08-12-2007, 04:10 PM
PERFECT STORM: CREDIT FREEZE AND DISTRESS SELLING BY HEDGE FUNDS
Now that the credit boom has officially gone bust and the financial markets are in meltdown, it's time to assess what is going wrong , and what has gone really wrong. By any stretch of the imagination, this is not a slow leak at all, liquidity is drying up very fast and many deals-in-progress -- including leveraged buyouts, mergers and acquisitions and private equity deals -- are not going to happen because the buyers are beginning to vanish and there are very few bids, and many offers.
Distress selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system. Billions were wiped from the value of listed companies around the world last week, with several major indices experiencing their worst day in more than four years, despite the injection of over USD 2 50 billion of liquidity by central bankers -- most notably the European Central Bank, the Federal Reserve and the Bank of Japan. The silence of the Bank of England has been deafening. Initially, turmoil was limited to credit markets but it quickly spread to global stock markets after central banks were forced to intervene to keep markets from collapsing completely.
It is becoming clear that hedge funds, which from one perspective are supposed to help stabilise the financial system by diversifying risk and providing liquidity, were instead at the centre of the unfolding turmoil at the end of last week. Problems spiralled when top investment banks including Goldman Sachs, Lehman Brothers and Merrill Lynch -- whose prime brokerage arms act as lend ers to the hedge funds -- insisted that the hedge funds settle a greater proportion of their debts at the end of the trading day than they had done previously. Other banks are said to have followed in hiking their margin calls. The increased payments forced hedge funds to perform distress selling of assets to cover their losses. When analysing trading patterns, Thursday and Friday were characterised by remarkably light but very volatile trading with those who didn't have to sell staying at home while those who were forced to sell being ruthlessly punished for doing so.
This appears to have brought about a one-in-a-100-year event in which there are extremely unusual correlations in financial markets that no one appears to be prepared for and everyone is very scared to take or hold on to risk. Financial stability was further shaken as hedge funds' losses mounted, compounding fears that some funds could collapse. Goldman Sachs's Global Alpha fund, the US fund s -- AQR Capital Management, DE Shaw & Co, Renaissance Technologies -- and New York
based Tykhe Capital were significantly down. In particular, Renaissance Technologies, a USD 26bn fund run by the billionaire and former Mathematics Professor -- James Simons -- said it had lost 8.7% of its value in the last 10 days. In a letter to investors, Mr Simons suggested that the hedge funds, which rely on computer models were all reacting similarly, causing ripples of downward momentum. "We have been caught in what appears to be a large wave of de-leveraging on the part of quantitative long/short hedge funds," he said. Many so-called quantitative funds with supposedly low-risk strategies involving investment in both debt and equities were particularly hard hit because weeks of turmoil in the credit markets made it impossible for them to sell debt, forcing them to sell more stable equity assets at a significant loss.
It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically. Because hedge funds borrow much of the money they invest from banks, the concern is that contagion could spiral again when the markets reopen.
At the root of last week's uncertainty are poorly performing home loans, mostly those given to borrowers with weaker credit histories or who have overextended themselves by taking on large amounts of debt. These so-called subprime loans are going into delinquency and default at alarming rates, and the worst of the problem is still ahead. The real problem loans are expected late this year and throughout next year. Housing and financial analysts think that lenders dangerously weakened lending standards in 2005 and 2006, when there was a flurry of exotic home loans and adjustable-rate mortgages. Many of these loans are due to bump up to higher interest rates late this year and next year. And since home prices are falling or stagnant, and banks are wary of lending, these loans may prove hard to refinance.
Years ago, banks held home loans on their balance sheets. Today, they're sold on the secondary mortgage market, where they're pooled together, bundled and sold to investors as so-called mortgage-backed securities. The big investment banks such as Bear Stearns, Lehman Brothers and others are deeply involved in this, and may also have extended credit to some of the buyers of these securities. Generally, better-quality loans are sold to Fannie Mae, the quasi-government agency that does some of this packaging. The riskier loans have been issued by so-called private lab el issuers, Wall Street firms that sell these bonds to investors in the US and abroad.
Gavyn Davies, Gordon Brown's former economic adviser and former chief economist at Goldman Sachs, has warned that central bankers around the world would need to address serious deficiencies in the regulatory system once th is crisis had blown over. Meanwhile the Financial Services Authority has beg un to audit UK banks to assess their exposure to the US sub-prime mortgage crisis and to highly leveraged corporate loans following a similar move by the US Securities & Exchange Commission (SEC). The S EC is looking at the books of major investment banks to see how they are valuing their mortgage-backed securities. Regulator s fear that major Wall Street and European banks might be masking the size of their subprime losses.
