FrameworkCase studyBankingCrises and market historyRisk
Illiquid and insolvent are different problems with different rescues
Too Big to Fail · 2011
The idea
A firm that cannot pay today but whose assets are worth more than its debts is illiquid. A firm whose assets are worth less than its debts is insolvent, however much cash it has this afternoon. The distinction decides the rescue. An illiquid firm can be lent to against its assets and will repay. An insolvent firm needs capital, and anyone who lends to it is simply the next creditor to lose. Too Big to Fail shows September 2008 from the Treasury and the Fed, where the question of which firm was which was being answered under extreme time pressure and with incomplete information.
Lending cures illiquidity; only capital cures insolvency. Decide which problem you have before choosing the remedy.
When it works
Questions about why Lehman was allowed to fail and AIG was not, about central bank lending, or about any distressed situation.
When it may fail
In a panic the two are hard to tell apart, because asset values depend on the panic ending. A firm can be solvent at yesterday's prices and insolvent at today's, which is why the official choices in 2008 are still argued over.
How to use it
Asked about a company in trouble, first say whether it is a liquidity problem or a solvency problem and what evidence tells you which. The two answers lead to different conversations about covenants, lenders and new money.
Where it came from
Film Too Big to Fail · 2011
What the source says. September 2008 from the official side, where the difference between an illiquid firm and an insolvent one decided who was rescued and how.
Connected ideas
Worth knowing first
A bank run is a maturity mismatch, not a solvency problemA bank fails when its liabilities come due faster than its assets, which can happen to a solvent bank.
Supports
Buying a bank's bad assets helps only if you overpay; giving it capital helps directlyA rescue that swaps assets at fair value changes nothing; only new capital changes a bank's solvency.
Puts it to work
Judge a decision on what was knowable at the time, not on how it turned outThe fair test of a decision is the information available when it was made; hindsight is a different exam.
Concepts
Put it to work on L3VLUP
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