Did you hear the story about the successful company with no liquidity?  No, you did not.

Recent failures of finance and commodity trading companies have again brought into sharp focus the incredible importance of liquidity.  Profitability is good, too, but many firms suffer losses and keep on chugging - for a while at least.  Inability to meet immediate funding demands, though, has swift and dramatic consequences.  You can be out of business NOW.

Although it is possible that many trading companies with significant problems may be able to eventually work things out, the simultaneous refusal of a large number of counterparties to trade with them on open credit can easily make collapse a fait accompli.

That is why the immediate response by many troubled firms to relieve market concerns is to raise large sums - or at least increase access to committed funds - and then crow about it as loudly as possible.  Their hope is to reduce or prevent a "run on the bank" like the one described by Jeff Skilling to explain the speed of Enron's fall.  Bear Stearns' approach was to immediately offer guarantees by prospective acquirer JPMorgan Chase to their trade counterparties; Enron's was to quickly get a $1.5 billon loan from Dynegy.  Obviously, that response doesn't always work.

Even firms not as firmly in the crosshairs understand the need to reassure the market at the first hint of even flimsy rumors.  Lehman loudly made it public knowledge that they not only had $30+ billion in cash and $60+ billion in available credit, but they were issuing billions in additional capital as well.  Just to calm any remaining doubters.

This is because many trading companies operate in the over the counter (OTC) market at reduced cost by maintaining large open credit lines with their trading partners.  They simply get to buy on credit in a manner not allowed on exchanges, which mark exposures to market every day - essentially "collateralizing" them anyway in a "pay-as-you-go" manner but reducing the magnitude of an unforeseen "liquidity shock" from the instant loss of open credit lines.  Maintaining the confidence of one's OTC counterparties is obviously critical.

Illiquidity often stems from collateral demands from trade counterparties for mark-to-market (MTM) exposures for fixed price deals.  This is to cover the difference between current market prices and the contracted amount the parties originally agreed to for deals which occur in future periods.  When market prices move away from those fixed contract prices, one party is exposed to the future performance of the other.  In fact, if a fixed price deal is struck while the market is open, one party will likely have some amount of MTM exposure within minutes.

Trading contracts often contain provisions permitting frequent - often daily - margining between counterparties if exposures exceed approved limits.  They may also permit the reduction or elimination of those approved limits upon a "material adverse change" in the condition of the parties or even in the case of events causing "reasonable" grounds for insecurity of a party.  This means that not only does a company have to worry about a.) suffering actual capital losses on completed transactions as well as b.) whether their current MTM position of ongoing deals will exceed approved open credit limits, but they also need to fret about c.) whether their existing limits will disappear on the whim of their counterparties who may be spooked by market rumors and bring current and future business to a halt until "adequate assurance" is provided.

It is ironic that the actions intended to mitigate concerns over a company's future performance can cause its immediate failure.  "We are not sure that you will survive, so we are gonna kill you now."

It is even more ironic that the fixed price positions put on by a company could spell its doom even though they may be part of a profitable hedge or may become profitable over time if permitted to run their course.  This is not baseball, though, where "it ain't over ‘til it's over".  When facing a liquidity crunch, it is not uncommon for companies to be forced to close out or sell off even positive positions at a discount in exchange for quick cash or to stop the bleeding.  In fact, a large part of hedge fund Amaranth's approximately $6 billion hit in 2006 (2/3 of the fund's value) was due to its being forced to immediately sell illiquid positions at fire sale prices and lock in losses.  The urgent need to trade was accelerated by collateral calls and the damage was done in only a few days.

It can't be stated too loudly or too often - liquidity is the mother's milk of a trading operation and must be managed with that in mind.  You can make a bad deal here or there and live to tell about it, but if you run out of cash or other collateral, you may be out of business even if the value of your trading book is positive.  It is critical that those running such efforts understand the consequences of the contractual terms they agree to and the market venues they choose.