Hedge Hemorrhage and "Capitulation Crash"

Stocks sold off strong in the final hour of trading. The Dow Jones industrial average plunged 679 points, dropping below the 9,000 mark for the first time in five years.

The selloff came as Standard & Poor's Ratings Services put GM and its finance affiliate GMAC LLC under review to see if its rating should be cut. GM has been struggling with weak car sales in North America.

The action means there is a 50 percent chance that S&P will lower GM's and GMAC's ratings in the next three months.

General Motors Corp. led the Dow lower, falling about 30 percent.

In fact GM shares fell below $5 to their lowest level since 1950.

I have already written that deflated balloons can't bounce but I was expecting some bear market rally to develop because we are due for an oversold bounce.

Moreover, the volatility index (VIX) keeps heading up to record territory, leading some to conclude that it the market has gone down too far, too fast and that it feels like capitulation.

But now that we sliced through key support levels, it could easily get worse. I am very worried that we are heading for a good old fashioned "capitulation crash" where the VIX explodes up exponentially above 100 on massive blow-off volume never before seen.

Tomorrow is Friday and I do not expect traders to be holding positions going into the weekend (we are blessed it is Thanksgiving weekend here in Canada and the Toronto Stock Exchange will be closed on Monday).

If this relentless rout continues tomorrow, we are going to see real panic and fear grip markets early next week.

And what is causing this relentless selling? Massive liquidation by huge hedge funds that are selling into any rally to cover their redemption calls.

How do I know? Just take a look at recent activity of Soros Fund Management compiled by MFFAIS:

Activity for Soros Fund Management

Do you see all those red "sold all" labels? Despite selling, the fund is still down 36% year to date. And Soros is one of the smarter hedge fund managers because he saw this disaster coming. Other hedge funds are hemorrhaging profusely and they are liquidating positions to meet margin requirements and redemptions.

Moreover, today the Markit leveraged loan index plummeted to a record low as hedge funds and banks sell assets:

The Markit LCDX, a benchmark credit- default swap index used to hedge against losses on leveraged loans, fell to a record low as banks tried to sell holdings of the debt.

The index fell 3.35 percentage points, its biggest drop ever, to a mid-price of 85.50 of face value, according to Goldman Sachs Group Inc. The index falls as credit risk increases. It's the lowest price since the index was introduced in May.

Prices of leveraged loans have tumbled to record lows as hedge funds seek to sell assets in the wake of the worst monthly performance in 10 years, the failure of Lehman Brothers Holdings Inc. in New York and the takeover of Kaupthing Bank hf by the Icelandic government today. Lower loan prices make it more expensive for companies to raise capital.

``There's a massive pullback in buyers and there are forced sellers including hedge funds facing redemptions,'' CreditSights Inc. analyst Chris Taggert in New York said.

It's a disaster. People are losing their retirement savings because the hedgies are all getting blown out of the water and liquidating their positions.

Worse still, there are no natural buyers! Everyone is on the sidelines waiting for the hedgies to liquidate their holdings.

What started off as a subprime crisis has morphed into a global crisis of epic proportions that now threatens humanity.

The Paulson Plan? Hah! If the markets crash, we are all heading for bread lines and that $700 billion rescue package will do nothing to prevent social anarchy and global famine.

***Slope of Hope

Make sure you read Tim Knight's latest comment "Pandemonium".

I quote the following:

Now, I got in touch with my inner bull near the end of yesterday, and it cost me today. I've lost track, but I think I got blown out of half my positions easily (and the other half, I assure you, are almost all in the red!). I made up for it with a pretty decent collection of puts I've held on to for a long time, as well as some pretty deft DXD and SDS trades.

But my game plan is unchanged. FIRST, a multi-week or even multi-month uptrend; and SECOND, once that retracemtn appears to be done, short like there's no tomorrow. I actually think that will be a bigger opportunity than the one we've witnessed since September 18th (doesn't that seem like about ten years ago now, even though, incredibly, it's just a few weeks!??!?)

Although I may live to regret it, I loaded up on SSO when the Dow was down nearly 700 points, based simply upon the fact that the aforementioned retracements were getting nailed. I am putting my money on the idea that tomorrow will rally.

This market is not headed to zero. I believe, and have never stopped believing, that we're in a sustained, multi-year bear market, and I also believe that deflationary depression outlined by Prechter is in the process of taking place. So don't worry about me getting all bulltard on you. But this market will at some point find buyers, and when it's even slightly obvious that there's potential for upside (like two days in a row where the Dow is in the green, even if just a little) you're going to see buyers storm in for "bargain prices."

Huge fortunes are being made and lost in this market, and financial history is being made. Ten years from now, when you look at a chart, you will still easily see the past few weeks reflected in the market action. The key is to remain calm, rational, and focused (And, of course, read Slope constantly). And if you ever feel like kicking yourself over a mistake, make use of the handy table I've generously provided at the top of this post.

***Morning update (10-10-2008)

As panic selling grips global markets, professor Nouriel Roubini - the NYU economist who predicted this crisis a long time ago - is urging world central banks to cut interest rates by 1.5% to avert a full-blown disaster:

``It will take a significant change in leadership of economic policy and very radical, coordinated policy actions among all advanced and emerging-market economies to avoid this economic and financial disaster,'' the New York University professor of economics said. From late 2006, Roubini highlighted the dangers flowing from a likely U.S. housing crisis.

