Hedge Funds Get FED Aid

Robert Waldmann

You knew it was coming. Hedge funds are getting public help too. I’m not waiting for people who argued against regulation on the grounds that hedge funds are lightly regulated (except for the little rule that they can only take money in chunks of 100 million) and doing fine to uhm revise their views. For one thing, officially, the idea is to help hedge funds help the economy.

Krishna Guha reports in The Financial Times

The Fed said on Friday it would offer low-cost three-year funding to any US company investing in securitised consumer loans under the Term Asset-backed Securities Loan Facility (TALF). This includes hedge funds, which have never been able to borrow from the US central bank before, although the Fed may not permit hedge funds to use offshore vehicles to conduct the transactions.

Hedge fund failures will be difficult to arrange, since they can’t be in debt to anyone but their investors, who bear risk and can’t pull out their money quickly. This is not due to regulation, it is do to you would have to be a fool to loan to a hedge fund. I can’t borrow hundreds of billions either.

The head of the FED knows a lot more about banking than I do. Also The Financial Times is often alleged to be the worlds finest newspaper and would be expected to be rather good on finance. I find the logic of the FED as explained by the FT strange as I explain after the jump.

The Fed thinks risk premiums or “spreads” for consumer loans are much higher than would be justified by likely default rates, even assuming a nasty recession.

It attributes this to a lack of buying interest in the secondary market where the loans are sold on to investors. By making loans to these investors on attractive terms it aims to increase market liquidity.

Ahhh now I understand why people think liquidity leads to high asset prices. It turns out it means “buying interest” but not “selling interest”. That is a liquid asset is easy to sell for a high price not easy to sell for the current market price.

Well that sure explains why a decline in liquidity will cause prices to fall and why everyone is sure that more liquidity would be good for their balance sheets.

Look the FED and the FT have to distinguish between two different issues. One is the level of demand for assets. The other is liquidity — an asset is liquid if the *price elasticity* of demand for that asset is very high. If someone suddenly demanding a lot of some asset makes its price jump up, then it is not liquid. If it is very hard for say the Treasury to drive up the price of assets by buying some then they are just too damn liquid.

I’d tend to imagine liquidity is very closely correlated with trading volume. That doesn’t mean that high trading volume will cause a large increase in asset prices. It certainly doesn’t mean that innovation which causes increased trading causes a large increase in asset fundamental values.

“Making the scheme open to all US companies is a radical departure for the Fed, which normally supports financial market liquidity indirectly by ensuring banks have adequate liquidity to make loans to other investors.”

Now two other meanings of liquidity. The first, market liquidity, is not the liquidity of an asset but the amount of liquid assets in financial markets. And a fourth meaning “Banks have adequate liquidity” means, in part, investment banks have adequate capital and cash flows. It also means reserve requirements are not binding on depository institutions. Dealing with that is indeed standard FED policy. But standard FED policy has little to do with the FEDs view that risk premia are too high or too low.

Hedge funds were not borrowing from depository institutions (in fact I asserted above that they weren’t borrowing at all). We are not talking about loans which aren’t made because of reserve requirements. It is likely that we’re talking about loans which aren’t made because the lender expects to lose money, because the lender thinks that securitised consumer loans aren’t underpriced. Basically Bernanke thinks that he has a better estimate of the value of securitised consumer loans than the market, so he is subsising their purchase (note one can’t get a low interest loan in order to short securitised consumer loans).

Now I guess that is mainly fine by me. Basically, I think that, even if Bernanke doesn’t know best, he sures knows better than the market which is always grossly inefficient and is now panicked.

The article closes with incoherance

Since the credit crisis erupted, hedge funds have complained that they cannot get the leverage they need to arbitrage away excessive spreads and meet high hurdle rates of return.

“Demand is there for leverage but not supply,” said Sylvan Chackman, head of global equity financing at Merrill Lynch.

Huh ? The argument is that hedge funds can’t exploit miss-pricing of assets, because the asset they want to short (evidently their debt) costs too little ! It’s not arbitrage if you can only do it with public sector help.

Now there is demand for “leverage” uhm that means people want to borrow but no one wants to lend. Now I would have thought that supply and demand depend on prices, so the statement makes little sense to begin with.

The point is that no private agent is willing to accept securitised consumer loans as collateral for “low-cost three-year funding” which is not based on the full faith and credit of the borrower (that of hedge funds is worth little anyway as their balance sheets are secret).

There’s a lot of abuse of jargon trying to hide the fact that the FED has decided to move a market price other than the safe interest rate. Radical policy yes. More palatable if people try to hide what is going on by changing the meanings of words in mid sentence ? Not to me.