We Have Been This Way Before: “Liquidity” Is a Straw Man

Steinhardt blamed his losses on a sudden evaporation of “liquidity,” a term that would be on Long-Term’s lips in years to come. But “liquidity” is a straw man. Whenever markets plunge, investors are stunned to find that there are not enough buyers to go around. As Keynes observed, there cannot be “liquidity,” for the community as a whole.

The mistake is in thinking that markets have a duty to stay liquid or that buyers will always be present to accommodate sellers. The real culprit in 1994 was leverage. If you aren’t in debt, you can't go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.

So, consider it stressed.

Noted with interest: Lehman’s (LEH) balance sheet is currently levered 40 times, with four times its capital in Liar Level's (more formally, Level III (LVLT)) alleged assets, much of which (ahem) bear more than a passing resemblance to the garbage currently in the process of taking down 32-times levered Carlyle Capital.

When Genius Failed
The Rise and Fall of Long-Term Capital Managemet
by Roger Lowenstein

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