited, a repeat European high yield bond issuer that operates entertainment attractions, such as Legoland and Madame Tussauds, included an emphasis of matter paragraph in Merlin’s audit opinion stating that “the challenges posed by the COVID-19 pandemic constitute a material uncertainty that may cast significant doubt on Merlin’s ability to continue as a going concern.” Despite this warning from the auditors investors oversubscribed Merlin’s issuance. (For context: At the date of the issuance, 121 of Merlin’s 130 attractions remained closed, and Merlin reported to burn an average of GBP 50 million per month during the lockdown, which would mean that it ran out of cash during Q3 if the lockdown lasted until mid-July 2020 and the recovery was slow.)
One may read Merlin’s debt issuance as an example for how abundant market liquidity provided by the official sector clouds investors’ judgment and prevents them from making a “sound” and “disciplined” “market decision.” Solvency is never alone about market participants believing in the prospects of a business but always also about whether they believe that, if necessary, they can sell the debt of a business at par, i.e. whether there is a liquid market for the debt claims of a certain debtor (this is what most people refer to as “market liquidity;” elsewhere in this post I use the term “liquidity” as synonymous to “funding liquidity”). So long as there is a perception that a market maker stands ready to buy the debt of a certain company if an investor wanted to sell it, investors are likely to consider that company as solvent and will provide liquidity to it. So investors’ judgment on the solvency of a company is always intricately linked to the market liquidity of certain (or possibly even most) of a company’s assets and investors’ perception of whether a market maker would backstop a certain company. And this is what makes market makers so powerful!
Consider Kirch Media Group, an infamous German bankruptcy case! In a Bloomberg interview in 2002, then Deutsche Bank CEO Rolf Breuer publicly questioned the solvency of the company. Shortly thereafter the group collapsed. At the time, there had been persistent rumors about the unsustainability of Kirch’s debt. Yet, only when Deutsche Bank as one of its largest creditors destroyed the perception that it would backstop the company, creditors staged a run.
Recall Greece in 2015! In late June 2015, the ECB cut Greek banks’ access to the ECB Emergency Liquidity Authority, which meant that they could no longer open for business. The background to this was the political conflict over the sustainability of Greece’s debt. At the time, the ECB considered that it was not within its mandate to opine on the solvency of a member state and deferred to the Eurogroup. In essence, the ECB refused to act as market maker as long as its market making activities were not backed by Eurozone governments.
Decision making around solvency considerations is incredibly intricate because it has subjective elements and directly affects the distribution of wealth.
The solvency challenge of the AC economy is that, given that there will be no V-shaped recovery and supply chains have been severely disrupted there is a lot of “overhang capacity” in the economy at large and at the individual company level in particular (the issue can also be described as a massive output gap). This “overhang capacity” (e.g. supply contracts obligating to purchase supplies that will not be used, capacity to produce goods that will likely not be bought) weighs on the balance sheets of individual companies, depresses a their net worth (possibly into negative territory), can lead to solvency issues and will either have to be cut off as losses or converted from “overhang capacity” into “used capacity.” For now large scale official sector liquidity provision is ensuring market liquidity and thus providing good reasons for investors to consider firms solvent. Yet, unless we start thinking about how to adapt the underlying (debt and business) structures to the AC economy reality, we will be stuck in a liquidity trap, which means that we will not only have to maintain but increase official sector liquidity provision and we will achieve very little with it.
Issues high on the agenda are, how to realistically assess the losses of the C-19 crisis and how to distribute them in a way that facilitates the recovery and does not further increase inequality. Some of the open questions are: Should businesses go through bankruptcy? Should (some) loans be converted into grants? Could a debt jubilee be implemented? When and how will commercial banks enforce government guarantees? Are they sufficiently resilient to absorb the losses on the loan tranches that are not guaranteed or will (parts of) the banking system have to be recapitalized through resolution proceedings? Will some government loans be converted to equity and held in a special purpose fund as recently suggested by Simon Glesson, a bank regulatory lawyer particularly concerned with the soundness of the banking system? Will debt on central bank or central bank SPVs’ balance sheets have to be written off? Potentially all of the above. It will also—not only though—depend on how much fiscal stimulus there will be.
Rarely mentioned is the damage that even the “right” decisions on losses and loss distribution may do to democratic governance. Making decisions on solvency matters is essentially picking winners and losers and there is great potential that it will be perceived as arbitrary by some, if not many, unless there is a cohesive narrative around it backed by a broad political consensus. Consider the following: Central banks have great power and are for good reason somewhat isolated from democratic governance and accountability. However, does bailing out entire industries and countries go well with isolation from democratic control? Neither are commercial banks democratic institutions, yet their enforcement practices and restructuring strategies will be in part decisive for the overall shape of the recovery. Similarly, if governments were to take equity stakes in some firms but not in others, how to ensure equal treatment, and separately how to ensure smart decision making in nationalized companies? Official sector governance arrangements in most Western democracies are not built for large scale official sector involvement in the economy. How we supplement our existing governance arrangements to weather this crisis, how we distribute the losses and which political narrative we build around it will matter a big deal for what the AC economy will look like and whether we can avoid a potentially destabilizing political backlash.
Maria C. Schweinberger