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?

28 comments:

Anonymous said...

Remarkable issues here. I am very happy to look your article.
Thanks a lot and I am taking a look forward to touch you.
Will you please drop me a mail?
Check out my webpage ... Luscious Amateur Gets Her Face Drizzled With Warm Cum

Anonymous said...

Great blog here! Also your site loads up very fast!
What web host are you using? Can I get your affiliate link to your host?
I wish my web site loaded up as quickly as yours lol
Also see my site :: free porn tube

Anonymous said...

I've read some just right stuff here. Certainly worth bookmarking for revisiting. I surprise how a lot attempt you set to make any such fantastic informative website.
Also visit my web blog : teen porn

Anonymous said...

Hi, I do believe this is an excellent blog. I stumbledupon it ;) I may return yet again since i have
book marked it. Money and freedom is the greatest way to change, may you be rich and
continue to guide others.
Feel free to visit my website ... teen sex videos

Anonymous said...

Greetings! Very helpful advice within this post! It's the little changes that produce the largest changes. Many thanks for sharing!
my page: Horny Brunette Sucks a Big Rod

Anonymous said...

Pretty! This was an incredibly wonderful article. Many thanks for supplying
these details.
My blog post - Orlando hookah bar

Anonymous said...

Wonderful blog! I found it while browsing on Yahoo News.
Do you have any suggestions on how to get listed in Yahoo News?
I've been trying for a while but I never seem to get there! Thanks

Also visit my web blog best honeymoon destinations

Anonymous said...

Wonderful blog! I found it while browsing on Yahoo News.

Do you have any suggestions on how to get listed in Yahoo News?
I've been trying for a while but I never seem to get there! Thanks

Visit my blog post; best honeymoon destinations
My page > Clkbank com _

Anonymous said...

Hi there! Do you know if they make any plugins to help with Search Engine Optimization?
I'm trying to get my blog to rank for some targeted keywords but I'm not seeing very good results.
If you know of any please share. Many thanks!

Also visit my blog ... Affiliate Marketing Success
my webpage - http://aholab.ehu.es/tiki/tiki-index.php?page=UserPageemilystrou

Anonymous said...

It's nearly impossible to find experienced people in this particular subject, however, you seem like you know what you're talking about!

Thanks

My web-site; home equity loan refinance
Also see my web site: Keep reading

Anonymous said...

Very energetic post, I loved that a lot. Will there be a part 2?


Also visit my web-site - www.Le-G.com

Anonymous said...

What's up, its nice article on the topic of media print, we all be aware of media is a great source of information.

Here is my web site ... credit cards for people with bad credit

Anonymous said...

I'm not sure why but this website is loading extremely slow for me. Is anyone else having this issue or is it a problem on my end? I'll check back later on and see if
the problem still exists.

Have a look at my web page; Benutzer:ClaraW61 - PBV e.V.

Anonymous said...

We are a group of volunteers and starting a new scheme in our community.

Your web site offered us with valuable information to work on.
You have done a formidable job and our entire community
will be thankful to you.

Here is my webpage http://lovespot.ro/InabpbCue

Anonymous said...

Hi, There's no doubt that your web site might be having browser compatibility issues. When I look at your website in Safari, it looks fine however when opening in Internet Explorer, it's got some
overlapping issues. I just wanted to provide you with a quick heads up!
Other than that, great blog!

Here is my page ... private krankenversicherung für kinder
my web page: http://www.karenscomputers.com/?attachment_id=224

Anonymous said...

Thanks in support of sharing such a nice thought, piece of writing is
nice, thats why i have read it fully

Also visit my weblog ... Seo marketing companies

Anonymous said...

I'm curious to find out what blog system you have been using? I'm experiencing some minor
security problems with my latest blog and I would
like to find something more secure. Do you have any recommendations?


My site: schuhe online billig kaufen

Anonymous said...

When I originally commented I clicked the "Notify me when new comments are added" checkbox and now each time a comment is added I get four
emails with the same comment. Is there any way you can
remove people from that service? Thanks a lot!

My blog; please click the following website

Anonymous said...

Great blog! Is your theme custom made or did you download it from somewhere?
A theme like yours with a few simple tweeks would really make my blog jump out.
Please let me know where you got your design. Thanks

my site ... Irish Photographers

Anonymous said...

I am really pleased to glance at this webpage posts which contains plenty of
valuable data, thanks for providing these kinds
of statistics.

My page; Read More

Anonymous said...

Ahaa, its good discussion on the topic of this piece of
writing at this place at this webpage, I have read all that, so
now me also commenting at this place.

my weblog :: porninvader.net

Anonymous said...

My coder is trying to persuade me to move to .net from PHP.
I have always disliked the idea because of the costs. But he's tryiong none the less. I've
been using WordPress on numerous websites for about a year and
am worried about switching to another platform. I have heard fantastic things about
blogengine.net. Is there a way I can import all my
wordpress content into it? Any help would be greatly appreciated!


my blog ... http://www.porn-index.net

Anonymous said...

Good answers in return of this difficulty with solid arguments
and explaining everything concerning that.

Feel free to visit my webpage http://girlmovies.net/videos/-brunettes-in-bikinis-angry-together-3019.html

Anonymous said...

When some one searches for his vital thing, so he/she wishes to be available that in detail, therefore that thing
is maintained over here.

Take a look at my homepage - lesbo porn

Anonymous said...

Good write up…normally I never response to these matter
but this time I will, Thanks for the important info.

my page - Stay at home jobs for moms that are not scams

Stock Future Tips said...

Really I am impressed from this post....the person who created this post is a genius and knows how to keep the readers connected..Thanks for sharing this with us. I found it informative and interesting. Looking forward for more updates.

Unknown said...

The blog was absolutely fantastic! Lot of great information which can be helpful in some or the other way. Keep updating the blog, looking forward for more contents...Great job, keep it up..
Stock Tips

http://equitytipsproviders.blogspot.in/2013/10/strategy-of-intraday-stock-market-news.html

Commodity Tips said...

I would want to thnkx for that efforts you've invest script this web page. I touch hopeful the similar high-grade web position placement stopping at you inside the forthcoming as anyway. Clothed in genuineness your imaginative writing skills has motivated me to achieve my own blog today. In fact your blogging is actually spreading its wings fast. Your invent is a sunny paradigm of it.
Free Accurate Commodity Tips