Sunday, June 12, 2011

Bankruptcy vs. Insolvency

While Bill Gross believes the US is facing an economic default of some kind, because its $75T in explicit and implicit guarantees simply cannot be paid, the bond markets appear to pay him no mind. US interest rates are low so investors clearly don't seem to be worried. But then again, insolvency is only weakly correlated with bankruptcy, because as long as people think you are solvent, your actual balance sheet does not seem to matter. Consider that General Motors (GM) was insolvent for years, especially looking at their off-balance sheet obligation, but only went bankrupt in 2008 when the financial crisis cut off the essential cash inflows needed.

Another good case is what happened to Charles Ponzi. On July 26 1920, the Boston Post started a series of articles that asked hard questions about the operation of Ponzi’s money machine. The Post contacted Clarence Barron, the financial analyst who published the Barron’s financial paper, to examine Ponzi’s scheme. Barron noted that to cover the investments 160 million postal reply coupons would have to be in circulation. However, only about 27,000 actually were. The United States Post Office stated that postal reply coupons were not being bought in quantity at home or abroad. Ponzi's scheme was logically impossible, irrespective of any actual happenings.

On July 26, Ponzi agreed not to accept any new money. Yet, while many did try to redeem their shares, many did not, and missed a golden opportunity over the following weeks. By August 12 he was arrested, redemptions were cancelled, and remaining investors received 37 cents on the dollar.

Given the facts, why did so many not get out when early warnings had been so compelling? Confidence. It does not prevent crisis, only delays it.


jon whiteford said...

75 billion, with a b is going to cause a default in the US?

Eric Falkenstein said...

heh. Should be a T!

walt said...

I read somewhere that some of Madoff's victims hope to claw back from those who, for whatever reasons, got out before the scheme unravelled.

Anonymous said...

Mr. Ponzi promised a return. The people investing in dollars have been promised nothing (other than more dollars). So the concept of default is meaningless. There is no sense in which the U.S. can default.