Bring Back The Specialist, Hank
Written by A Forex View From Afar on Saturday, October 18, 2008Mr. Paulson said today, in a televised interview, that only banks would have accesses to the $700 billion fund, excluding hedge funds from the list. You know, hedge funds, those that are set up and allowed to short the market. Although this may not sound important, the underlying factors are that hedge funds are the undisputed champions when it comes to leverage. It is common for a hedge fund to use up to 1:30 leverage, beating even a retail trader in what can be levered from a single asset. You may say that forex traders use a 1:100 leverage, true, but we use this lever just for the open position, while hedge funds use a 1:30 leverage for their whole balance sheet. Big difference!
Going back to the implications of hedge funds not receiving apenny from the bank’s bailout money, things may get rough because of the high leverage that they put to use, and in order to achieve the high leverage they need to borrow their money from banks. The problems appear when hedge funds will have to write down the toxic debt they own. Having practically no market in which to sell the assets, the only solution is to mark them as losses. As the losses are marked the equity (net asset value) shrinks, increasing the leverage used to control the exposure.
Just a look at the Libor rate which tells us that banks do not lend too much to anybody these days, and certainly not to those that lever the debt, and rightly so many would say. Having the credit line removed means that hedge funds leverage can only go higher as the risk-exposure increases. If we generalize this, it is very likely that a systematic risk will hit the market, similar to when a bank (let us say Lehman) goes into bankruptcy.
The solution to avoid such a scenario is for hedge funds to de-lever their market exposure. There are two ways this can be achieved: either increase the net assets, which means attracting more investors – something very unlikely these days, or reduce the market exposure, meaning cutting down market positions, into an arena that is not buying debt. While hedge funds reduce their market exposure the asset price will fall down, being commodities, equities or all sorts of derivatives, and as market prices keep falling, more de-leveraging will be needed. The vicious cycle is what the markets are witnessing right now.
In order to draw a quick conclusion, not allowing hedge funds to sell their toxic assets is not such a good decision. However, any investment that is made in a highly leveraged investment machine comes with a risk, and the situation is showing that algorithm-based investments, made on complex risk models based on mathematical pricing formulas does not beat the market after all.
The halcyon days of having a specialist on the desk to float the market and create the liquidity are sorely missed, and now the M.I.T. graduates that were maintaining the computer coding in the black box may have to accept that supply and demand may after all trump debt ratings and quantum lines. Maybe now traders can start to look for a trend that lasts longer than the lunch break.
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