The International Monetary Fund has weighed in with an appeal for calm, playing down the extent of underlying problems. The Washington , DC, based institution sai d, "We continue to believe that the systemic consequences of the reassessment of credit risk that is taking place will be manageable. The fundamentals supporting strong global growth remain in place." President George W Bush and his economic team are also talking up the US economy and saying that the fundamentals remain strong. Most economists think the housing sector's problems will shave a full percentage point of growth from the US economy this year. As long as employment indicators remain strong and consumer confidence robust, there shouldn't be a recession. But if credit problems in the banking sector become a full-blown credit collapse and people can't get loans to buy homes or cars or to start businesses, the US economy would be hit very hard and the global economy would suffer too.
We are grateful to:
. Dr George Feiger, based in Berkeley, California, USA, for " Two Faces of the Same Coin;"
. The ATCA Editorial Team, based in Canary Wharf, London, for "Contagion and Systemic Risk? ECB Injects Record Euro 95bn post Major Disturbance ;"
. The ATCA Editorial Team, based in Canary Wharf, London, for " Flight to Quality as Markets finally
A ppreciate R isk ;"
. Robert McNally, Chairman, London Chamber of Commerce Property and Construction Group, for "Erosion of Commercial Real Estate as a Solid Asset Class ;"
. Alexander Hoare, CEO, C Hoare and Co, Private Bankers, based in the City of London, for "Destructive Creativity, Leverage and The Derivatives Market ;" and
. Dr Harald Malmgren, CEO, Malmgren Global, based in Washington, DC, for " The Fear of Central Bankers -- Flight from Illiquidity, Derivatives and Heightened Risk of Contagio n ; "
in response to, " Are the Currency Markets Warning that there is Trouble Ahead? The Precipitous Decline of the US Dollar and its Impact on the World."
For and on behalf of DK Matai, Chairman, Asymmetric Threats Contingency Alliance (ATCA)
ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment ; radical poverty and microfinance ; geo-politics and energy; organised crime & extremism ; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk ; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians ; 1,500 Chairmen and CEOs of corporations ; 1,000 Heads of NGOs ; 750 Directors at Academic Centres of Excellence ; 500 Inventors and Original thinkers ; as well as 250 Editors -in -Chief of major media.
Now that the credit boom has officially gone bust and the financial markets are in meltdown, it's time to assess what is going wrong , and what has gone really wrong. By any stretch of the imagination, this is not a slow leak at all, liquidity is drying up very fast and many deals-in-progress -- including leveraged buyouts, mergers and acquisitions and private equity deals -- are not going to happen because the buyers are beginning to vanish and there are very few bids, and many offers.
Distress selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system. Billions were wiped from the value of listed companies around the world last week, with several major indices experiencing their worst day in more than four years, despite the injection of over USD 2 50 billion of liquidity by central bankers -- most notably the European Central Bank, the Federal Reserve and the Bank of Japan. The silence of the Bank of England has been deafening. Initially, turmoil was limited to credit markets but it quickly spread to global stock markets after central banks were forced to intervene to keep markets from collapsing completely.
It is becoming clear that hedge funds, which from one perspective are supposed to help stabilise the financial system by diversifying risk and providing liquidity, were instead at the centre of the unfolding turmoil at the end of last week. Problems spiralled when top investment banks including Goldman Sachs, Lehman Brothers and Merrill Lynch -- whose prime brokerage arms act as lend ers to the hedge funds -- insisted that the hedge funds settle a greater proportion of their debts at the end of the trading day than they had done previously. Other banks are said to have followed in hiking their margin calls. The increased payments forced hedge funds to perform distress selling of assets to cover their losses. When analysing trading patterns, Thursday and Friday were characterised by remarkably light but very volatile trading with those who didn't have to sell staying at home while those who were forced to sell being ruthlessly punished for doing so.
This appears to have brought about a one-in-a-100-year event in which there are extremely unusual correlations in financial markets that no one appears to be prepared for and everyone is very scared to take or hold on to risk. Financial stability was further shaken as hedge funds' losses mounted, compounding fears that some funds could collapse. Goldman Sachs's Global Alpha fund, the US fund s -- AQR Capital Management, DE Shaw & Co, Renaissance Technologies -- and New York
based Tykhe Capital were significantly down. In particular, Renaissance Technologies, a USD 26bn fund run by the billionaire and former Mathematics Professor -- James Simons -- said it had lost 8.7% of its value in the last 10 days. In a letter to investors, Mr Simons suggested that the hedge funds, which rely on computer models were all reacting similarly, causing ripples of downward momentum. "We have been caught in what appears to be a large wave of de-leveraging on the part of quantitative long/short hedge funds," he said. Many so-called quantitative funds with supposedly low-risk strategies involving investment in both debt and equities were particularly hard hit because weeks of turmoil in the credit markets made it impossible for them to sell debt, forcing them to sell more stable equity assets at a significant loss.
