Wednesday, August 20, 2008

Beware of the Hedge Fund Stampede


There is an old saying in the investment world that bulls make money, bears make money and pigs get slaughtered.

It seems that a lot of hedge funds have been getting greedy these days focusing their attention on a few trades, namely, long energy, short US dollar, and short financials.

But when these highly levered positions unravel and hedge funds have to unwind them or risk getting crushed, you end up getting colossal market swings.

Karl Denninger wrote an interesting post on his blog last week covering this topic which he titled Where's the Kaboom?

I quote the following:

Take your pick last night [August 14th, 2008]. Right after the market closed, the dollar started strengthening again. A lot.

Then, suddenly, the floor dropped out of Gold, and the S&P 500 Futures spiked HARD, with over 2,000 contracts bought at the market.

A few hours later, it happened again. And at 4:30, once more!

What in the Sam Hell is going on?

Simple, really. See, there are what - 8,000 hedge funds? Well, for 7,999 of them (up until the last few days anyway) they have all been in one trade, more or less - short dollar, long energy, short financials.

Nice, if and when it works.

But now that trade has been unraveling at a frightening rate. As the dollar has gotten stronger it has squeezed people. Hard. See, these guys are not just investing the money they get from rich folks all over the world - they are taking that money and borrowing, then investing that.

So when these bets go bad - oil falls, the dollar goes higher, or any of the "parameters" they've been working get the rug pulled out from under them, they have a huge problem, all at once, and they have a very bad hair day.

That's happening. In spades.

This is where the "recovery" has come from in the stock market the last month or so - you kick the shorts in the nuts and they cover, then the lemmings rushing in, once again listening to the idiotic calls of "the bottom is in" from media outlets like CNBC that will shove a microphone under the snout of anyone who toes that line.

This trade started unwinding slowly, but in the last week or two it has gotten very disorderly and so have the markets.

As credit has continued to deteriorate the weaker hands get flushed and forced out. This causes them to have to buy back their short dollar trade, which spikes the DX. THAT in turn spooks someone else, who then covers a big futures short, which in turn freaks out someone in the gold market, and they dump a big long.

Mr. Denninger adds:

Oh, and those very same Hedgies are some of the guys "guaranteeing" the credit in these default swaps, which means as they go down, credit continues to blow wide, never mind the actual deterioration which is far worse than claimed because these so-called "guarantors" can't actually pay.

What you need to understand is that there is nothing that can be done to stop this. Not by the government, not Bernanke, not The Fed, nobody. The overly-geared will die, one by one, until there is nobody left who has too much gearing on for the trade and credit risk they took.

What's worse is that some of our "big institutions", sensing this - that credit quality is deteriorating very, very rapidly, are looking for someone, anyone, to offload the bag to. Over the last few months they've found a few people they can try to throw the bag at - maybe those with poor risk controls, with automated trading systems that aren't actually verifying anything, and perhaps there's a bit of a pollyanna view at a few of them too?

If you can't find those folks because there aren't any of that sort buying the debt you're desperate to unload (since you know its going to go "boom!") then the next move is to "sell" that debt to some private equity guy but carry back the financing (in some cases on a non-recourse basis!), as several folks have done recently, which makes it look like you got 20 cents on the dollar when in fact you only got 5.

For the Hedgie or P/E guy who makes the bet, its not a bad deal - they have a defined risk trade, like a CALL option. For you, the writeoff is real but its 75% less than it should have been, with the rest sitting out in limbo pending the truth being discovered in the fullness of time (when the deal blows up and your "non-recourse" deal comes back at you like a boomerang.)

How many of those folks will die, and what impact will it have on the credit markets in general? I can't quantify it accurately - I don't think anyone can. But what is obvious from the magnitude of these "little tremors", and the rapidly increasing rate at which they are coming, is that:

  1. Its very bad.
  2. Its getting worse, at an increasing rate.
  3. A number of supposed "liquidity providers" have either been gamed (and this has not been recognized and reported to the public) or they're "buying" this debt with carried-back loans, making their actual risk of loss tiny compared to the nominal "value" transferred. In other words and to put it in terms "Joe Q Public" can understand, everyone is still lying!
  4. There is a "supercritical" point where all asset values will get hit at once, unless the process runs to exhaustion first, and I don't think there is a snowball's chance in Hell that it will.

I may be wrong about the impending supercriticality, but if I'm not, well, it would be a good idea to be sure you are in safe places with your money.

Equities and debt other than treasuries would be in the "not" column on the list of safe instruments, and note carefully the very specific constraint on exactly what sort of debt is safe - all other, and I do mean all, is not.

I would echo Mr. Denninger's warning. We are on a collision course with debt deflation and many of these crowded trades will work for a while until the hedge fund stampede exits them and chaos ensues.

How long will this volatility last? Your guess is as good as mine, but judging by the increase in swap spreads, financial institutions are already spooked and we may be in for a very scary fall.

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