The economist urges immediate action as officials from the International Monetary Fund, World Bank and Group of Seven nations meet in Washington this weekend. Stocks tumbled around the world today as the year-long credit crisis deepened, sending Japan's Nikkei 225 Stock Average to its worst weekly drop in history.

In the U.S., the Dow Jones Industrial Average fell below 9,000 for the first time since 2003 yesterday. More than $4 trillion has been erased from global equities this week.

``At this stage the risk of an imminent stock-market crash -- like the one-day collapse of 20 percent plus in U.S. stock prices in 1987 cannot be ruled out,'' said Roubini, 50. ``The financial system is breaking down, panic and lack of confidence in any counterparty is sharply rising and investors have totally lost faith in the ability of policy authorities to control the meltdown.''

The world is experiencing the simultaneous bursting of housing, equity, bond, credit, commodity, hedge-fund and private-equity bubbles, the economist said, and even better- performing economies such as Brazil, Russia, India and China are at risk of ``a hard landing.''

The threat of a global financial meltdown means a decade- long ``L-shaped'' recession -- like Japan's after its real estate and equity bubbles burst -- cannot be ruled out, Roubini said.

As demand falls, the next challenge may be deflation as the world faces a glut of excess capacity and goods, he said.

Also, read Minyanville's Todd Harrison latest comment, Freaky Friday Potpourri, Chicken Little Skinned!

I quote the following:

I’ll once again communicate that this is with the trading portion of my book and my long-term bucket remains 100% cash.

Looking forward, the bull case is that if the market turns, fund managers will be forced to chase the averages higher. In the industry formerly known as Wall Street, under-performance is the only thing worse than absolute loss.

The bear case is that, as the point of recognition manifests the mainstream, everyone and their sister is waiting to sell the rally. I hear it on the Street and I see it in the faces of friends outside the industry who repeatedly tell me “I’ll sell something when the market rebounds—it always does.”

There are two wildcards. The first is the hedge fund universe, which bubbled for years and officially popped when the government declared financial Martial Law. The fallout will be pervasive and painful, both on a human level and with regard to further contagion.

The other unknown is credit default swaps and the counter-party risk thereof. At the end of my NYU speech, someone asked me how this would be resolved. My response was an honest “I don’t know the answer in terms of how it will settle but I do know that there’s not enough money to go around.”

***Lunch comment: Day of Reckoning for Lehman CDS Auction...

The ambiguity surrounding this evening's auction for the settlement of Lehman Brothers' credit default swaps (CDS) has contributed to today's plunge across global stock markets:

According to Reuters Knowledge, Lehman Brothers had around $113 billion of borrowings outstanding when it filed for bankruptcy last month, but its CDS debt level is estimated to be at least three times higher.

CDS's are used to buy and sell protection against borrowers' defaults with the protection seller agreeing to pay the buyer the difference between the face value of the debt and what investors expect to recover through the bankruptcy process.

No one knows how much protection was written on Lehman's debt, or moreover, who the end holders of the underlying debt are as credit default swap deals are negotiated privately.

In the UK , Barclays-which by midday saw its share price off 17% - has been rumoured to have some exposure to Lehman's credit default swaps and the worry weighing down the market in this case, is whether those that lose out in the process will be able to pay off their respective debt.

Insurer Aegon is another which is believed to have exposure, but they are unlikely to be alone.

A Lehman bond that fetched 95 cents on the dollar in late August is now reported to be trading at about 11 cents, so any firm that sold protection on the debt will face major losses.

Bloomberg reports that sellers of credit-default protection on bankrupt Lehman Brothers would be forced to pay holders 90.25 cents on the dollar under initial results of an auction, setting up the biggest-ever payout in the $55 trillion market:

Preliminary results of the auction to determine the size of the settlement on Lehman credit-default swaps set an initial value of 9.75 cents on the dollar for the debt, according to Creditfixings.com, a Web site run by auction administrators Creditex Group Inc. and Markit Group Ltd. A final price is scheduled to be announced at 2 p.m. New York time.

Based on the results, sellers of protection may need to make cash payments of about $270 billion, BNP Paribas SA strategist Andrea Cicione in London said. The potential payout is higher than investors anticipated, based on trading in Lehman debt, and caused the bonds to fall. The bonds fell to about 9.5 cents on the dollar today. They traded at an average 13 cents yesterday, indicating a payout of 87 cents was expected.

``The bottom line is that the final recovery will be below current market prices,'' said Tim Brunne credit analyst UniCredit SpA in Munich. ``Possibly far below.''

No one knows exactly how much is at stake because there's no central exchange or system for reporting trades. It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other, exacerbating the global credit crisis and prompting calls for regulation of the market. More than 350 banks and investors signed up to settle credit-default swaps tied to Lehman.

...

Credit-default swap indexes around the world soared today on concern the deepening credit crisis will trigger company and bank failures. The Markit CDX North America Investment Grade index, linked to 125 companies in the U.S. and Canada, jumped 14 basis points to 212 basis points as of 11:09 a.m. in New York, according to Barclays Capital.

Credit-default swaps are financial instruments that can be based on bonds and loans. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

I wonder how many public pension funds have exposure to these CDS losses. Unfortunately, if you think transparency in the CDS market is non-existent, it is just as hopeless in far too many public pension funds.