It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically. Because hedge funds borrow much of the money they invest from banks, the concern is that contagion could spiral again when the markets reopen.
At the root of last week's uncertainty are poorly performing home loans, mostly those given to borrowers with weaker credit histories or who have overextended themselves by taking on large amounts of debt. These so-called subprime loans are going into delinquency and default at alarming rates, and the worst of the problem is still ahead. The real problem loans are expected late this year and throughout next year. Housing and financial analysts think that lenders dangerously weakened lending standards in 2005 and 2006, when there was a flurry of exotic home loans and adjustable-rate mortgages. Many of these loans are due to bump up to higher interest rates late this year and next year. And since home prices are falling or stagnant, and banks are wary of lending, these loans may prove hard to refinance.
Years ago, banks held home loans on their balance sheets. Today, they're sold on the secondary mortgage market, where they're pooled together, bundled and sold to investors as so-called mortgage-backed securities. The big investment banks such as Bear Stearns, Lehman Brothers and others are deeply involved in this, and may also have extended credit to some of the buyers of these securities. Generally, better-quality loans are sold to Fannie Mae, the quasi-government agency that does some of this packaging. The riskier loans have been issued by so-called private lab el issuers, Wall Street firms that sell these bonds to investors in the US and abroad.
Gavyn Davies, Gordon Brown's former economic adviser and former chief economist at Goldman Sachs, has warned that central bankers around the world would need to address serious deficiencies in the regulatory system once th is crisis had blown over. Meanwhile the Financial Services Authority has beg un to audit UK banks to assess their exposure to the US sub-prime mortgage crisis and to highly leveraged corporate loans following a similar move by the US Securities & Exchange Commission (SEC). The S EC is looking at the books of major investment banks to see how they are valuing their mortgage-backed securities. Regulator s fear that major Wall Street and European banks might be masking the size of their subprime losses.
The International Monetary Fund has weighed in with an appeal for calm, playing down the extent of underlying problems. The Washington , DC, based institution sai d, "We continue to believe that the systemic consequences of the reassessment of credit risk that is taking place will be manageable. The fundamentals supporting strong global growth remain in place." President George W Bush and his economic team are also talking up the US economy and saying that the fundamentals remain strong. Most economists think the housing sector's problems will shave a full percentage point of growth from the US economy this year. As long as employment indicators remain strong and consumer confidence robust, there shouldn't be a recession. But if credit problems in the banking sector become a full-blown credit collapse and people can't get loans to buy homes or cars or to start businesses, the US economy would be hit very hard and the global economy would suffer too.
We are grateful to:
. Dr George Feiger, based in Berkeley, California, USA, for " Two Faces of the Same Coin;"
. The ATCA Editorial Team, based in Canary Wharf, London, for "Contagion and Systemic Risk? ECB Injects Record Euro 95bn post Major Disturbance ;"
. The ATCA Editorial Team, based in Canary Wharf, London, for " Flight to Quality as Markets finally
A ppreciate R isk ;"
. Robert McNally, Chairman, London Chamber of Commerce Property and Construction Group, for "Erosion of Commercial Real Estate as a Solid Asset Class ;"
. Alexander Hoare, CEO, C Hoare and Co, Private Bankers, based in the City of London, for "Destructive Creativity, Leverage and The Derivatives Market ;" and
. Dr Harald Malmgren, CEO, Malmgren Global, based in Washington, DC, for " The Fear of Central Bankers -- Flight from Illiquidity, Derivatives and Heightened Risk of Contagio n ; "
in response to, " Are the Currency Markets Warning that there is Trouble Ahead? The Precipitous Decline of the US Dollar and its Impact on the World."
For and on behalf of DK Matai, Chairman, Asymmetric Threats Contingency Alliance (ATCA)
ATCA: The Asymmetric Threats Contingency Alliance is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment ; radical poverty and microfinance ; geo-politics and energy; organised crime & extremism ; advanced technologies -- bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk ; as well as transhumanism and ethics. Present membership of ATCA is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians ; 1,500 Chairmen and CEOs of corporations ; 1,000 Heads of NGOs ; 750 Directors at Academic Centres of Excellence ; 500 Inventors and Original thinkers ; as well as 250 Editors -in -Chief of major media.