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Fed liquidating hedge fund

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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.

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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.