Excessive leverage behind global panic

By Neil Behrmann

August, 2007:- Wonder why market participants are running around like headless chickens?


Hedge funds and other speculators have not only borrowed to the hilt but have massive positions in the derivatives market. With this sort of leverage a small share price decline or rise is magnified out of all proportion, causing panic sales and purchases. Little wonder that shares, corporate bonds and commodities plunged for several days and then rallied dramatically when the Federal Reserve cut the discount rate on Friday. The global market has become a giant casino and the outsider, the little investor, is swept along with the chips on the table.

The numbers explain the extent of leverage. Investors placed an estimated $1.5 trillion in several thousand hedge funds. The average hedge fund borrows twice to three times that amount, according to industry estimates. Thus hedge funds have been playing the market with somewhere between $3 trillion and $4.5 trillion. Some hedge funds borrow a lot more. These include the so called quant funds run by astrophysicists, mathematicians and Phd’s. Investors poured billions into these funds. How on earth could the quantitative trading models of these geniuses go wrong?

Investment bank excesses

At a conference call last week Goldman Sachs executives disclosed that about $75 billion or half the investment bank’s alternative investment funds were quants, going long and short in equities, bonds, commodities, currencies and their derivatives.  Goldman and some investment partners had to infuse some $3 billion in its Global Equity Opportunities quant market neutral fund that lost almost 30 percent in a week. That fund and two others were down by almost US$5 billion to US$ 10 billion.

How could prime Goldman Sachs fund managers with their Ivy League education, market expertise, exceptional information and network of contacts, perform no better nor worse than inebriated gamblers in Las Vegas? Simple. Goldman Sachs disclosed that the leverage of Global Equity Opportunities Fund was six times investor capital. Thus if a trade lost 2 percent, the fund would lose 12 percent. Goldman disclosed that after dumping positions and reducing borrowings, leverage is now down to 3.5 times. Thus any loss or gain of 2 percent would be levered to 7 percent. This is supposedly conservative! Goldman Sach’s shares are 25 percent down from their highs earlier this year.

Bear Stearns’ two leveraged credit funds had combined capital of around $1.6 billion. According to varying reports and corporate statements borrowing of those funds was anywhere between $10 billion and $20 billion. In other words leverage was about 10 times capital or more. The funds are now bankrupt and several investors who have lost all their money, are suing. That’s not the end of the story. In its latest quarterly report disclosure to the US Securities Exchange Commission, Bear Stearns stated that the firm's stockholders’ equity was $13.3 billion at the end of May 2007. Financial instruments owned by Bear Stearns’ proprietary trading division amounted to US$148.7 billion “at fair value” at the end of May. Those holdings comprised mostly equities, corporate and convertible debt, mortgages and asset backed securities, and derivative financial instruments. Financial instrument uncovered sales totalled US$46.3 billion. From a peak of US$172.6 a few months ago, Bear Stearns stock plunged to just under $100 and is currently trading around $123.5.

Mind boggling derivatives growth

And that is only one aspect of leverage. Hedge funds, managed futures funds, investment bank proprietary traders are heavily exposed to the derivatives market. A tiny margin deposit can be placed on a derivatives contract and a move of between 2 to 5 percent, depending on the size of the deposit can wipe out the margin on the trade. Latter day fund manager gamblers are borrowing billions to punt on derivatives where leverage is anywhere between 20 to 50 times their margin deposit. In other words there is leverage on leverage! Amaranth’s $ 6 billion losses in natural gas markets last year is a prime example on how those trades can go wrong.

The size of the global derivative market is mind boggling. In the first quarter of 2007, combined exchange turnover of interest rate, currency and stock index derivatives was US$533 trillion. The Bank for International Settlements shows that notional amounts of over-the-counter foreign exchange, interest rate, equity, credit default swaps and commodity derivatives soared from US$220 trillion in 2004 to US$415 trillion by the end of 2006. Hedge funds account for as much as 60% of total trading volume in the credit derivatives market, higher than their 40% to 50% volume on the New York and London Stock Exchanges, the Bank estimates.

So where do the gunslingers go from here? The recent rally in the market helped reduce losses of those who had long, or bull positions in the market. But no doubt, the hedge fund bears who had sold short hoping for a further market decline have been hurt. Goldman, Fortress and others say that they are waiting for opportunities to buy.

Small investors can only close their eyes and pray!

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