Hedge fund margin calls appear to be playing a role, perhaps a substantial one, in the precipitous fall in stock prices. One hedge fund manager told us yesterday that a West Coast hedge fund was supposed to have dumped a lot of risky fixed income positions late in the day yesterday. That affected the stock market over the fear that the distressed prices its paper was fetching would force banks and other financial firms to mark similar assets down, leading to further losses.
But some believe that hedge funds are also liquidating stocks. And this research note claims that some prime brokers have arbitrarily tightened their margin requirements, This is not only plausible, but it has happened before.
From Bull’s Eye Research (hat tip reader Marshall):
The selling has reached historic proportions. There literally is a “run on the market,” as investors worldwide are dumping stocks. It seems that the major catalyst for this selling is the fact that the newest large banks primarily J. P. Morgan, Goldman Sachs, and possibly Morgan Stanley as well — have issued massive margin calls to hedge funds and other professional traders who use these banks as prime brokers.
These calls were not issued because of market losses, but more because the banks arbitrarily decided that they wanted their customers to use less leverage. Margin rates as low as 15% for broker dealers were raised to 35%; hedge funds who had been used to operating on high leverage were told that they had to bring accounts up to a much larger percentage of equity.
In this illiquid environment, where all manor of exotic securities literally have no bids, the only place to raise the cash to meet margin calls was to sell stock. That is what really set this market over the edge — as the first notice of these calls were issued on October 2nd and 3rd. There was something of a grace period to meet the calls, but funds realized they weren’t going to be able to meet them other than by selling stock. There are rumors that the most massive of the calls are due Monday (October 13th). If so, this market could continue to decline through then.
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A question for the econometrically minded: is there a simple model in which prevailing leverage ratios influence long-term stock valuations?
Of course they are liquidating stocks, together with other assets.
And the stocks and other assets they are liquidating are likely to be those that are easiest to liquidate.
Accordingly, there is liable to be no particular relationship between the extent to which given assets fall and their likely intrinsic value.
they also have to post margin as cds contracts go deeper and deeper under water (most hedge funds are net protection sellers).
they are also no doubt experiencing massive equity withdrawals on the days that they allow liquidity in their own shares.
i wonder how many hedge funds are already massively insolvent?
Anonymous:
Here is a paperr examining leverage and future returns
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1138082
speaking of hedgies:
Star hedge fund crashes to earth
What is the total assets under management (leveraged) that HFs hold ?
You just have to look at volume after 2:00 pm and compare it to the volume for the rest of the day to realize how much margin call related selling is going on. It has been huge all of this week.
JP Morgan and Goldman are deliberately triggering a fire sale of stocks to rebuy those at pennies on the dollar. Very clever, if not transparent. The beauty in it all is that they aren’t even doing anything illegal.
Ah, Grasshopper. The light is dawning.
No, ‘they are not doing anything illegal’…
I feel certain that they are true believers in whatever idol they pray to. It is difficult, if not impossible, for a sociopath to link his actions to immorality. Where is that guy that ‘broke and threw out of the temple the moneylenders tables’ when we need him?
When markets are chaotic, as now, the pig men make out like the bandits that they are.
All business models based on leverage are bankrupt. All business models based on short term borrowing and long term lending are problematic. The commercial paper market has been going to 0 for 4 weeks now.
No one wants to be a short term lender even for repurchase agreements with any entity at risk of the Lehman treatment.
Yet to be exposed, the practice of insurance companies, AIG etc, and wealth management of lending garbage securities or insider stock and using proceeds to make further investments. This is alluded to as the second AIG bail out was directed to insurance subsidiaries with garbage investments as opposed to the AIG London swap operation in the first bail out. Check out the Boston Scientific founders force stock sale.
Follow the money. 65 trillion in Assets, 24 trillion at Bank of New York.
The question to pose is “Which hedge funds *aren’t* getting margin calls?”
Are there hedge funds that aren’t leveraged? With nearly every asset class except cash and perhaps gold declining, it’s a very stormy sea to navigate.
A lot of hedge funds use no leverage, but I dimly recall the average is something like 1:1, which means some funds are heavily levered.
If I remember, I will try to track the factoid down, it’s useful.
Anon wrote: "Is there a simple model in which prevailing leverage ratios influence long-term stock valuations?"
Why, sure! It's called Modigliani-Miller. And it says, "Leverage don't matter." I kid you not:
http://en.wikipedia.org/wiki/Modigliani-Miller_theorem
But anyone can see that leverage is procyclical. That's what's giving us the current amplified downside. Any business which expects to survive long-term knows that the economy is cyclical; therefore, leverage is limited practically by the need to survive a period of losses during a downturn. Graham and Dodd spelled it all out in 1934. Some folks just didn't read the minutes of the last meeting.
Companies which were using up cash to buy back shares and shrink their equity cap may have pimped management's stock options, but they are paying for it now.
So, here's my M&M corollary: when prevailing leverage ratios are excessive, there IS NO long-term.
— Juan Falcone
Yo Marshall (River?), thanks for the bird dogging on this one. Folks who want to find a trigger for the October Massacre have it.
