Liquid assets are those that are easily and quickly convertible to cash. Liquidity, in turn, refers to the availability of liquid assets to a company, person or even an overall market. Everyone from the average Joe to property owners and lenders have a need for liquid assets to meet their short-term financial obligations.
The Federal Reserve and Congress have taken multiple actions to provide liquidity for businesses and individuals during the novel coronavirus (COVID-19) outbreak so the economy can continue to function and avoid a prolonged downturn. In this article, we’ll explain what liquidity means for people and businesses and why it’s so important.
The Average Joe
For the average person, liquidity can refer to cash in hand or in their savings and checking accounts. It could also refer to investments such as stocks or U.S. Treasury bonds that can be easily sold, or liquidated, and converted to cash. Typically, people maintain their liquid assets in a combination of cash, stocks and bonds.
Investments in a 401k or an Individual Retirement Account, however, are not considered liquid because these investments have heavy penalties designed to deter people from making early withdrawals. Additionally, investments that cannot be sold until the investment period has ended are not considered liquid assets.
Why does personal liquidity matter? Picture a situation where someone has just lost their job because of COVID-19. Without income, they will be forced to use their savings to cover rent or mortgage payments, groceries, and other necessities. In the absence of cash, they may turn to selling other investments they have, in order to sustain themselves until they can find new employment. This could entail selling stocks, mutual funds, or exchange-traded funds, for instance. However, in a financial crisis, the value of these assets can be very volatile and potentially lose significant value. Therefore, selling these assets in turbulent times could lock in losses, and may not be an ideal source of liquidity to depend on during a financial crisis.
A lack of liquidity in a dire situation could lead the person to default on their mortgage or fail to pay rent, losing their place to live and negatively impacting their credit score and future financial prospects. Ironically, someone can have a high net worth, but if those assets are all illiquid, they can suffer financial ruin if they have no way to pay expenses until their situation improves.
In light of the liquidity issues that many individuals are experiencing today, the government has passed the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), which provides financial relief to individuals and businesses through stimulus checks, Small Business Administration loans and other tax relief programs. The CARES Act has also removed some penalties up to a limit for an early withdrawal from a 401k.
Real estate is generally considered an illiquid asset. While an investment in real estate can ultimately be converted to cash via a sale of the property, the process can take months. Because of this, property owners generally maintain some cash reserves to cover non-routine financial events that may occur, such as maintenance issues, unexpected cost increases, and decreases in rental revenue, which can occur as tenants may not have the resources to pay rent due to COVID-19. This could lead to properties without sufficient reserves that are unable to meet their financial obligations and cover debt service.
Another way that property owners can obtain additional liquidity — assuming their property’s value has increased — is by refinancing their current loan with a new loan or by taking on additional debt. Even though multifamily investments are typically resilient in a downturn, it remains unclear whether the current state of the credit markets will reduce the ability for property owners to refinance or upsize loans.
The CARES Act provides for mortgage loan forbearance to multifamily property owners who have Fannie Mae or Freddie Mac loans if they prove hardship from COVID-19 and agree to suspend evicting delinquent renters. Other protections will vary from state to state and lender to lender, but given the widespread reach of the effects of COVID-19, it is believed that various parties will work together to find solutions until the situation stabilizes.
In the same way property owners need liquidity so they can meet both scheduled and unscheduled obligations during normal times and during a financial crisis, banks and other lenders also need liquidity to meet their expected and unexpected financial obligations.
In fact, banks and other depositary institutions have reserve requirements set by the Fed to maintain cash at a Federal Reserve bank location or in their own vaults to ensure they can meet their liabilities.
In order to help banks preserve liquidity in light of the effects the coronavirus has had on businesses and the economy, the Fed took an extraordinary step on March 26 to reduce reserve requirements from as high as 10% to zero percent for all banks and depositary institutions. This frees up liquidity in the banking sector and will allow those institutions to continue lending and funding other obligations. The Fed has not announced how long this reduced reserve requirement will last.
The economy is cyclical, and there have always been ups and downs. Maintaining liquidity during times of financial uncertainty can not only ensure people and businesses meet their financial obligations, but could also allow them to capitalize on opportunities at a discount when heading into a financial recovery. Various federal, state and local programs have been put into place to alleviate some of the short-term liquidity issues that have arisen these past few weeks, and help weather the storm until the economic picture brightens again.