Musical Chairs

A former colleague of mine from Lehman wrote on his website yesterday "The value of liquidity is still underappreciated." Those of you that are regular readers here know that this is a central theme of this blog. As the fixed income markets slog through the "great unwind", liquidity will remain at a premium for years (probably) to come. Fixed income traders know this, if they know what they are doing. The problem has been that many people have jumped or been allowed into this marketplace, backed by vast pools of highly levered capital, that really didn't know what they were doing. It isn't hard to make money in a one way market (ask anyone involved in NASDAQ in 1999). The liquidity issue still isn't focused on in the popular press primarily, I believe, because they don't understand it. Most of the media that claims to have some sort of financial background had exposure to the equity market. On the liquidity front, that market is a completely different ball of wax from the fixed income game. The easiest way to explain it to people is to liken the situation to a game of musical chairs.

This game of musical chairs, up until last summer, was one where there were 20 players and 50 chairs. The music never stopped and the only time you sat down was because you were tired. Sitting was never a problem, however, because there were many more chairs than players. Finally, someone read the rules and realized that the music was supposed to stop and chairs were to be removed. So, the market removed 40 of the chairs and stopped the music. Twenty people tried to sit down, and some not knowing any better, fell on the ground. Those who got chairs found out that some of them only had three legs. The music was turned back on but the people in the chairs were tired from all the walking, were afraid of losing their chair, and didn't get up. The music kept playing but still no one got up. The party organizer (aka the Fed) then stepped in and tried to get the players up and moving again by offering treats (lower rates). Some though about getting up, but quickly sat down again. Then, the organizer tried adding a few chairs back to the game, and that seemed to make the players feel better and start to want to play again.

In this game of musical chairs, the players are the investment/commercial banks, you know who the Fed is, the chairs are liquidity and the music represents transactions. However, the goal of this game isn't to have one player left at the end, but rather to keep the game going as long as possible. The music stops once in a while, and someone find themselves odd man out. That's OK, this is a normal function of the checks and balances of the system. On the flip side, there are new market entrants, in which case chairs are added to the game. The organizer watches over the game, sometimes controlling the music and sometimes not, making sure there are the appropriate balance of players and chairs so that the game functions normally.

That balance got out of whack in the past few years. Unfortunately, to bring it back to a harmonious state will cause some of the players to cry and throw tantrums. That is too bad, but perhaps they shouldn't have been playing in the first place.