Sunday, November 8, 2009

Banks and Hedge Funds

Banks are essential, but troublesome institutions that keep checking accounts for depositors, but only hold a fraction of deposit liabilities in reserve to pay for checks.

Normally 15 cents on the dollar will be adequate reserves because those writing checks will about equal those making deposits. Normally borrowers will be paying principal and interest to further assure that banks have reserves to pay on their checking accounts.

Because a bank’s liabilities include personal and business checking accounts, i.e. money, the larger society has a special need to regulate banks to make sure they have reserves to meet their account liabilities.

Even though bank regulations requiring minimum reserves have been around a long time banks have been left to decide which loans to make and which loans to refuse. Individual banks decided when to make loans to hedge funds and how much to loan.

To make payments on their loans hedge fund managers need to have their own reserve funds from investors, or profits, but hedge funds are unregulated so it is up to hedge fund managers to decide their reserves.

More than a few people urge that hedge funds should be regulated like banks because they are taking risks more risky than banks, which can bring down the financial system.

To judge the risk yourself suppose it is 1993 and you are the manager at Long Term Capital Management, a new hedge fund. You notice in August that a new 30 year Treasury bond with coupon interest of 7.2 percent starts trading at 7.24 percent interest and a price of $980.84 for a $1,000 bond, but another 30 year Treasury bond first sold in February 1993 is trading for 7.36 percent interest at a price of $995.13.
(Price calculations are from MS Excel function PRICE)

To exploit the difference of price, the spread, you get a loan to buy the cheaper and older $1,000 bond at $980.84. Then you borrow the other bond from a brokerage house like Merrill-Lynch and immediately sell it for $995.13 cash.

The two transactions will be profitable if the interest rates converge over time: the low one rises and the high one falls. Economic theory predicts price differences will be temporary for a product or service; low prices rise and high prices fall until all are equal.

Suppose in two months the interest rates do converge to 7.3 percent.

At 7.3 percent interest you can sell the older bond for $987.83: a $6.99 profit. You buy back the newer bond for $987.77 and return it to Merrill-Lynch. Since you sold it for $995.13 you make $7.36 on the second transaction. Total profit equals $14.35.
Earning $14.35 will not make you rich, but if a bank will lend you $1 billion to buy many bonds and interest rates do converge then you can get rich.

Banks made billions in loans to hedge funds and many made profits doing the same and similar transactions as the one above. Eventually though, interest rates diverged and some countries and companies defaulted on the bonds in hedge fund portfolios.

Hedge funds could only sell their bonds at a loss, if at all, and without reserves or cash they defaulted on billions in loans. Banks needed those loan payments to have enough reserves to clear checking accounts: my money and yours. That was the downward spiral, the crisis.

Maybe it’s high finance? Maybe it’s gambling? Maybe it’s time to regulate hedge funds like banks?

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