The Last Bubble
...the reduction in systemic liquidity from the slowdown in housing, from less people borrowing, is being replaced through us by hedge funds that are still taking the credit.
"What do you have for me today Bill?"
"Well sir, we did another $2 billion in repo yesterday morning with the New York Fed. We certainly do not need the cash, but the repo rate was so attractive that I took it in. I called around and once again, the only takers of the cash was our stock arb desk and prime broker."
"Yes, I spoke to commercial lending Wednesday and they are at their risk limits. What is our stock position and how much are we out on prime broker?"
"The figures as of Wednesday night show us long stocks and short futures about three quarters our limit and we believe the rest of the Street is similar. Just so you know, the spread has been getting cheaper into expiration and our trader does feel there is a growing chance that we will wind up selling a large amount on expiration one of these times. If we do, then others will as well so it might shake the market somewhat. It may even be in September. The prime broker has been a consistent taker of capital. One thing that does concern me is the level of leverage they are at with hedge funds in general. They tell me that as volatility in the markets goes down, their VAR risk models allow them to lend more to the funds. There is demand for leverage from hedge funds for the same reason...as volatility goes down they want bigger positions to make the same amount of money."
"Are you suggesting another LTCM?"
"No sir, this is a little different. LTCM was using huge leverage, maybe 100 to one, trading assets that did not move much. The currency crisis made those assets move 50 times more than they usually did and all that was concentrated in one huge fund. This is a more general and marginal increase in leverage, maybe from four times to six or seven times, but these hedge funds are trading much more volatile assets with more directional risk. Interestingly what it is doing is injecting liquidity into the system as they borrow more from our prime broker and buy more risky assets. This is our biggest business, sir, and we have to be very careful not to curtail it at the wrong time. But the risk is growing due to the cross correlation of the hedge fund system....We know that as volatility rises, the process reverses and hedge funds will try to reduce risk by liquidating and reducing leverage. As that happens some will experience enough losses to cause redemptions. This will actually cause a request from these funds for us to increase lending to them just at the wrong time. If we cannot get liquidity ourselves at that time we may actually request funds that are doing fine to reduce their leverage to compensate."
"What are you saying Bill?"
"Well, the reduction in systemic liquidity from the slowdown in housing, from less people borrowing, is being replaced through us by hedge funds that are still taking the credit. The problem is that there is a scenario where this may unwind and reverse if volatility picks up significantly; hedge fund liquidation may cause a spike in demand for our credit just when we don't want to give it. As treasurer, you should be aware of this risk."
"Ok, I'm going to lunch now. I'll be back in a few hours."
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