There was a brilliant article last Friday in the FT by Gillian Tett that bears worth reading. “The Vicious Spiral That Haunts the Debt Markets” “The western financial system is caught in a trap … on the one hand, there is an urgent need for clearing prices to be established for impaired assets to restore confidence; on the other hand, if this is done in a mark-to-market world, there is a risk that some banks will run out of capital. Policymakers are in the unenviable position of knowing almost any step they take risks denting sentiment further”.
“The risk now is that we will remain trapped in this climate of grinding fear for months – at best. Few institutions have much incentive to voluntarily create clearing prices. However, hedge funds are now being forced to make asset sales in an ad hoc, opaque manner that is adding to the sense of fear. This is forcing the banks to mark books lower and pull in their horns, sparking even more hedge fund sales and fuelling concern about banks. It is a viciously unpleasant spiral”.
In plain language this is what is happening. The banks lent too much money to the hedge funds. In some cases on a 30 to1 ratio. For every 1 dollar the hedge fund had in capital the hedge fund was able to purchase 30$ worth of goods. In a rising market this, amplified the funds returns. But now, in a declining market the hedge funds are going under along with the banks’ money they borrowed.
As the value of the assets in the hedge funds have been going down, the banks have been making margin calls. The hedge funds have been forced to sell those assets into the market. And as these funds have continued to liquidate its holdings, the hedge funds have been driving the value of its own assets down- thus incurring more margin calls. In turn this is forcing wide spread liquidations. This is why there does not appear to be an end in sight.
There is now talk of watering down capitalization regulations so as to minimize the massive liquidations. Gillian Tett concludes with this ominous note:
“We are now up to $188bln in terms of total write downs globally from the estimated credit losses. These mounting losses in turn make it more difficult for economic agents to secure funding. That then leads to more economic weakness, which then fuels the wave of delinquencies, defaults and foreclosures.”
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