Yves, your blog is one of my first reads every am.

The prime brokerage market is highly concentrated. Goldman, Morgan Stanley, Deutsche and Bear have about 75% of the market, maybe 80%. I just read that BofA was trying to sell or had sold its PB.

Goldman is a pig and very clever about not looking like one (this is based on having worked there). They’d be my prime candidate for pursuing your strategy.

2 rules of financial investing:

1) Don’t panic.
2) If you have to, panic first.

As far as I can tell, the only reason banks didn’t shut down hedge funds earlier is because all that crap would end up on their own books. But now that they have a reliable way of disposing of that stuff, why not? It’s not like they have any fiduciary duty to the hedgies’ investors. The only reason hedge funds haven’t done this yet is because they can’t.

In essence, I’m afraid the Fed has created the mother of all arbitrage opportunities. If you have access to the Fed’s TSLF/TAF, then the Fed is acting as your market maker, able to convert your toxic bonds into liquid and safe treasuries for a price above what the private market will pay.

But only a privileged few have access to the Fed. Thus, the banks are able to arbitrage the enormous difference between the private market for toxic debt and the public (i.e. Fed) market for toxic debt, leaving the private market (i.e. hedge funds) wiped out.

I don’t know if I have the energy for another long post tonight (all this drama is enervating), but I wanted to write one on the prisoner’s dilemma. We seem to be here now (Eugene Linden sent me one of his pieces which argued that vampire bats do a better job than we humans do).

If everyone sells each other out, like all the IBs shut down the levered hedgies (they’ve already started down that path), they might think they are improving their risk, but systemically you create a disaster and leave everyone worse off. If everyone showed a bit of forbearance right now, we’d all be better off, but the mindset is “devil take the hindmost.”

Re: JP Morgan. My theory is, the reason that JPM & The Fed offered $2B, was because this was an arms length deal, and in the end, JPM only had $2B in the vault. This price of $2 is as meaningless as The Fed opening the door for any shoeshine boy that needs to trade a bike for cash. The Fed Pawn Shop is not a welcome turn of events and, as usual, it would be nice to see some fringe element from this government to come forward to take control, or to investigate or to do something other than look like limp puppets in a mafia casino. We don’t even seem to have the press asking questions, it’s like deer in the headlight syndrome, where thoughts are frozen. Where the hell is DOJ, FTC or even IMF, NATO, maybe Colin Powell. Maybe this is what happens when Rome falls, people sit around looking at each other, reading the news, as buildings burn down…..

This is getting weird yves!

That was the first unintended consequence, wasn’t it? Lower overnight rates to unfreeze the mortgage market and watch 10-year rates increase as people worry about inflation.

I’m wondering: if the demise of Carlyle and BSC was hastened because they were firms that couldn’t access Fed money and thus were foreclosed by firms that could, what will happen Monday? I’m thinking hedge funds, unable to access the Fed directly, will be eaten alive by the IBs.

Why? Because I’m figuring they’ll find it safer to shut down hedge funds, take their collateral and convert it into Treasuries, even at the usual Fed haircut, rather than deal with the prolonged uncertainty and volatility of working with their hedge fund clients for an orderly unwind of their positions.

When there was no choice but to choose option #2, plenty of IBs bent over backward to try to keep the hedgies afloat, lest the market collapse. But now, better to shut them down, stuff the Fed with the remaining crap, and sleep better at night knowing your collateral is now in Treasuries rather than illiquid and opaque hedge fund positions. Which IB out there wouldn’t be willing to convert their whole CDS position into treasuries even at a 50% discount (especially since with a repo, if the CDSes don’t default, you’ll get them back at par when the storm has settled)?

That was a great comment.

The Fed is already at the end of its debase the currency strategy. The ten-year Treasury auction last week stank. A steeper yield curve means more costly mortgages, unless people do floaters as they did in the inflationary 1970s (they aren’t so awful if they have interest rate ceilings and floors, but from what I can tell, no one has dusted off that product. Plus with subprime ARMs having taken down so many borrowers, you might have a problem with customer receptivity to the product).

We’ve already seen the law of unintended consequences so far:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Now we have 3) Fed opens TSLF to broker-dealers. Given the track record of our esteemed Fed so far, I shudder to think what the unintended consequences of this one will be, and I’m disturbed that it’s very likely that no one has thought about that while running around in a panic shooting from the hip at any shadow that comes up. Anyway, here’s my speculation…

The Fed is already close to tapping its full balance sheet. The trigger for the collapse of the past few weeks has been the rise of agency spreads, which is the cause not the effect of all the implosions we’ve seen so far. So to stop the panic, the Fed would have to intervene in the agency market. But it’s remaining reserves of ~$400bil is tiny compared to the amount of debt out there. Furthermore, even a full faith govt. guarantee is unlikely to stop the rise in premiums (witness Ginnie Mae debt, where spreads are increasing even with a govt. guarantee). This is partially because of panic, and partially because agency debt will have fundamentally different behavior when it includes all the extra debt Congress is talking about stuffing it with. So with that uncertainty and unpredictability, it’s no wonder spreads are increasing.

As the spreads continue to claim more casualties, more firms will line up for funding (when do hedge funds get to drink directly from the punch bowl? At this rate, probably in a week or two), and the Fed, unable to say no, will have to start issuing treasuries to expand its balance sheet. Within a matter of a month or two, the Fed will find itself with a trillion or so dollars of impaired debt in a “repo” that can’t ever be recalled (some because the counterparty’s balance sheet is still too weak, others because the counterparty has gone BK). The ultimate casualty? The Fed itself, unable to lower interest rates below 0%, facing default on collateral on its hands, and counterparties (central banks) unwilling to trust the Fed to manage the dollar any longer.

Oh yeah, and mortgage markets will still be frozen.

Happy St. Patrick’s day, Yves

If government had done its job (curbing the excesses of the greed-driven among us) it would not now be trying to do the impossible. Does this crisis show the ineffectiveness of government? Or the utter unreliability of our financial institutions and the people who run them so recklessly? Or both? Is it just the latest chapter in the long, long book of human folly?

This could be the day of the Wahoo bird.

That’s the bird that flies in ever-decreasing concentric circles until if flies up its own asshole screaming WAHOOOOOOOOOOOOO!!!!!!

TomD