January 2012: The European Financial Crisis Explained

The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”                                   Rudiger Dornbusch (MIT economist who was a professor to Mario Draghi, the new head of the European Central Bank)

Liquidity Problems vs. Solvency Problems

It is important to understand the difference between a liquidity problem and a solvency problem. They are two separate types of financial problems.  It is possible to have one of these problems but not the other, and it’s possible to have both problems at the same time. Understanding what they are and how they differ is essential to understanding the mounting European Financial Crisis.  Recent efforts to fix European banking liquidity problems should not be mistaken for fixing the solvency problems faced by European banks and countries such as Greece, Portugal, Spain and Italy.

Liquidity is a measure of your available cash for meeting your current bills and expenses (for banks, this includes deposit withdrawals). For example, if a family, business, or government has insufficient cash to pay current bills and expenses, and if their assets (e.g., real estate or a business ownership) cannot be quickly converted to cash, they have a liquidity problem.  Even if they have more assets than debts, if they are short of ready cash they have a liquidity problem.

Solvency is a matter of whether you own more assets than the debts you owe.  That is, if the worth of your assets is greater than the amount of your debts, you are solvent.  Conversely, if the value of your assets is less than the amount of your debts, you are insolvent (a.k.a., “broke”).  Even if you have $10 million of assets, if you owe more than that, say $12 million, you are insolvent. When creditors seek repayment, and there are not enough assets to satisfy all the debts owed, you have a solvency problem.

Now let’s look at the liquidity and solvency issues of European banks.  Their financial statements typically show they have assets worth slightly more than their debts, roughly $30 of assets for each $29 of debt that is owed to the bank depositors and bond holders. On paper they are solvent.

However, the assets of those banks include bonds issued by various foreign governments, such as Greece, Portugal, Spain, and Italy.  On their books, European banks show those bonds at full value – that is, 100 cents on the dollar. European banking rules allow this accounting even though the market prices of these bonds are considerably less than 100 cents on the dollar.  In truth, the value of the assets these banks own is not enough to cover all of their debts. They are insolvent.

European banks have a solvency problem. Banks may pretend they are solvent, and conventional accounting rules for European banks may allow it, but investors and depositors know otherwise. No one is fooled by pretending that the bonds of fiscally troubled nations are worth face value.  So, knowing that the banks cannot repay everyone, demands for repayment (i.e., deposit withdrawals coupled with refusals to extend short-term financing) accelerated during the final months of 2011.
The solvency problems faced by European banks caused their short-term funding to dry up and accelerated deposit withdrawals which, in turn, led to liquidity problems.  Depositors and providers of short-term funding to European banks want to be repaid in full before the illusion of solvency becomes untenable and they get stuck with losses.

European banks now face both liquidity problems as well as solvency problems.
At the end of November the central banks of the U.S., Canada, Switzerland, Japan, England and the European Central Bank launched coordinated actions to provide liquidity (ready cash) to struggling European banks via funds channeled through the European Central Bank. It is important to note that they aren’t giving money to banks; they are lending them money secured by bank assets.  Why? As the insolvency of European banks became more acute and more obvious, depositors and providers of short-term bank funding fled and short-term cash needs could not be met without this intervention.

When central banks stepped in to address the liquidity problem, stock markets worldwide reacted as if this consortium of central banks had also resolved the solvency problem of European banks.  Stock markets responded as if the crisis had miraculously disappeared overnight.  This is a dangerous misperception.

Providing liquidity to European banks did not cure their solvency problems.  Their solvency problems remain intact and are growing.  European countries with deteriorating credit worthiness continue to run high deficits that will push already worrisome debt levels even higher and will further impair their abilities to meet debt obligations.  The market value of Greek, Portuguese, Spanish, and Italian government bonds owned by European banks will decline even more, thereby making bank solvency problems even worse.

What’s Next?

After much talk about grand plans, little detail has been offered and no action has been taken. Great hopes are pinned on the European Union finding a solution to unchecked government deficits of weak countries.  If the weaker countries can somehow become strong (apply magic here), their credit worthiness will improve, the value of their bonds (held by European banks) will rise, and European banking solvency problems will disappear. Unless these countries can heal themselves, reforming from spendthrifts to thrifty, the underlying problem will not be fixed.

Otherwise, as the prices of Greek, Portuguese, Spanish, and Italian government bonds slump further and/or borrowing costs (interest rates) surge higher, the specter of European bank insolvencies grows. Despite liquidity supplied by central banks, fixing a liquidity problem is not the same thing as fixing a solvency problem.

Some of the “solutions” being considered include creating a colossal bailout fund, financed with more debt, to buy and prop up the prices of government debt.  Seriously?  That’s absurd.  A debt problem cannot be resolved by creating more debt. The debt burden is already becoming unmanageable; a higher debt burden will only be more unmanageable.

Much like a family that is deeply indebted, countries have limited options for fixing their solvency problems:

1. Increase income by producing more (high economic growth). This is wishful thinking when the world is stuck in an economic slow-growth environment that has been resistant to government programs of massive stimulus and monetary easing.

2. Austerity. Reduce spending and live below their means to undo the ill-effects of living beyond their means so many years. Politicians hoping to be re-elected will never suggest this option.

3. Restructure the debt through defaults and write-downs, meaning stick someone with the losses. (Note: This should be bank shareholders and bond holders, not taxpayers.) Any volunteers to take the losses? Nope.

4. Pretend and Extend, commonly referred to as “kicking the can down the road,” promising significant reforms and massive bailouts, but conveniently deferring the details of such plans until a later date (that never comes). This has been Europe’s game plan for the past two years. Lots of talk, but no substantive changes. How long will investors allow themselves to be strung along before acknowledging that government assurances are empty and governments are not able to fix these problems?  Once investors look behind the curtain and see that the wizard-government is not all knowing and all powerful, the investment terrain will change dramatically.  

Until debt levels are on course to be reduced and thereby become manageable, today’s problems cannot be resolved. Politicians and central bankers cannot provide a quick or easy fix to this problem. If they could, they would have already done so.  There are no more monetary or fiscal tools left.  Changes will likely be forced when government bond investors say “Enough!” and demand much higher interest rates -- causing already burdensome debt levels to become clearly untenable.  ***

Greg Schultz & Bruce Grenke

© Asset Allocation Advisors, Inc. 2012