Wednesday, September 24, 2008

Why are Broker/Dealers dropping like flies?

The chart below offers a perfect explanation. Broker/Dealers are faced with the challenging task to roll over a quarter of their assets every night. When crisis hit short term financing is harder to obtain and the roll over stops. In order to stay solvent they have to sell assets at fire sale prices (if they can sell them at all). Hence the margin/haircuts erode their capital base and equity shrinks. If they cannot get a capital infusion (volatility is high, equity is low and the dilution effect is high) they are forced to sell even more assets at fire sale prices. This creates a "loss spiral" that will eventually drive them into bankruptcy.

That's why it is crucial that the government steps in and buys up assets at a premium price (according to Bernanke testimony close to maturity). The idea this would stop the "loss spiral". The question being are 700 billion dollar enough or do we need another capital infusion of this magnitude? This could very well overwhelm authorities and make a financial meltdown unavoidable. The Austrian's Mises and Hayek might eventually be proven correct and the neoclassical concept of economics need revision.

click to enlarge

Unfortunately the chart does not include commercial banks. The situation might be similar. It would be interesting to see how much of their assets are financed in the overnight repomarket.

source: Thoughts on a New Financial Architecture
Markus Brunnermeier,
Crisis on Wall Street Panel Discussion - September 23, 2008

source: Statement of Ben S. Bernanke before the Committee on Banking, Housing, and Urban Affairs

September 23, 2008

source: Austrian School

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