As financial markets of all flavours convulsed on Thursday, a scary suggestion was doing the rounds - namely that the Fed’s emergency action this week could have the (presumably) unintended consequence of encouraging wholesale liquidations across the hedge fund industry.
As Robert Peston, discussing the collapse of Carlyle Capital Corporation, explains on his BBC blog:
…it’s arguable that the banks’ seizure of Carlyle’s $20bn-odd in assets has actually been encouraged by the Fed’s mortgages-for-Treasuries offer. Because the Fed’s new lending emergency lending facility allows the banks to swap mortgage-backed debt for Treasury Bills in a way that Carlyle could not do.
So it would be rational for the banks to take Carlyle’s assets and exchange them for top-quality, liquid US government bonds, rather than leave loans in place to a business, Carlyle, whose assets remained highly illiquid.
Apply this logic to the rest of the hedge industry and the consequences are pretty appalling. Any hedge fund trying to resist pressure from its banks to deleverage - arguing, say, that its underlying assets are either unfairly priced by the market or simply too illiquid - risks the banks saying “Fine, we’ll have those assets!”
Indeed, the Term Securities Lending Facility could quickly turn into grotesque money laundry.
Alarmist, perhaps. But as the dollar fell below 100 yen and equities dropped 2 per cent across London, there is every reason to believe something seismic might be underway…
Related links:
Robert Peston’s blog
Alea - Unintended Consequences
