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Saturday, March 21, 2009


risk capital is gone

yves smith reads a gillian tett piece in the financial times harshly, but her essential point is right -- the status quo ante is dead and will not be coming back. a lot of people, including the united states government, are still in denial of this basic fact and the resulting misperceptions are dangerously misleading.

important observations relayed by tett:

... [S]ome recent anecdotes are chilling. Last week, for example, a group of senior hedge fund players and chief investment officers gathered in Dublin – and collectively guessed that about 80 per cent of the risk capital that was sitting in the European system a year ago has disappeared....

What is even more dramatic – but less visible – is the disappearance of banks’ proprietary trading desks... traders in London say there is really only one bank in Europe which is even pretending to run an active prop desk now – namely Goldman Sachs. As a result, billions of dollars of risk-taking capital is believed to have quietly vanished.

That has had all manner of extraordinary consequences. Two years ago, a host of hedge funds and prop desks in London were building up their distressed debt-trading teams to take advantage of a future turn in the credit cycle. Logic might suggest such funds should be wildly busy right now, swooping in to buy distressed companies, or securities. Nothing could be further from the truth. As banks have slashed their risk-taking operations, they have also cut their distressed prop desks, and most have stopped making markets in distressed products. Hedge funds dealing with distressed assets have also folded, unable to raise funds.

As a result, there is a dire shortage of capital to organise – or fund – even “simple” restructurings of companies, distressed investment entities or anything else. Hence the gridlock on dealing with toxic assets.

But not just credit assets are being hit. As asset managers hunt for places to put their cash away from the carnage of the credit or property world, some have been tempted by the world of small-cap equities. But trading in small caps can only take place with market makers – and right now, banks are not just cutting prop desks but market making activity too. As a result, fund managers are sitting on their hands. “We would love to buy small caps but we just cannot tolerate the liquidity risk,” explains one large asset manager. “Almost any sector which needs marketmakers is half-dead.” Logic would suggest that eventually this pattern should change. After all, oodles of cash remain in the system. That cannot all stay in government bonds for ever, least of all in a world where the Fed is busy intervening in such a dramatic fashion to suppress yields.

in fact it can stay hidden and likely will. sidelined risk capital is a myth -- it has been destroyed in the great unwind. much of what is hiding in t-bills is not risk capital, and a lot of it won't be coming out of t-bills.

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