Solvency

Today’s punishing session on Wall Street just ended down over 280 points. The glee of yesterday is well and truly over. Lehman Brothers in particular, was punished today as news of its stalled talks with the Korean Development Bank reached the market. Lehman was down 45% today on solvency concerns. It begs the question as to exactly what solvency is.

Wikipedia says:

In finance, solvency is the ability of an entity to pay its debts with available cash. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth. The better a company’s solvency, the better it is financially. When a company is insolvent, it means that it can no longer operate and is undergoing bankruptcy.

Solvency is a different concept from profitability, which refers to the ability to earn a profit. Businesses can be profitable without being solvent (e.g. when they are expanding rapidly). Businesses can be solvent even while losing money (e.g. when they cannibalize future cash flows, like selling accounts receivable). A business is bankrupt when it is unprofitable and insolvent.
–Wikipedia

That’s a pretty good definition. But, I would like to highlight something. Companies usually bankrupt because of liquidity. When it comes to solvency it is usually an issue of cash flow and not profitability. An institution can be perfectly profitable and become insolvent, just as an unprofitable institution like General Motors (with over $50 billion negative equity – see their Q2 2008 balance sheet) can continue as a going concern.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

I am not making a statement about Lehman Brothers, WaMu or any other institution. I just thought it would be useful to keep in mind what a crisis does to the real economy and why government officials fight against them — often in vain.