Dumbest Trade in the World .... to be Guaranteed by the U.S. Government :-(

"Borrow Short / Lend Long" - let's call it BSLL.  This is an ancient and finely tuned scheme to lose lots of money in a flash.

BSLL has much in common with the Ponzi Scheme.  They both have deep roots in the optimism, opportunism, and gullibility of human nature.

Before Lehman Brothers and Bear Stearns, headline victims of BSLL have included the hedge fund Long Term Capital Management (LTCM) and Bob Citron's Orange County (California) Investment Pool.

On Wall Street, there's a different name for BSLL:  "Banking"

Today's Bloomberg reports that a class of repurchase ("repo") transactions may soon be guaranteed by a to-be-named-later guarantor which we say ultimately would be the Fed / Government.

Enough with the glib thumbnails, here are specific points:

• Collateral to be guaranteed (initially) is Treasuries and agencies.  Lehman and Bear did not fail due to Treasuries and agencies (though there's a different story of Bear and agencies).
• The real BSLL problem with repo is the inclusion of potentially illiquid collateral (everything other than Treasuries and agencies).  Simple solution:  the Lehmans and Bears of the world should fund illiquid assets with longer term borrowing.  Regulators can force that discipline on banks (by fiat or through larger haircuts, for example) if they wish.
• In "real world" repo trades with illiquid collateral such as ABS and CDOs, the repo lenders (mutual funds and the like) don't pay attention to the collateral as they arguably should.  Instead of guaranteeing collateral, it would be both easier and equivalent for the Fed to simply guarantee the secured debt of the borrower (banks, hedge funds, etc).  Why go in that direction?  All segments of U.S. society have had enough of guarantees for banks.  Who would seriously propose guaranteeing hedge fund (repo) debt?!
• Why would the Fed ENCOURAGE BSLL by guaranteeing the trades?!  It's as if a young couple wants to buy a house with a loan that matures in a week.  The one-week loan is a "good deal" because the interest rate is lower than a 30-year mortgage and the couple assumes they can roll the loan each week at the same rate.  It's not at all clever to "roll the dice" every week.
• The concept of a guarantee of the repo trade is meaningless once one asks a few questions.  At what price is the guarantee?  The loan amount?  Is the guarantee on the collateral value only or also on the credit risk of the borrower?  If the former, the guarantee cost is huge.  If the latter, the guarantee cost entails a complicated credit derivative.
• Yes, we know that "all of banking" relies on BSLL.  But this doesn't make BSLL "good."  Rather, it explains why the banking system is so fragile.  Despite the protests of vested interests, it is entirely possible to reduce the risk of BSLL in banking.  The country does not need the Fed to INCREASE the risk.