Fed liquidating hedge fund
Another concept mentioned was a repo resolution authority with the power to claw back losses (from liquidation).Finally, “an ex post emergency central bank liquidity backstop for the dealer’s creditors” was examined.
This is easy to do after the fact, but in the fog of war (our new favorite metaphor) we wonder.If the defaulted portfolio is sold down at a steady rate (implied by the liquidation timing) assuming prices implied using 120- day volatility over the Sept 2 to Dec 31, 2008 period, a calculation can be made of how much cash could be lost.With a 99% confidence, shortfalls ranged from .96% for US Treasuries to 23.18% for equities.The weaknesses of this approach will sound familiar: moral hazard and difficulty in getting a facility set up quickly enough. With all the stuff we have heard as of late about funding shock — from the FSOC to Fed Governor Tarullo (see yesterday’s post here), we can’t help but think this paper is serving as the intellectual backbone behind a lot of it…to say nothing of the shape of regulation to come.A link to the Fed NY paper is here, […] But remember that hedge funds are typically highly leveraged and get their funding from the bank repo desks and prime brokerages. They have focused primarily on the knock-on effects of funding shocks.We have written about this before, calling it the question a cash lender never wanted to ask their legal department — for fear of being told they needed to manage the eligible collateral to their investment parameters.
That is a technological nightmare (although it may be the only real way to fix the problem).
The Fed NY report “The Risk of Fire Sales in the Tri-Party Repo Market” (May 2013) by Brian Begalle, Antoine Martin, James Mc Andrews, and Susan Mc Laughlin certainly caught our eye. Excessive sales by a single firm can also propagate stress to other institutions if they face margin calls and are forced to sell assets…” The paper argues that since tri-party is so big and some participants vulnerable to runs, that fire sales are likely when there is a default.
Fire sales can “…amplify problems faced by a financial firm because the reduced sale price of the assets can result in realized losses that lead to a decrease in capital and the possible need for additional asset sales.
The paper outlines some suggestions for dealing with pre- and post-default liquidation. The authors suggest that an agreement between dealers to form a consortium to buy out government paper from the cash lenders (should there be a dealer default) could mitigate the risk of a fire sale.
We wonder how that would work and if it isn’t just passing the hot potato?
We also wonder about changes to liquidity during stress.