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Tim Geithner has some experience with this question. In late 2006 he went on a fact-finding mission through Wall Street to the prime brokers (like Bear Stearns, Goldman Sachs (NYSE:GS), Merrill Lynch) and asked them how much margin they extended their hedge fund customers. As inferred by this Bloomberg article, 10-1, 12-1 were customary. Mr. Geithner didn't raise any red flags, at least publicly from these inquiries.

Hedge funds raised investments from pension funds, wealthy individuals and other institutional investors. Then they levered up at ratios of, let's say 10 to 1 on average. Let's assume that the largest lenders to hedge funds were indeed the prime brokers, and that the loans given them to by banks, while large, was a modest percentage.

This simply begs the question of who lent the money to the prime brokers. Certainly there is equity and debt that forms their capital base. They levered up into the thirties to 1. This seems to be where the real action took place. Where did they get the money to do this? One can look at the bankruptcy filing for Lehman (OTC:LEHMQ) to get an idea. Citibank was number one by a large margin, then Bank of NY, Aozora, a Japanese bank. Okay, but during the Lehman debacle there was all this talk of "counterparties", so obviously Lehman owed a lot of people money. Clearly Lehman had margin accounts at various other prime brokers with whom they did business.

Fractional reserve dynamics are in place if the majority of Lehman's business is done with counterparties. This includes prime brokers, Credit Suisse (NYSE:CS) and Deutsche Bank AG (NYSE:DB). Hence the term "shadow banking system."

Let's say equity and debt investors pony up 1B$ in cash. Now a hedge fund opens a prime brokerage account with 10:1 leverage. They deposit 1B$ in cash. Now a corporation puts out a bond issue of 500M$, 500M$ credit goes into an account held by the corporation, who are "encouraged" then to leave it on account. The hedge fund buys the bond, moves the bond into hedge fund assets, and moves 500M$ (excluding fees of course) to the corporate account. Rinse, repeat 20 times. The corporate account now has 10B$ of "cash". The hedge fund has 10B$ of corporate bonds, yielding 7% a year, generating 700M$ yearly interest, held on account, of course; it has a 9B$ margin balance, charged at 6% a year or 540M$ netting 160M$ fee cash flow per year, or 16% profit on the original 1B$. The prime broker has created 10B$ out of 2B$ in actual cash. A very modest 5:1 ratio, yet severely liquidity challenged.

But let's say that the corporation takes out some of the money to make a payroll. The prime broker turns to a bank to make up the difference, since the prime broker has pretty limited "liquidity", since they want to maintain some kind of reserve ratio. This is the essence of the engineered financial system. So a bank comes along and makes an unsecured loan to the prime broker. Corporation extracts $1B of their $10B, so now the bank ponies up, and the prime broker has a 1B$ liability to the bank on their balance sheet, but it's just shifted from being owned to the corporation to now being owed to the bank.

If the corporation wants to use $1B to do an LBO, buy another company, then no actual money needs to change hands if the transaction can stay inside the prime broker ecosystem.

Of course, this omits the fact that the prime brokers themselves had divisions which acted like hedge funds. I'll set that aside for now and say that the model is essentially the same as outlined above.

So basically, the banks are the lender of last resort to the prime brokers. Now to peel the onion, who lends money to the banks? Basically there is money under deposit from individuals and corporations, but is that enough to support hundreds of billions of dollars of loans to prime brokers? Well, banks (at least European ones) were lucky enough to be able to buy insurance against their loan portfolios. This reduced risk enough for them to really crank up their lending ratios, again up into the 30:1 range. Who had the courage to provide systematic failure insurance? AIG!

Who else funded the banks? Well, oddly enough a major consumer of the RMBS (residential mortgage backed securities) aside from other banks, were hedge funds. So for every dollar that the banks lent to the prime brokers, they were able to generate 30 dollars of RMBS securities, in the best case. They probably considered that a virtuous circle at the time.

Okay, so we have a house of cards. Nobody shakes the table and it won't fall down. Enter the RMBS market seizure. This caused hedge funds, which are marked to market, to fail, which toppled the prime brokers, the banks and of course AIG.

Investors in AIG thought they owned an insurance company, not a hedge fund. I'm not sure why someone isn't in jail for that.

Where was the Federal Reserve, who is supposed to be protecting the value of the US dollar instead of overlooking this obvious Ponzi scheme?

Disclosures: none

Source: Credit Bubble: Who Lent to the Hedge Funds?