A hedge fund manager explains the financial meltdown to n+1:
When you’re talking about risk management, there’s an assumption that not every asset class will be correlated. So, sure, sub-prime blows up but the bank’s OK because prime will hold up, or there won’t be a perfect correlation with leveraged loans. But what’s going on is that all these credit products are performing badly at once.Because?
Because there are some real linkages. If consumer spending has been supported by people extracting equity from their homes, the mortgage market shutting down will hit consumer spending. And that will hurt companies that rely on consumer spending.
And then there are the financial linkages — hedge funds blowing up so that they can’t buy leveraged loans anymore, or banks that got hurt in sub-prime that have to sell down leveraged loans to generate liquidity, and the buyers are gone.
So that’s one financial linkage, but also there’s capital — the banks’ capital base. Every time a bank takes a write-down, that erodes its capital base, and the bigger the base the more risk it can take. There are rules for that — Basel 2 capital adequacy — and if a bank is writing down 10 billion dollars, suddenly the risk-taking capability is reduced. Assume basically capital adequacy ratio for all these banks is 10 percent. So if a bank falls 10 billion below its capital adequacy target that’s 100 billion dollars in risk-taking capacity that disappears.