Liquidity is not solvency. And the market will learn the difference the expensive way.

Bear Stearns' funds didn't fail from lack of liquidity. They failed because what they held was worth less than everyone pretended to believe while the market was working.

Two Bear Stearns hedge funds collapsed this week, with losses that nearly wiped out investor capital. The funds had concentrated exposure in CDOs backed by subprime mortgages. The prevailing narrative is that the problem was one of liquidity — that the funds couldn't get financing to maintain positions when margin calls arrived. But liquidity and solvency are not the same thing, and the distinction matters now more than at any point in recent years.

A liquidity problem is when you have good assets but can't sell them fast enough to meet short-term obligations. You're still solvent — you just need time or a lender of last resort. A solvency problem is when the assets you hold are worth less than your obligations. No matter how much time you have — the arithmetic doesn't work. What Bear Stearns' funds faced wasn't a lack of time to liquidate positions. It was the discovery that the positions, marked to market, were worth a fraction of what they were being carried at on the books.

The systemic problem isn't Bear Stearns. It's that the same instruments held in these funds are in dozens of other portfolios that haven't yet been forced to mark them to market. The collapse of these funds is the first moment the market had to discover what these assets are really worth when someone actually needs to sell them. And what it discovered was that buyers, at the price sellers needed, simply didn't exist. This isn't a momentary liquidity problem. It's a revelation that the pricing system was wrong from the start.

Leo Bentier