Bankruptcy vs. Insolvency

While Bill Gross believes the US is facing an economic default of some kind, because its $75B 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.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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