Levered Investors Sell Anything Easy
BY NORM ALSTER
INVESTOR'S BUSINESS DAILY
Posted 10/10/2008
Leverage giveth, and leverage taketh away.
This might be the prime lesson from the long, stomach-turning decline in stocks.
Leverage once padded bank and hedge fund profits and helped fuel recent bull markets. Now new capital must be raised to repair sagging balance sheets, so institutions have had to unload stocks and other assets.
"I think 90% of the sell-off is tied to deleveraging," said Robert Arnott, chairman of Research Affiliates, an investment management firm in Newport Beach, Calif. "It is the dominant catalyst. Nothing else even comes close."
Investment banks, commercial banks, hedge funds and pension funds have all been unloading assets to lever down, Arnott says.
Retail investors are limited in how much debt they can take on to buy stocks. Not so the investment banks, which since 2004 have been able to leverage at debt-to-equity rates of 30-to-1.
Unregulated hedge funds had margin rules set by brokers more than willing to bend for their business. Money center banks such as Citigroup (C) used off-balance-sheet, highly leveraged structured investment funds to get around theoretically tight capital caps.
Profits, Profits, Everywhere
In a rising market, high leverage produced massive profits. With 30-1 leverage, a 10% gain on $1 million in capital grows from $100,000 to $3 million.
Institutions juiced profits even more by plowing into mortgage-backed securities, credit default swaps and other complex financial instruments.
But when markets turned south, leverage became a financial tapeworm, eating away at asset values.
With each decline, leveraged investors must raise more capital. To do so, they sell what they can. This puts more downward pressure on asset prices and triggers new margin calls.
Worse, that mortgage debt became toxic. Values plunged, but it was hard to find buyers at any price. Selling at fire-sale prices forced firms to mark down the rest of their portfolios.
"These institutions are not failing because 95% of the assets have gone bad — they're failing because 5% of the assets have gone bad and they over-stretched their capital," John Hussman, president of Hussman Investment Trust, wrote in a note last month.
Liquidity Loses
As margin or capital calls came, banks and funds dumped liquid securities such as stocks and commodities. Among equities, they've tended to unload the most liquid.
Chris Tessin, a portfolio strategist at Russell Investments, studied third-quarter performance of the Russell 2500. Overall, the index fell 6.7%. But the most liquid stocks — the top 20% — plunged 22%. Average declines fell along with liquidity. In fact, the most illiquid stocks actually rose 3.6%.
"Everyone has been asking, why are the best fundamental stocks doing the worst?" Tessin said.
He figures the prime reason high-volume stocks sold off is that they could be unloaded quickly.
But there were other reasons. Many of the summer's worst losers were heavily traded financials suffering big losses and trying to stay afloat.
Large multinationals that leaned heavily on exports have faced selling pressure due to renewed strength in the dollar and weaker demand overseas.
Meanwhile, big institutions buy liquid stocks. So when they sell, they tend to sell liquid stocks.
Commodities are another asset class facing heavy selling. Big institutions poured into commodity and energy futures during their long runs, reaping huge profits.
The commodity fever finally broke over the summer as waning global economies took their toll on demand. But pension and hedge funds, under pressure from losses elsewhere, liquidated their holdings in bulk.
Falling commodity prices also have spilled over into related equities.
Bill Gross, managing director at bond-fund giant Pimco, wrote in a market comment last month that the current deleveraging process is dragging down prices of virtually all asset classes.
During most bear markets, some asset classes usually buck the trend and thrive. But in deleveraging markets, almost nothing rises.
Several other asset classes suffered inordinate damage from the forced selling.
Municipal bonds suddenly sold off in August 2007 because many highly levered hedge funds had to raise cash to cover bad bets on Treasuries, says Tom Doe, CEO of Municipal Market Advisors, a muni research firm.
"The troubled securities firms and dealer-banks have had to unload leveraged positions in municipal bonds several times this year," Doe said.
Research Affiliates' Arnott also cites routs in convertible bonds from forced sales. Convertible arbitrage hedge funds have had "massive redemptions because of poor performance," he said. To meet them, they've had to sell.
One of the big unknowns in today's markets is the overall impact of hedge funds. So far the big financial blowups have been well-known banks, brokerages and insurers such as Lehman Bros., AIG (AIG) and Washington Mutual, rather than hedge funds.
But some hedge funds are levered 20 to 40 times, says Joe Battipaglia, a market strategist at Stifel Nicolaus.
When the market goes against hedge funds, they must raise huge sums of capital — and fast.
"Sometimes, the only liquid thing to sell is U.S. equities," Battipaglia said. "Liquidation by hedge funds has contributed to market declines."
Arnott agrees: "I think hedge funds are a big part of this deleveraging."
He adds that he believes the deleveraging process is "more than half done."
Battipaglia says deleveraging will weigh on the market "into next year as more and more leveraged investors need to liquidate." |
