Hello to you. We are in the eye of the storm here, quite literally. It is now 70 degrees outside on December 4, 1998 in New York! My god. Goodness. What great weather we are having. Not good for the oilies I suppose.
Well let's check out the bad news department.
From Brazil..coutesy of the bear Fleckenstein, "Bad news from Brazil... Last night was one of the wilder nights of action that we have seen for quite a long time. We got bad news out of Brazil as its Congress rejected the first step in the austerity package by refusing to go along with social security cuts. This will postpone the next step in the package and puts the whole thing in jeopardy. Brazil was slaughtered today, finishing down 9 percent.."
FYO you might check out my previous posts about where and what Brazil is in the cosmology of debt these days.
And on our favorite subject: Derivatives. Yes. You guessed.
For Private Use Only
"The Developing Credit Crunch!
Hedge Funds - REVISITED
Our September observations on over-leveraged hedge funds developed into a much greater issue in recent weeks, bringing it to the forefront. So much so that Alan Greenspan, Robert Ruben, the New York Fed, and many large financial institutions became involved in a private bailout of the hedge fund, Long Term Capital Management (LTCM). Its failure would have jeopardized the entire world financial system according to the Fed, and it still may have longer term implications to deal with as we see the recent action as another band-aid solution that will only slow the bleeding for a while, until even more money is needed to hide the reality of almost limitless losses.
The bailout was facilitated by the New York Fed, between LTCM's John Meriwether and officials from fifteen of the world's largest financial institutions. Baron's called Meriwhether, the ex-manager of Salomon Brother's bond trading operation "a supertrader", as they reported he had lost about $2 billion in August alone (a bit ironic in our opinion). The Fed feared a failure of the magnitude of LTCM would disrupt the already flailing international capital markets, adding to the reluctance of creditors who recently tightened their lending standards that contributed to the world's illiquidity and developing credit crunch. A consortium of 17 of the world's largest financial firms agreed to a $3.5 billion bailout in return for control. LTCM's board included some of the best minds on Wall Street (supposedly), including former Ex-Assistant Treasury Secretary, David Mullins, and Nobel Prize laureates Merton Miller and Myron Scholes, who have been credited as two of the inventors of modern option pricing.
The Carry Trade: The $4 billion dollar LTCM hedge fund had invested over $90 billion by borrowing heavily in Japanese yen, paying interest as low as 1/2%, converting the loans to rubles and dollars (or any higher yielding currency) to invest in the US, Russian and other markets around the world. Their first problem was that they could not hedge their currency risk. This was okay for several years as the yen seemed to have no bottom, adding to their returns beyond what the markets were bearing.
As the Asian contagion forced the Japanese government to more seriously address their economy, bad bank, and burgeoning real estate debts, the yen began to firm, rising a record 19 yen per dollar in just two days as short sellers panicked to buy back their shorts. On the other end of LTCM's trades, they were heavily invested in the Russian and US debt markets, including derivatives (more leverage), betting that US rates would rise and Russian rates would fall.
They were also heavily short the gold market, using this as an additional source of cheap capital. By shorting gold, they received the proceeds of these sales of the gold they borrowed from many central banks, using same to even more heavily leverage their other, already leveraged investments in illiquid foreign markets
Eventually, these too would have to be repaid. When equity and currency markets began to collapse, their losses began to implode exponentially on them. Instead of unwinding their positions, they did nothing, allowing their trouble to get worse and worse by the hour. US rates continued to DROP against their Treasury short sales, and Russian rates SURGED to over 100% on their bankruptcy news, against LTCM's heavy long Russian bond positions. Petrified investors moved even more money into US Treasuries and gold in a dramatic flight to safety, pushing prices further against them. LTCM alone was said to be short as much as 400 metric tonnes of gold, all borrowed from the world's central banks
They, along with as many as 100+ other hedge funds were essentially bust over night. At the peak, their value reached a high of $134 billion (again on only $4 billion of their own capital). According to Investor's Daily, LTCM's value dropped to about $80 billion by late September, leaving them with a large net deficit. It is anyone's guess how many other big problems will emerge, or how much more will be lost before all the damage is done.
