One Sided Balance Sheets
I’m seeing a lot of negative headlines about how much more debt Spain is adding. How much subordination there is going to be for existing creditors. That is in spite of a lack of detail. I’m not here to cheerlead this deal, but at the same time, falling prey to the easy headlines is dangerous.
No one seems to be talking about the “asset” side of this program. The FROB will borrow money and it will buy assets. The proceeds from either repayment or sale of those assets would be used to pay back FROB’s borrowing. If everything FROB buys is worthless, than yes, the Kingdom of Spain will owe a lot of money under those guarantees. If the FROB made great investments, all the debt could be repaid by the investment and no claim ever made under the guarantee.
Once again, the answer is likely to be in between. The U.S. has done okay on TARP. Since the U.S. forced some of the better banks to take on money, the recovery/repayment rate is artificially high but at least worth looking at. The IMF involvement is a good sign here. If Spain was completely in control of investing FROB’s money, I would quickly assume the assets would wind up with no value. That might be unfair to Spain, but I would not for a second trust them to make decent investments with the FROB money. The IMF, I will grudgingly admit, does seem to actually try and run numbers and make sane decisions. They seem less likely to lose all the FROB money.
When I see everyone talking about all the great points of the deal, I will reconsider my view, but right now, I see simple headlines and negative reactions to those simplistic headlines. I don’t see this deal as a game changer on its own, but I don’t think it is as bad as some are pitching it right now, and more importantly, am very scared as a potential bear that there are more ideas and programs in the global pipeline.
Solvency and Liquidity are usually two different concepts.
A “liquidity” problem is when a solid borrower who for some reason cannot get access to money at a particular point in time. There is usually some reason that the company cannot borrow, and it has less to do with the creditworthiness of the borrower than on the market as a whole.
A “solvency” problem is when a creditor is so weak, overleveraged, that they have no way to borrow because they are on the verge of default.
Typically those two situations are different. If some entity tried to address a solvency problem by lending more and more, they could do that, but eventually they would run out of money as the market would stop lending to them. If A is a horrible credit, B can choose to lend to B so long as B has money. If B is willing to lend cheaply and in ever increasing size, A can continue to avoid default. It is the doubling down on an unlimited table theory in blackjack. In the real world, B will start having trouble getting money to lend to A because its creditors will see how stupid it is behaving. That mechanism is what separates solvency from liquidity.
What happens when the lender can print its own limitless supply of money? If you can print money and are willing to continue to print money you can use liquidity to avoid solvency for a very long time. I don’t condone that. I think it is horrible in the long run. I think we should have let more entities go bankrupt, starting with Bear Stearns back in 2008, and Greece in 2010, but for whatever reason the politicians have been petrified to do that.
Will they finally step up and let failure and bloated balance sheets run their course? I hope so, but I doubt it. I think we will see more activity, and for all the talk that you can’t solve a solvency issue with liquidity, you are right, but sadly a lender with virtually unlimited access to cheap money (since he prints it) can provide enough liquidity to address solvency for a long time. The end result is likely to be ugly, but that doesn’t mean the central bankers won’t try.