Insolvency versus Illiquidity

Emmanuel Derman has an interesting post about how we got into the present mess. His argument is essentially that the bubble created a class of assets that were way overvalued and holders are insolvent, and that this spilled over into other asset classes that people could not judge the quality of. So you have insolvency in some classes inducing panic that causes illiquidity in other classes.

As everyone fled the insolvent and illiquid securities they lost confidence in the economic future and stock prices fell, and people felt poorer and spent less and companies projected less future profits and fired people who then spent less money and so they drove other companies that depended on them to do badly and so on and so on.

The administration is trying to cure insolvency and illiquidity with stimulus, but stimulus is mostly a cure for illiquidity. They are using a medicine for living people to revive the dead. The best thing would be to ring fence and restructure only the insolvencies and to stimulate the illiquidities. The desperate effort to treat insolvency with stimulus and the Chicken-Little warnings about the consequences of not doing so detracts from the confidence necessary to restore liquidity.

I find this argument very insightful. But there is another point to remember. That is the change in leverage. As we go from 30-1 leverage to 2-1 leverage assets that were not toxic now seem to be. Risk aversion leads to this loss of leverage and to the flight from these assets. So there is a point to the argument that some of these assets may become viable if confidence is restored. Derman's point, however, is that this will not be possible if we don't bury the dead. That is an important point to remember.