When the Fed decides to take certain risky assets as collateral and not others, the other assets become worthless as collateral to a BD that's lending money to hedge funds. As BDs deleverage (not a bad thing), it's important they do so in a balanced way. Because convertible bonds aren't accepted as collateral by the Fed, BDs can't use them as collateral. They therefore suddenly called up hedge funds and demanded full cash (no leverage) overnight.

This created one of the biggest sell-offs in history, as hedge funds were forced to sell convertible bonds at any price in order to raise the cash demanded by their prime brokers. They had no choice in the matter. Large hedge funds in business for 15 years or more went out of business overnight.


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The above chart shows clearly what most people never see. John’s hedge fund operates on very low leverage (it waits for good prices instead), so they were in position to buy these bonds at zero leverage at these prices, to make a good return for the risk.

I use this example to show the world the nature of government intervention: That it does much more harm than good, because it operates from imperfect information and non-economic motivation. They try to “fix” one thing, and another breaks. The government has ruined a very important asset class by trying to fix completely broken ones that use much more leverage.

Eventually the government by nationalizing/socializing markets will plug all the leaks by throwing enough “money” at things. But logic tells us this has major consequences: It will significantly lower productivity and profits. People say stocks are cheap, but they're wrong: When you pay even 10 times earnings for a stock, it must be because it has growth. If there is no growth, the right P/E for a stock might be as low as 5.

Another example was the letter sent by Congress to Goldman Sachs (GS) objecting to using government funds to pay bonuses. Well, I don’t believe the government should have done that in the first place, but once they did, they shouldn't be telling a private company what to do with its money. If Goldman doesn't pay its people well, the best of them will leave (there are still bids for good people, at least for now), leaving the company a shell of what it once was. An example yet again of what happens when you reward non-productive organizations and penalize productive ones: You will eventually destroy productivity.

So before you cry to the government for help (are you listening, General Motors (GM), General Electric (GE), Goldman, JPMorgan (JPM), etc.?), be ready for the consequences.

Risk is high and returns are low.