Lending to external trading vehicles leaves you short liquidity

Lending to vehicles such as Hedge Funds, Special Purpose Vehicles is the same as renting your balance sheet for a fee, whilst retaining downside exposure when things go wrong. This sort of lending can be done in a number of ways - prime brokerage, repo agreements, backstop facilities. The difficulty with these type of relationships is that they do not price in the fact that when things go wrong, it is the lender that has to take whatever assets that have been bought and try to sell them in the open market. This is after the vehicle has lost all of its money and is effectively bankrupt.

The exposure therefore looks much more like having a long exposure to a super-senior piece of a CDO, where the vehicle takes the equity. In this arrangement, the hedger would look at the tranche delta and put on some hedges in the honest opinion that once the equity has been gobbled up, the exposure is all his.

In prime brokerage, the underlying assumption is that they will be able to get out of any risk before the equity is wiped out, thus allowing an orderly retreat. In other words the prime brokerage guy would never spend some of that fee income on a hedging strategy and therefore go through a surprise realisation that the assets are theirs during a period of market meltdown.

Both approaches - the CDO super-senior risk and the prime brokerage haircutting absolutely do not price in the risk of liquidity. At inception most people look at historical graphs and announce that the size of whatever trade can be supported during a timely retreat. This observation misses a couple of important points. 1) hedge funds are related since there are a small number of trades they can execute 2) historical analysis usually reflects the good times as everyone gets in on the trade (crowded) and thus has suppressed volatility 3) the point at which you have to force a liquidation in particular when it is deemed highly unlikely (AAA ABS assets as an example) then things are likely to be very bad for everyone.

The key exception is Amaranth that betted against the market. Unfortunately until 2007 this was the only large hedge fund collapse. Oh happy days.

So my conclusion is that when you lend to a trading operation, you are buying protection on the first loss piece of the assets in question. And that's it - no point in pretending these vehicles are anything other than two ex-traders and a bloomberg which no assets other than their upfront collateral.