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Liquidity and Insolvency Crises

It is not unusual to come across expert opinion that a given financial crisis is based on a failure of liquidity and not caused by a failure of insolvency (e.g., Financial Times, August 14, 2015). Supporting such an argument with the premise that because an entity has recently been experiencing and expects to continue experiencing spending more funds than it receives period-over-period does not really persuade the analytical mind that the crisis is only indicative of a failure of liquidity: this type of financial failure is really often a symptom of the root cause of an insolvency problem. That an entity aggravates a preexisting unsound financial condition with unsound financial performance year-over-year with revenues trailing expenditures (that is, deficit spending) does not in any credible way support the conclusion that it is not insolvent. In fact, the entity would not likely be experiencing financial distress if its net position (that is, total asset value less total liability value) contained a satisfactory rainy day fund of asset value with which to fund these periods of deficit spending. If it had such a rainy day fund, it could liquidate / spend this fund to head off any condition of liquidity failure; that is, it could continue to meet its short-term obligations as they came due without resort to complete coverage through current revenue, notwithstanding deficit spending, for a time. That the moment arrives when the entity is in financial crisis, it is because there is no such rainy day fund; that is, there is generally an insolvency condition where asset values are inadequate to meet liability values, notwithstanding reported values on the financial statements. See also Lehman Brothers, case no. 08-13555, filed 9.15.2008, wherein reported assets at May 31, 2008 were valued at $639 billion, and total debts were reported at $613 billion.

Formal / legal insolvency of asset value less than liability value is often not as much of an issue in practice as informal / factual insolvency of needing more external capital, whether from loans or from capital contributions / equity. From a manager’s perspective – it sure sounds better to request some immediate funds to tidy oneself until the big payoff comes in than to request some immediate funds because one is busted.

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