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Unintended Consequences


One important asset class destroyed to protect the highly leveraged ones.

Many are asking the government for help. Be careful what you ask for.

I've been talking for some time about the socialization of markets: How government intervenes in the market process of allocating resources with public (printed) money. When a large non-economic entity interrupts the marketplace, it only creates imbalances and unintended consequences; that entity is operating with limited information and political motivation.

I spoke to my friend John - he runs one of those evil hedge funds, and he gave me a clear example of this. Over the last year, the normal process of creating credit has broken down. Banks can't borrow through the repo system, because they ran out of capital. So the Fed has stepped in and has been willing to give banks capital in exchange for risky assets; for a bank, that means bad loans.

The Fed has a potpourri of risky assets they're willing to accept in exchange for capital. Because banks have no capital of their own, they can't decide to extend credit on any asset not on the Fed's list of acceptable collateral.

This brings us to convertible bonds. Corporations have used convertible bonds to raise money over the last 10 years, to the tune of $1 trillion. It has therefore been one of the most important capital-formation asset classes in the world.

Without getting too complicated, corporations exchange a lower interest rate as a cost of funds for a call option on their stock. The whole thing works because hedge funds have been able to pay a higher price for the convertibles, because they can hedge the risk by selling stock short. This requires just a modicum of leverage - about 2 or 4 times.

The companies are happy, because they can raise money at a good cost of capital. The hedge funds are happy because they can earn a reasonable return for a fair risk. There was liquidity in the system.
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Positions in GS, GM, GE, JPM
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