The Treasury's New Hedge Fund

Legislation is on the table proposing a $700 Billion taxpayer floated hedge fund operated by the Treasury Department. Who knows if the Democrats will make amendments that the White House can or cannot live with. The urgency, pressure, and patriotism seem to be brewing that often bring about non-partisanship decision making on Capitol Hill. The situation is dire. We are facing an all out collapse in the financial system of the United States. After Lehman's failure the most stunning news was the collapse of the money market system and the prospect of an all out run on the banks exposing the fractional reserve system. Furthermore, overnight lending stopped and the tri-party repo-system came to a screeching hault as banks hoarded cash. It should have came as no surprise that the federal government stepped in. The Federal Reserve was modified by legislation in the Great Depression that charged it with the responsibility to stabilize financial systems and use all of the tools necessary as the lender of last resort. What was inconsistent and unpredictable was the White House's policy towards bail-outs and rescues as it appears those decisions are less based on principal or economic philosophies as they are executive practicality, favoritism, and fear.

Paulson may be putting on the best trade in history. However the requirement to avert financial catastrophe by announcing his new hedge fund hasn't optimized his entry price. Paulson's proposal of a treasury hedge fund injecting $700 billion of liquidity into the frozen asset backed securities market is ironic to say the least. The biggest advocates of free market principals and the invisible hand are proposing the most socialist market bail-out in history. The biggest beneficiaries are likely the Broker Dealers on the cusp of free fall, Goldman, Merrill, and JP Morgan. After all, they will surely survive if this measure is approved. It's interesting that the largest financial transaction of human history was publicly announced prior to its execution. Try finding a Sovereign Wealth Fund that will let on any hint of potential investments. The treasury, of course, has done this purposefully to drive up the perceived value of Mortgage Backed Securities. Most participants in this market believe that Mortgage Backed Securities are priced far below their fundamental value as a liquidity hole exists in the market. Nearly all of the major asset backed security market players had on the same trade.

Where will these events take us next? The empire of debt has taken on an enormous new loan. A loan that was necessary to prevent an all out fire sale of assets and chaotic de-leveraging of the financial system. But our temporary relief will not change the fact that we are a nation of debtors living leveraged and beyond our means. A new era of economic hierarchy is among us as the cost of servicing our debt and recognizing the "true" value of our assets will limit our means of production and consumption. An economic stagnation similar to the lost decade of Japan will prevail and the dollar depressed unavoidable asset sale of the United States will push the boundaries of protectionism and independence.

Regional Banks

I think the Regional Banks are next. They are so dependent on big broker dealers like Lehman, Merril, etc. and liquidity in the money market. During the last couple decades they've flourished because interest rates were so low, and their was so much cash in the financial system. This allowed them to make big spreads on the difference between their borrowing rates and lending rates. Considering that the Ted Spread and Libor (London Inter Bank Overnight Rate) has spiked the last few days so dramatically (from 2% to 6% for libor) its will leave regional banks unable to cover deposit withdraws. The fed fund rate is low, but the actual cost of borrowing between banks has skyrocketed as their is no trust within the financial system. Banks have to borrow between one another to cover cash deficits and effectively use surpluses. I suspect a run on the regional banks as the main street phase of this problem. Regional banks also became very dependent on securitized lending. WAMU, National City Corp, etc. aggressively brokered auto, student, and housing loans regardless of the credit ratings of the borrowers. They made huge origination fees, closing fees, etc. The volume in the mortgage business was stunning. The loans were sold to big broker dealers like Lehman, Goldman, etc. who partitioned and put the paper back into the money market (pension funds, money market funds, and insurance companies bought it all up). The Fed is trying to inject the liquidity back (at the expense of the dollar). Regionals have been perceived as not particularly at risk considering that they have millions of customer deposits. A public run on the bank, not an inter-bank run will probably be next. There are Exchange Traded Funds that allow shorting of the regional indices.