29 October 2008

Another reason for the credit crunch

As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.

It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.

This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.

Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.

But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.

1 comment:

zedman said...

As I wrote in my blog, I think that Robert Peston is taking concurrent events and incorrectly trying to show causal links.

The crisis over the past 15 months has clearly shown how the financial world is intricately intertwined. While all the things written in the blog are correct in and of themselves, the connections are tenuous.