More carnage in the markets tonight with the Dow losing 7% of its value in the afternoon session. None of this is reflected in the UK, and currently the FTSE is trading 5% down off market. It’s very grim, and it’s anyone’s guess when it’s going to stop.
Many years back (it feels like a lifetime ago) I was a trader for for a hedge fund. We traded mostly US equities – mostly long, some short and often with options. We had a margin facility – when I joined it was 100%, so for every pound we invested we could borrow another pound to invest alongside. As time went on this margin facility increased and we were able to borrow more and more to increase the risk we were taking.
These were early days in the hedge fund revolution – a lot has changed and I couldn’t honestly say I understand the landscape these days, but the basic principles are the same. They have a certain amount of money, they borrow a lot more and they invest – typically a mix of long and short positions. Often they will buy one stock and short another, which means they have to borrow the shares of the company they are shorting in order to sell them – this makes the margin picture more complex. They have been able to borrow significant multiples of the cash they have, and this has become one of the features of this crash – the unwinding of these margin positions.
The hedge funds are being hit in a number of ways. When you borrow stock to short you have to lodge cash with the lender to cover your liability – this cash is typically invested in commercial paper, which is totally safe provided the issuing bank doesn’t collapse. When Lehmans went down a number of hedge funds took massive hits on their paper, often without having realised that they had this liability in the first place.
A bigger issue for many funds is simply the fact that they are margined up to the hilt now – they have borrowed as much as they are allowed to – and the cash requirement to keep this margin is changing day by day. They have to maintain a percentage of the total asset value of their fund, and for many this asset value has been falling dramatically day after day – at the same time it is becoming more and more difficult to borrow money. Each new day they are marked to market – the value of their portfolio is assessed against the closing prices from the night before – and if the value has fallen they have to stump up the cash to make up the difference.
The Dow Jones Industrial Average just posted its sixth consecutive triple digit down day, and it was the biggest of the lot – a massive 679 points. There’s no money to be borrowed now, and some funds will be staring at the mother of all margin calls tomorrow with no cash in the bank. They will have no choice but to sell stock at whatever price they can get.
I’ve spoken to various people about the net effect of all of this, but no-one I know has any idea how it pans out. This is a serious problem – no-one is in a position to see the whole picture and it is major guesswork to work out who is under the cosh and for how much at any time. The ones who can see the picture most clearly are the lenders, and they are still not lending, which suggests they don’t like what they see.
I think there will be real panic in the US tomorrow with a lot of small investors dumping what they have at any price – this will coincide with the forced sellers from the funds. I think we’ll see a massive move down right from the bell. When the initial move subsides it might bounce back – it has to sooner or later and there’s plenty of smart money waiting on the sidelines. Whatever happens it will be a big and important day.