September 28th, 2009
06:14 AM GMT
“My accountant says I did this at a very bad time. My stocks are down. I'm cash poor or something. I got no cash flow. I'm not liquid, something's not flowing.” - Isaac Davis in Woody Allen’s “Manhattan.”
There are a number of metaphors that can be used to describe liquidity in the financial markets. One is to think of every object of value – cash, stocks, houses, art – as pieces of ice, frozen in value. Its liquidity can be measured by its ability to melt and reconstitute itself in value while changing hands.
Cash is highly liquid, because there is little change in value when sold or exchanged – so it melts and freezes quite nicely. Rare objects of art are among the most illiquid – they are auctioned and transferred back into cash once every few decades.
A way I prefer to think of liquidity as is oil. What caused the global economy to sputter last year was the commercial paper market, a financial tool as mundane as the motor oil that sits in the engine pan of every automobile. Imagine, however, the oil in every car in the world suddenly drying up below manufacturer specifications – poorly maintained cars start choking, creating traffic jams worldwide. Even Ferraris begin to ping and rattle.
The commercial paper market keeps companies running day-to-day because a going concern’s accounts receivable rarely matches its accounts payable. Large companies regularly borrow millions for one-day, low-interest loans so they can, for example, make payroll while waiting for clients and customers’ checks to clear. When Lehman Brothers went bankrupt, however, the Reserve Money Fund – the market’s oldest money fund that is fed daily by the commercial paper – “broke the buck”. For the first time ever every dollar invested in the fund was worth only 97 cents.
When you hear about “the collapse of the world financial system,” this is the ground zero event. Investors in the traditionally safe fund suddenly run for cover, exacerbating the crisis. Well-run, profitable businesses with no connection to the subprime mortgage debacle suddenly face a liquidity crunch.
Like Isaac Davis in “Manhattan,” the world banking system found “something’s not flowing.” And many of the efforts of governments around the world are to keep the spigot going.
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