22 January 2008

No Good Comes of Treating Insolvency as Illiquidity

As the good doctor Roubini says, there is a difference between an illiquidity crisis, and an insolvency crisis.

A corollary is that dealing with insolvency as illiquidity simply throws good money after bad*, and the extensions that are being granted to ACA Bond Holdings to "unwind" its credit swaps, is an attempt to deal with insolvency as illiquidity.

ACA has lost 97% of its market cap over the past year, it's been downgraded to CCC last month (12 steps all at once), and it's currently being run by its regulator, the Maryland Insurance Administration, which, "extended an agreement that waives collateral requirements, policy claims and termination rights until Feb. 19, the New York-based company said in a statement on Business Wire late yesterday."

It's hit an ice berg, and it's going down. Delaying this in the hope of finding stupid investors is going to help no one in the long term.

*To quote Roubini on the difference, "But the current market turmoil is much worse than the liquidity crisis experienced by the US and the global economy in the 1998 LTCM episode. Let me explain why. Economists distinguish between liquidity crises and insolvency/debt crises. An agent (household, firm, financial corporation, country) can experience distress either because it is illiquid or because it is insolvent; of course insolvent agents are – in most cases - also illiquid, i.e. they cannot roll over their debts. Illiquidity occurs when the agent is solvent – i.e. it could pay its debts over time as long as such debts can be refinanced or rolled over - but he/she experiences a sudden liquidity crisis, i.e. its creditors are unwilling to roll over or refinance its claims. An insolvent debtor does not only face a liquidity problem (large amounts of debts coming to maturity, little stock of liquid reserves and no ability to refinance). It is also insolvent as it could not pay its claim over time even if there was no liquidity problem; thus, debt crises are more severe than illiquidity crises as they imply that the debtor is insolvent, i.e. bankrupt, and its debt claims will be defaulted and reduced. In emerging market crises of the last decade, we had liquidity crises (i.e. a solvent but illiquid sovereign) in Mexico, Korea, Brazil, Turkey; we had debt/insolvency crises (a sovereign that was both illiquid and insolvent) in Russia, Ecuador, Argentina."

You have to just love this, footnotes almost twice as long as my post.


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