Solvency - a primer

What is solvency? Answer: Ability to meet your obligations. Assets equal to or greater than liabilities. Positive cash flow – more coming in than going out.

What is insolvency? Answer: Opposite of above.

What happens with insolvency? Answer: Some form of collapse and/or restructuring. Could be receivership, one of the forms of bankruptcy, and, if there is a going forward plan, a restructuring.

Why did so many entities such as FNMA, FHLMC, AIG, Bear Stearns, GM, Chrysler, Lehmann, Citibank and others fail? Answer: One of more of the above forms of insolvency.

What saved the situation? Well, let’s assume the situation was saved because there is absolutely no proof or evidence that the situation has been saved. Answer: What saved the situation was the entry of the US government with its checkbook. Think of it as the cavalry arriving as in a western movie. Only no armed militia on horses; just bureaucrats armed with the government checkbook and, as a consequence, avoidance of collapse and/or restructuring.

Is this a good thing? Answer: Usually not. The bankruptcy/restructuring process permits a resolution and moving forward process to occur which includes losses to the involved parties. With the cavalry/government involvement, the bad assets and money losing entities are being propped up with government funding. If the asset values increase and cash flows improve, some of these companies may survive. The problem is that the financial assets were grossly overvalued. Further, the car companies have been losing business to the competition for years, including years of high sales volume.

What could happen? Answer: There could be a substantial decline in the value of the US dollar. The US government has no money. It can only borrow from others and, when that is no longer available, print money. It is doing both now. These acts could lead to a substantial decline in the value of the US currency. US leverage has now been substituted for private leverage. Leverage is just a fancy term for rising borrowing and debt when asset values and cash flow (tax revenues to government entities) are declining. The only remaining source of funding, if it is even available, is to sell assets. That would mean the US would need to sell its assets such as government buildings, land, parks and equipment.

Well, at least we could fall back on asset sales if necessary, huh? Answer: Some states and cities are already doing exactly that. It is, at best, a very short term gap filling answer because virtually all government entities in this country have large future, growing obligations and limited assets to meet those obligations and declining revenues. Government entities in the US are massively leveraged. The combination of large and growing obligations (pensions, entitlement payments, huge payrolls and other commitments), limited and declining asset values and declining revenues means we have not attained solvency. Solvency will prevail. Either we attain it through frugality and sacrifice or external forces will impose it.