This was about the time the Fed stepped in to orchestrate the "private" bailout. LTCM was supposedly the all-star of hedge funds. Others have been disclosing their own huge losses, many of which tried to emulate the past successes of LTCM by copying their trades. These too were heavily funded by major brokerage firms, banks, insurance companies and very large net worth individuals to speculate in essentially the same way, as they all let their greed cloud their judgment.
The losses and continued exposure is just beginning to trickle out. A partial list of funds and banks that have reported losses include, George Soros's Quantum Fund (lost $2 billion), Bank of America, Citicorp, Chase Manhattan, Bankers Trust, Travelers, Ellington Fund Mgt. (forced to sell off $1 billion in losing mortgage securities), Julian Robertson's Tiger Fund Mgt. (lost $2 billion +), Convergence Asset Mgt. (up to 1500% leveraged), Merrill Lynch, Dean Witter, DLJ, UBS Securities ($950 million loss). One of the latest, Bank of America, after taking an immediate $372 million write down, assuming the $20 billion portfolio of the DE Shaw fund, and increasing their loan loss reserve by an additional $500 million, still carries a $1 billion loan on their books along with other undisclosed losses. Reuters reported another hedge fund, Eagle Capital Management began liquidating their $327 million offshore and domestic Eagle Global Value Funds (mainly in equities, bonds and futures) in order to shut down operations by the end of the year. Nomura Securities plunged as their head derivatives trader resigned after disclosing losses totaling $560 million. These risks seem open ended and limitless because they aren't completely closed out and many more losses are likely to lie ahead for dozens of companies.
The Fed: In perhaps the most dramatic about face in its history, the Fed reversed from a tight bias to an easy one, quickly preceding their decisions to cut rates twice in just two weeks. The first Fed Funds 1/4% cut to 5 1/4% was decided at their September 29 FOMC meeting, "to cushion the effects of increasingly weak foreign economies and less accommodative financial conditions domestically." The markets were not satisfied with this. Before the next action was taken, Chairman Greenspan testified before the Senate banking committee stating, "The US can't remain an oasis of prosperity, unaffected by global turmoil looking forward. The restraining effects of recent developments on the US economy will likely intensify… We can already see signs of the erosion of production around the edges." Coming as a complete surprise, they announced a 2nd rate cut on Thursday, October 15 (well timed into Friday's option expiration). This time, they cut both the Fed Funds and the Federal Discount Rate each by 1/4%, commenting, "Growing caution by lenders and unsettled conditions in the financial markets are likely to restrain aggregate demand in the future." This risks more forced liquidation and further repatriation of foreign assets. They again cut both, the Fed Funds and the discount rate for the third time in less than eight weeks, after their November 17 FOMC policy meeting. As our favorite CNBC regular Jim Rogers stated, "Greenspan panicked. There was no reason to pump more money into the (already too liquid) system to bail out a bunch of (poorly managed and over leveraged) hedge funds… We now have the fastest money supply growth in 15 to 20 years
We wonder what the Fed knows that the public has yet to learn that motivates them to take such unusual and additional actions so soon after their first and second cuts. It looks like there is a sense of urgency because the credit contraction is slipping quickly out of their control. It is doubtful that a 1/4% or a 1/2% rate cut would have done much to motivate creditors to further extend credit to already distressed customers. It is even more doubtful that lower rates will stimulate consumer demand when they have already borrowed well beyond their means in an already low interest rate environment. They cannot buy more homes, cars, or boats, remodel, or refinance again just because rates are even lower. We must assume that the Fed sees at least the potential for BIG TROUBLE ahead.
