Citigroup: The "Great Unwind" Has Begun

Citigroup has declared a very bad scenario first forecast by analysts Stefan-Michael Staimann and Susanne Knips of Dresdner Kleinwort in February 2007, “The Great Unwind,” to be in progress. To their credit, they made this bold call months before the credit contraction began. They viewed it as an inevitable outcome of the hedge fund boom:

Transaction costs run to 4 per cent of the $1,300bn of hedge fund assets under management. Manager salaries and performance fees take another 4-5 per cent, meaning hedge funds need to generate average annual returns of close to 20 per cent to keep everyone (including their investors) happy. Yet the strategies employed to produce these returns are not necessarily sustainable.

A clear majority of hedge funds can be thought of as leveraged sellers of deep-out-of-the-money put options. They employ long-short strategies – removing market risk with what are essentially spread or arbitrage bets with a relatively low return. To boost returns they employ extensive leverage. These spread positions do produce what look like low-risk returns most of the time — but, once in a blue moon, what are effectively options written by the hedge funds will get called. Think LTCM.

While hedge fund strategies across the industry may look diversified, there is actually a high degree of correlation, since many funds are effectively running leveraged bets on stable or tightening risk premia. Any widening of risk premia will force large-scale liquidations of positions, with margin calls by the banks and redemptions by investors reinforcing the process.

While Citigroup apparently does not invoke the underlying theory, they see a massive deleveraging in process and tell investors to get out of the way. Via Marketwatch:

The Great Unwind has begun, Citigroup Inc. strategists warned on Wednesday.

As markets and economies de-leverage across the globe, investors should avoid companies and countries that have grown to rely too much on borrowed money, they said.

That means favoring public-equity markets over hedge funds, private-equity and real estate, while leaning toward emerging market countries and away from developed nations like the U.S., the bank’s global equity strategy team advised.

Within equity markets, the financial-services should be avoided because it’s still over-leveraged, while other companies have stronger balance sheets, the strategists said….

Financial-services companies are the most vulnerable to this reduction of borrowed money across the globe, they said.
During the last credit crisis in 1998, European banks were leveraged 26 to 1. In the early part of this decade, leverage grew to 32 to 1. Now the sector is geared 40 to 1 on average, according to Citi’s European bank research team.

“The banks have a long way to go,” the strategists said. “We would continue to avoid the sector while they are de-leveraging.”

Other companies are in much better shape, having rebuilt cash from strong earnings since 2003. Emerging market companies have developed particularly strong balance sheets, having learnt hard lessons from the Asian financial crisis a decade ago.
However, even though some companies may not have much debt themselves, they may be exposed to over-leveraged customers or highly leveraged investors, Citigroup warned.

Automakers, home builders and electronics retailers benefited as customers borrowed money cheaply in recent years to buy cars, houses and flat-screen TVs. That attractive financing is now being withdrawn.

“There will be plenty of companies that have strong balance sheets, so may not be most immediately vulnerable to the credit crunch,” “But they may find that their leveraged customers are vulnerable.”

The difference, or spread, between interest rates on investment-grade corporate bonds and Treasury bonds has jumped in recent months, even though most companies aren’t very leveraged.

This widening may be caused by leveraged investors such as hedge funds having to sell good quality assets to meet margin calls, or requests for more cash or collateral.

“It is the leverage of the investors who hold these bonds that is now being brutally exposed,” Matt King, a Citigroup credit strategist, said.

“We are now confronted by a broad bloodbath in the credit markets,” Citigroup said. ” The most leveraged paper is falling in value because it is leveraged, and now the least leveraged paper is also falling in value because it is owned by leveraged investors.”

Investors should also avoid hedge funds themselves, along with private equity, Citi added. Both types of investment rely at least partly on borrowed money to generate returns.

“Private equity returns have been especially strong. Without leverage it will be much harder to meet excessive investor expectations [most surveys suggest 20% annual returns are expected from the asset class],” Citi warned. “Similarly, many hedge funds have generated healthy uncorrelated returns by adopting cautious underlying strategies, but applying significant leverage. Again, that looks unsustainable in the current environment.”

Leveraged economies, like the U.S., should also be avoided, in favor of emerging market countries, which have reduced borrowing, the bank advised.

With less capital sloshing around the world, and the dollar falling, the U.S. may have to compete more to finance its deficits.

“The U.S. shows up as the world’s greatest consumer of external capital,” Citi noted. So it “has the most to lose as this capital becomes less freely available.”