7 November 2008

A truly dismal deleveraging nightmare

We are now facing a major de-leveraging cycle and it will suppress economic growth and put a lid on the stock market for years to come.

The Absolute Return Letter - November 2008

We are only in the first or second innings of this recession, and the emerging market story has the potential to wreak further havoc. So do credit default swaps - or something else.

There is no question that hedge funds are downsizing at present. It is likely that much of the recent sell-off in equity markets around the world can be traced back to hedge fund liquidations. The problem is to obtain precise data on the phenomenon.

If we estimate that the global hedge fund industry controls about $2 trillion of capital, and we assume that 15-20% is going to be pulled out between now and year-end (which is not far from the truth according to our sources), $3-400 billion must be returned to investors between now and 31st December.

That is not the whole story though. The average hedge fund uses leverage, to the tune of about 1.4 times (see chart6).

Hedge funds need to liquidate investments of at least $500-550 billion in order to meet current redemption requests. And the real number is probably higher because some of the worst performing strategies this year are the ones using the most leverage. The real number is therefore more likely $6-800 billion, and that is a big enough sum of money to put downward pressure on the markets.

Add to this the fact that some hedge funds (mostly the bigger ones) have been selling credit default swaps (CDSs). The buyer of a CDS supposedly makes money if the underlying credit blows up. I say 'supposedly' because the payment is a function of the seller's ability to pay up.

That was why Morgan Stanley had to be saved at all cost. MS has been, and continues to be, one of the largest players in the CDS market.There is no way we can establish precisely how many CDSs hedge funds have on their books, but please consider the following: The CDS market is a $50 trillion market (give or take). Before they blew up, AIG were one of the biggest sellers of CDSs with approximately $500 billion on their books. They ran into problems (partly) because they were heavily exposed to the financial services industry which is already in recession.

If AIG, one of the largest and most sophisticated financial institutions could get themselves into trouble with barely a 1% share of the global CDS market, what will happen to the sellers of the remaining 99%?

Who 'owns' this risk? Is it hedged or not? Is it even possible to hedge the risk, knowing that your counterparty might not be able to pay up?

...de-leveraging has a long way to run yet, not so much in the hedge fund community where I suspect that much of the damage will be behind us once we pass the next major redemption hurdle on 31st December, but in society more broadly.

I have borrowed Chart 7 below from BCA Research, and it shows total US bank loans as a percentage of US GDP. Unfortunately, the picture would be much the same for many of the European countries.

European banks at risk

Stephen Jen and Spyros Andreopoulos at Morgan Stanley suggest that an already weak banking sector in the OECD could be further stifled by non-performing loans to emerging market countries. Worldwide cross-border lending now stands at $37 trillion with about $4.7 trillion going towards Eastern Europe, Latin America and emerging Asia.

Cross-border lending by European and UK banks to emerging market countries accounts for 21% and 24% of respective GDPs compared to 4% for US banks and 5% for Japanese banks (see chart 4).

Europe has about $3.5 trillion of debt outstanding to emerging market countries whereas the US has only about $500 billion on the line

The country most exposed to emerging markets is Austria with total emerging market loans accounting for no less than 85% of the country's GDP – most of it to Eastern Europe. Austrian banks have been aggressively pursuing opportunities in Eastern Europe for years.

They have in fact been so aggressive that their total lending to the region (approximately $300 billion) exceeds the amount lent by Germany to Eastern Europe. Even more worryingly, Austrian banks are the largest holders of debt on Hungary and Ukraine – two of the most fragile economies on the old Soviet bloc.

As an aside, when the global banking system collapsed in May 1931 in the midst of the Great Depression, it was a run on the Austrian banks which acted as a catalyst.

Italy is possibly in an even more dire condition. Italy's public debt is now the third largest in the world, behind the US and Japan. And, at 107% of GDP, it is almost twice the limit set by the Maastricht Treaty (so much for treaties!).

Italy is also a big lender to Eastern Europe

Unicredit alone has about $130 billion of debt outstanding to Eastern European countries. Italy's predicament is well recognised by fixed income investors. 10-year Italian government bonds now yield 1.08% more than their German sister bonds. The market is telling us that something rather unpleasant could happen to Italy.

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