The dominos that began falling in recent months will most probably continue to fall. The Fed will fight to soften the burden of deflation, credit contraction, and debt repudiation but the problems appear to be much more massive than the Fed's very limited tools can handle. While they may win a few battles with carefully timed interest rate cuts, this tool is comparable to trying to put out "the Chicago fire" with a rake and a garden hose during a strong wind. The leverage used by hedge funds was so immense that the unwinding of these positions carries with them almost incalculable liability, so large that it is doubtful that the public has grasped an understanding of the consequences.
There are many other things now working against the market compared to what is working for it. Corporate earnings have diminished as competition remains intense for less demand. After a 20% market decline and recovery, its P/E multiple remained above that of all other bull market peaks in history and has recently reached another record level at 31.29. This will likely be even higher in reality as earnings continue to fall. These are but a few signs of the aftermath of a mania of such epic proportions. I haven't even mentioned the hostile political environment, eventual likelihood of more competitive currency devaluations that still loom, or the latest manic bubble now inflating in Internet stocks. Long term investors have yet to learn first hand what "professional" hedge fund managers are now grappling with, that their bravery was and is illusory once the real trouble begins. Of course, the popular averages have come back, but many classic bearish divergences are occurring as most stocks have NOT recovered as much as one would think from watching the evening news. We still see future bouts of forced liquidation because mutual funds still have little cash available to honor redemptions. Banks will become even less willing to lend if their losses increase, and the economy's future will no longer justify the public's high level of confidence required to remain so heavily invested. This will force more liquidation of assets at lower prices. So much for the long-term.
So far, the biggest losers have been the Hedge Funds. Typically, they are much more heavily leveraged - and their positions are much more concentrated than that of mutual funds. They usually borrow at least 95 cents on the dollar trading the futures markets (and often more), and can invest well over 100% of their assets in as few as one or two positions at any given time. When account values drop enough in these leveraged accounts, mandatory margin calls are triggered forcing the hedge funds to either ante up new money to bring their account values back up to a minimum level of good standing, or to liquidate the positions to satisfy their margin loan commitments. Either way, they've lost billions - and are forced to pay back loans on losing investments. Moreover, recent losses have forced them to cover other, more liquid positions. This has helped to reverse the trends in the yen, Deutsche Mark and gold. People often ask what happens to all the money in a bear market? They can't understand that it simply disappears - and was only really there on paper unless profits were taken.
It seems like US banks go out of their way to find at least one avenue each decade for their greed, poor judgment and aggressive lending practices to explode in their face. This decade the term, hedge fund, will join the ranks of the infamous "the S&L's", "bad Latin American debt", "junk bond collapse" and "over leveraged real estate". Every time the banks have a chance to shoot themselves in the foot, they blow off a leg! Neither the media nor the public have grasped the enormous magnitude of this problem. It may be bigger than the total sum of the others because the leverage used dwarfs their combination.
I've written about different types of over-indebtedness and debt repudiation on many past occasions. Eventually, this cycle will run its course, fully reversing the historical overvaluation that was reached, and has been reached again, as the seemingly out of control mania comes to an end. Until this purging of the excesses of the '90s is complete, expect the possibility of more bouts of forced liquidation and much volatility as many investors will continue to wait too long again and again before they are forced to sell at lower (or any) prices. This is a lesson that investors "could" learn from the LTCM crises if they weren't so conditioned to ride out ALL market declines. These many uncertainties will haunt long-term investors until they become short-term sellers. This may be for certain.
Hedge funds will likely continue to burn at both ends of the risk spectrum, convinced they had built a better mouse trap. Maybe it appeared true for a while, but in the end, the candle ended up vaporizing the funds that much faster (and it is still burning out of control). This is but one part of the cycle of debt repudiation and credit contraction that has emerged and it will surely create many other problems. Make no mistake, there will be more huge losses. The world may be coming to terms with the initial shock(s), but like a strong, partially rotten onion, many layers will have to be peeled away before the markets get back to a sound core of responsible debt issuance, risk management, and respect for the use of leverage when investing".
Mitch Harris
Editor - Reality Check Newsletter |
