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All posts by Dan Whalen,
Providence, RI (resume)

Friday, July 12, 2013

Liquidity

One night, I was out drinking with a few buddies of mine who were not economics majors (I was at the time).  I stood up from our table and announced to the gentlemen assembled that I had a "liquidity issue to resolve."

I was looking for the ATM.  My friends pointed me towards the bathroom.

True story.

What is "liquidity"?  Why is it important?  In this post, I'll give you a definition and a few working examples.

On the surface, it might seem like a kinda boring, technical concept.  But once you understand it, you'll see it actually comes up all the time - in a many ways, our entire financial system revolves around it!


Definition

Investopedia defines "liquidity" as: 

"The degree to which an asset or security can be bought or sold in the market without affecting the asset's price. Liquidity is characterized by a high level of trading activity. Assets that can be easily bought or sold are known as liquid assets."

Ick.  Here's a much less messy way of understanding the idea:

Think of money as something that either can be in a "solid" or a "liquid" state.  "Liquid" money is money that can be sloshed around RIGHT NOW.  It's cash in hand.

"Solid" money has to be made "liquid" before it can change hands - before it can "flow".  Solid money can be stuff like checking accounts or credit cards, but could also be real estate, or a car, or a stock share, or other sellable asset - something that can be taken to market, sold, and converted to liquid, flowable cash. 

A debt owed to you is also "solid" money.  If I write you an IOU for $50, yes, you could say that you have $50 more to your name.  But you can't use that money until I make good on the loan, and convert your IOU from a solid to a liquid.


How "liquid"?

Any solid object can be melted down into a liquid.  But some materials are harder to melt than others.  Think of the energy and equipment needed to melt steel vs the energy and equipment needed to melt an ice cube. 

Bank accounts and future incomes are easily made liquid, all you need is an ATM card or a credit card respectively.  Heck, at least where I live you can pay with your ATM card right at the register at most shops, permitting bank accounts to have the same liquidity as cash.

But some assets are a little harder to melt down.  How long will it take to sell that house?  How much time do you need to convert that bond into cash?  And if you sell it quick, will you get less for it than if you were to wait?

An asset's degree of "liquidity", is not a hard and fixed quality.  How liquid an asset is can vary over time, and in different situations and contexts.

If a bank were to charge, for example, a dollar every time a customer pays for something with their debit card, debit cards will feel a little less liquid.

Or what if I go on vacation somewhere we're very few people accept debit cards at the register?  Or where no one takes my credit card?  Just by changing my location, my wealth can become much less of a "liquid" than it was before.


The Financial Industry

Once you wrap your head around this "solid money"/"liquid money" concept, you'll realize that the main service of the financial industry is just resolving people's liquidity problems - and charging fees for doing so.

Let's say that you put $1,000 in a CD for one year.  You can't touch that money for 12 months, and in return, the bank offers to pay you 3% interest on the deposit (that'll be a $30 profit for you).

On the other end of the operation, the bank will be loaning out your $1,000 - through business loans and credit cards - to me, a guy who is about to start a new business.

Let's say the bank charges me 5% interest (meaning I'll owe the bank $1,050 at years end).  As long as my business has earned me $1,051, I'll have made a profit, and that liquidity I got from the bank will have been a worthwhile purchase.

So I'm paying a $50 fee for having $1,000 cash made available to me.  You get your promised $30, and the bank pockets $20 in the process.

Really, all the bank is doing is selling me liquidity, and buying liquidity from you.

You offer to make your personal wealth less liquid for a year (by putting it into a CD), in return for some payment from the bank (in this case, $30).  I get more liquidity than I would have otherwise, and I pay a fee for it (in this case, $50).


But when it goes wrong...

The financial sector innovates by creating new sophisticated or specialized arrangements, ones ever fancier than the simple example I just gave.  But in reality, they're all just variations on the theme.

The financial industry designs, administers, and manages plans aimed at producing liquidity where there is deficit of it, and buying it up in places where its in surplus.

...or at least this is what the financial industry is supposed to do.

Now, when works, it does provide a vital service to society.  Imagine a world where you couldn't sell or buy liquidity.  No student loans.  No mortgages.  No business loans.  Everything must be paid in cash. 

In that world, it would be impossible for anyone to get ahead who wasn't already wealthy.  Inequality would be permanent, and permanently growing.

HOWEVER, if the financial crisis has taught us anything, its when these liquidity products break down, they can break down catastrophically.

Throughout the 90s and early 2000s, regulators started 1) permitting the financial industry to create increasingly complicated plans for liquidity buying/selling (ie, more and more complex financial instruments); and 2) market them to a broader and broader public.

In retrospect, the problem with doing that is clear - we know the value of liquid assets.  If you want to know how much you cash is worth, just look at the little numbers in the corners.

But the value money in a solid state is always an estimate.  We cannot know what our assets are truly worth until we sell them - until they have been "liquified." 

If you think you're house is worth $100k, and you can't find a buyer willing to offer more than $75k, then you are wrong to say "I got less then the house was worth."  What you should be saying is "turns out the house was worth less than I thought!"  You don't know the real, usable value of the house until its sold!!


"Liquidity" vs "Solvency"

How many hundreds of movies contain this line, or some variant of it:

"Tell your boss I can get the money!!  I'm good for it!  I just need some time!"

Han Solo said it to Greedo in Star Wars, Harry Zimm said it to Chili Palmer in Get Shorty, Worm says it to that guy in Rounders...

In economic jargon, the speaker is arguing that they are "solvent, but not sufficiently liquid."

If a bank, company, person, government, etc. is said to be "solvent," that means that they are good for what they owe.

However, a solvent entity may be too "illiquid" to service their debts, meaning they cannot produce the cash fast enough to pay up on time.

During the financial crisis, when banks, investors, corporations, and so on were going belly up, the question was always whether or not the cause was "liquidity or solvency."  Translation: could the entity pay their expenses if we wait, or is it just all a hopeless case?

When a company receives a bailout from their govt, that govt is implying they believe the entity is just illiquid, not insolvent.

That is, the govt thinks the company just needs a little scratch to float them through a rough patch.  They expect the bail-out recipient will eventually pay back the money, but they need some time to free up the funds to do so (by selling off assets, collecting money owed to them, whatever).

A bailout given to an entity thought to be insolvent, however, would be throwing good money after bad.  It only delays the inevitable collapse.  Govts won't bail out something they think is just going to crash again a little further down the road.

If the company isn't breaking even today, but will be tomorrow, its a liquidity problem.  If they aren't breaking even today, and never will be again, the diagnosis should be "insolvency."


The Financial Crisis

So we can kinda think of the recent financial collapse as being precipitated by a severe over-evaluation of standing assets in the financial industry.

In short, everyone thought they were worth more than they actually were.  And no one found out until the movie mobster demanded his due, and the once-sure-of-themselves banks ended up digging in the couch cushions for quarters, and still coming up short.

Banks believed that they were liquid enough to handle a crash.  And many were.  However, many were not liquid enough to handle the panic, and needed bailout money to carry them over for a while.

Those that paid off their loans and are still around today (ex, General Motors), clearly had liquidity issues, not insolvency issues.  They had the money to keep the doors open, they just weren't able to free it up quick enough.

However, those that took a bailout and still couldn't survive the crisis (ex, Bear Stearns) were clearly insolvent, not illiquid.  It wasn't a case of "I have the money, you just gotta tell Fat Tony I need a cuppola weeks to get it together!"  It was instead a case of...well...not gonna make it to the movie's final scene...

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