Michael Corleone: “How bad do you think it’s gonna be?”
Clemenza: “Pretty dam bad. Probably all the other Families will line up against us. That’s all right. These things gotta happen every five years or so, ten years. Helps to get rid of the bad blood. Been ten years since the last one. You know, you gotta stop them at the beginning. Like they should have stopped Hitler at Munich, they should never let him get away with that, they was just asking for trouble.”

Clemenza is absolutely right – you gotta stop them at the beginning. But instead of addressing our problems at the beginning back in 2008 and 2009, our government officials have insisted on constantly tinkering with fiscal and monetary stimulus plans. The market has never really dealt with the financial crisis caused by the housing bubble crash. The market has simply lived off of stimulus and pretended that the problems have gone away. The events of the past two weeks, which includes the political circus surrounding the debt ceiling and the European contagion spreading, have demonstrated that our financial problems are still with us and if anything have grown much worse. It’s time for us to get rid of the “bad blood” and start addressing the root of the problems. Throwing some printed money at the problem has not worked so far and will not likely work if the Fed tries it again. Addressing the problems in a tough Clemenza-like way will cause some short term pain but may prevent longer term problems.

There is no doubt about it, yesterday was a terrible day in the equity market. But it was not a flash crash. Volumes were huge but were orderly. What we witnessed yesterday was how a market with no real liquidity providers handles a correction. Since there are no obligations anymore for market makers, they simply get out of the way when the market gets stressed. Bids faded quickly and if a real buyer did show up, the front running that normally juices a stock even more did not happen. The buy programs that magically appear in the middle of the day when volumes are very quiet did not show up yesterday. We have previously likened the stock market to a thin crust of liquidity with a hollow core. What we experienced yesterday was the cracking of that thin crust and the exposure of that hollow core.

All the fixes that the SEC has enacted since May 6, 2010 have not addressed the problem of phantom liquidity. Andrew Haldane of the Bank of England said it best: “HFT liquidity, evident in sharply lower peacetime bid-ask spreads, may be illusory. In wartime, it disappears.” Unfortunately, yesterday we went to the mattresses and the war may have just begun.