More thoughts on selling off assets to raise cash, hedge fund blowups and getting ready in a post-housing-bubble world

In Manias, Panics and Crashes, the most important words to remember for what always happens during a boom and bust are these:

The final phase is a self-feeding panic, where the bubble bursts. People of wealth and credit scramble to unload whatever they have bought at greater and greater losses, and cash becomes king.

I know a lot of us struggle with the idea of "rushing" to US dollars, and cash. What about gold! What about oil! What about other commodities! What about foreign currencies and stocks! What about baseball cards!

Yes, intuitively that feels right. But at the end of the day, when the hedge funds, pension funds, banks and foreigners find themselves in the inevitable selling freefall during the Great Unwinding, they'll sell their most liquid assets first (gold, stocks, bonds, commodities, etc) to raise cash to avoid margin calls and total wipeout. So everything - EVERYTHING - will fall in dollar terms initially as investors raise dollars.

And then the illiquid assets go at firesale prices - anything to get them off the books and turn them into desperately-needed cash. I think the biggest unresolved question pertains to the definition of cash - and the US dollar. I think the dollar is an asset class to itself, and foreigners during the panic may rush to the dollar as a flight to 'safety', or they may dump dollars in favor of 'safer' currencies. That's the great unknown.

As a final exercise, weigh this "rush to cash" concept against these words regarding the CDO/Bear Stearns/Hedge Fund disaster underway:

The risk to the financial system was not merely that some large brokerage firms may have been forced to write down a couple of hundred million dollars – they may still have to do that. But had the fire sale gone through, market values would have been available to the securities sold.

This in turn would have forced other lenders to revalue the collateral they hold; and as the collateral is worth less, the brokers will lend less money. That would have triggered further margin calls, further forced liquidations.

When hedge funds implode, they tend to sell off more liquid assets first; at the end of the sale, the prices of the liquid assets are depressed, yet the fund may still be left holding illiquid securities.

To illustrate this, take the example (this is not the Bear Sterns fund) of a hedge fund that may make bets on CDOs and, say, the price of oil. As such a fund needs to raise cash, it would close out the more liquid oil positions, causing a spike (or drop – depending on which way the unwinding works) in the price of oil.

The resulting volatility in the markets would be most painful for leveraged investors in the oil market, although the crisis originated in the CDO market.

Too many leveraged investors have become complacent because the low volatility we enjoyed in recent years. Aside from the short-term volatility, the high leverage employed by many hedge funds would need to be reduced permanently. As speculators pare down their leverage, they sell off assets to raise cash.