Liquidity versus Solvency

Liquidity versus solvency, what's the difference?

Simply put, illiquidity is when an entity owes money but doesn't have enough cash to pay off those debts. insolvency is when all of the entity's assets aren't enough to repay the debt.

As an example, a person may owe $1000 per month but only has $500 in cash each month. To cover the debt payment, the person would need to raise additional cash by selling something.

Corporations face the same problem for their debts. If they can't raise the cash, the corporation can be forced into bankruptcy.

When bankruptcies occur, it is usually due to a liquidity crisis because waiting until insolvency means there is no value left.

More difficult to handle are banks. A bank that doesn't have enough liquidity may be considered insolvent, too, because a bank has a hard job maintaining the value of its assets if it is viewed as illiquid. A "bank run" can quickly drain a bank. Liquidity dries up and the bank can't raise cash by quickly selling assets.

Three 'D's

The markets are scared of the 3 'D's -- debts, deficits, and defaults.

Debt is everywhere. Consumer debt grew into a massive bubble. Government debt too. Corporate debt isn't too bad.

Deficits from government is very troubling. The US deficit is now over $15 trillion.

Finally, the end of too much debt is a default. After defaults in South American and Asia over the last few decades, Europe's PIIGS are risking default.

Investors are watching these three 'D's because they know other Ds can follow -- depression, currency debasing, and maybe deflation.