Cost of interdependency ... a Ponzi scheme

In an excellent article in the Wall Street Journal, the editors of the BreakingViews.com section (Financial Insight, July 27, 2007) point out the hazards of interdependency of banks, hedge funds, and private equity houses and strike a blow in the heart of the misguided fallacy that, for instance, subprime mortgage mess should remain contained to one sector of the economy of the wealth sector.

Now that seemingly the "liquidity" is being drained from the market, bulge banks, which normally would have to become restrictive about providing loans to risky funds (read hedge funds) and other managers of loan obligations (read CDO and CLO), are finding themselves in a bind. The main reason here is that in the time of easy money and easy credit, banks loan to private equity to support the insatiable appetite for leveraged buy-outs (LBO) so that these soon-to-be dinosaurs could go on getting more obese. These so-called "bridge loans" are nice and juicy income-generators, so long as they remain what they are: bridge loans, until some else buys them from the banks.

The customers, it turns out, are the hedge funds, and CDOs and CLOs. Oooops! If the credit is becoming tight, you don't want to loan to risky hedge funds, but those same funds are also your main buyers. You're stuck, and may be the dance partners are not on the floor anymore. You're hooked with billions and billions of risky loans. This is what sank the Bears Stearns funds a month ago, and the same is happening to the commercial market.

Put another way, this is a scheme, where one transaction is dependent on the proceeds of another transaction in the same ecosystem, i. e. the Ponzi scheme. Thus far, all Ponzi schemes have collapsed and most are illegal. This may also be.

To see how tight things are becoming, consider that in the 1st half of 2007, more than $575 billion CLOs were issued, nearly $96 billion per month. In the month of July, no more than $2 billion have been issued thus far (S$P).