Overcapacity of bank-a-likes and credit ballooning need to shrink for the good of the real economy. This necessarily means that many if not most hedgies need to go out of business in the public interest, certainly if their models are base on gearing (and most were). On the other hand, moves by the top of the food chain ibankers to liquidate their competitor-clients more than stink. Their was a major element of this in the BSC takedown, the knife in the back, but here we see it in the most ugly way possible. No honor amongst theives, that’s for sure.
One way to read this, and I do, is that the ex-ibanks are contracting the financial economy around _their own_ defensible perimeters, so that when the large but not limitless purse of the Treasury is in fact opened they will get most or all of it since their competitors have been liquidated. If this wasn’t the US, the management tier of these folks would be gone already and their institutions seized. When I opine regarding fascism and plutocracy, it is of these lizards that I sing. Their actions ARE NOT IN THE PUBLIC INTEREST.
I’d have no problem with senior management and insiders at GS, JPM, MS, and Merrill being lined up against a wall, and not for identification, but they pay more security guards than I do. Violence isn’t the answer; unemployment and incarceration are a better way. That’s what underclass criminals receive, so time for the overclass to experience no little solidarity with their like.
So Juan F., that’s a good read. Let’s formulate it: Leverage and term are inversely proportional. You said it, so it’s yours.
Richard Kline…I don’t know Marshall, but have seen some of his/her posts.
I am an ex-pat from The Oil Drum. Once they introduced the ‘ratings system’ I took it on the lamb. :)
One of my last posts at that site was a comment about how this election would be dominated by ‘the economy’, not ‘peak oil’. That got me some down ratings. I wonder if TOD has noticed that the economy is a bit of a sticky wicket? I wish them well in their endeavors.
Thanks for the credit for the catch but credit belongs to Jesses’ Cafe American and of course Yves for providing us a great forum.
Just a comment on past comments.
According to past reading, and follow up research, the market was extremely overvalued, even after that 777 point drop on the dow after the house voted down the MOAB.
The call then was for a drop to the historical average, which at that point was SP500 960, or somewhere in the neighborhood. That was also before SP lowered earnings guidance.
The stock market usually overshoots, high and low. This would of course be amplified by leverage. More upside when the market goes up, more downside when the margin calls begin to pile in.
This is how it has always been, nothing has changed.
An interesting point may be too look further at the claim by some that the last bottom in the market, in 2002, was not a real bottom. Some people believe, and may have a very good point right now, that the fed increased liquidity way too much in response to the last recession, there never was a real bottom beacause of this.
The floor traders should be thanked today. There are still a few people out there in the mix, they are the ones who had to put that bottom in this morning, great job guys.
This also brings another point up, people in the mix. We need more. They serve as buffers, and in cases such as this morning can look around and realize what is going on. Computers do exactly what you tell them, we need more people in this mix.
First – It is unlikely that Morgan PB is issuing anyone with discretionary (those unrelated to adverse changes in P&L) margin calls for most large clients have bailed out completely from their PB unit in fear of getting caught pants down Lehman-style. Indeed anyone still with MS must be getting the Pasha treatment. Moreover, any manager of any significance worth his/her salt has stitched their PB with notice periods prior to changing promised leverage. Second any manager still tempting fate and employing extended leverage at this point in the game with current volatility and chaos is clinically insane and is deserving of their fate.
Finally, while I have no love of GS or JPM, conspiracy theories are pure fantasy since with more than 1-in-3 funds likely to disappear, PBs will be desperate NOT to rape and predate their clients IPB is (outside of bankruptcy advisory) likely to be one of the few areas able to make consistent money.
Juan, it is very unfair to Modigliani and Miller to suggest that they claimed that in the real world leverage does not matter. Their central insight was that under very specific idealized conditions (perfect information, infinitely deep capital markets, no taxes, no costs of financial distress) leverage (and dividend policy) would not matter. No one suggests these conditions represent the real world.
According to investopedia the minimum margin allowed BY LAW is 25%…”As governed by the Federal Reserve’s Regulation T”. And that is the maintenance margin, after the position has been established. The minimum initial margin is 50%.
the heavy selling and big downside price moves on Monday and Tuesday transpired on Monday from 7.15 am cst to 1.45 pm ~ down 86 points (SP). The heavy selling on Tuesday occurred from 8.30am to 2.45pm ~ down 78 points.
On Wednesday, the hurtful selling occured from 230 pm to 3.45 pm ~ down 56 points.
On Thursday, the selling began at 8.30 am and ended at 9.15 pm ~ down 137 points or more than 1% per hour.
On Friday, the hurtful selling began at 9 am until 12.45 pm ~ down 81 points.
Yes there was especially heavy selling pressure in the final hour of the markets being open. But, this activity need not have been hedge funds, in fact, most probably it was mutual fund redemptions.
Hedge funds, moreover do not usually lever up in stocks unless it is a sure thing, such as fixed income securities can offer. So,while it is entirely plausible that hedge fund margin calls are causing them to liquidate, most likely they were liquidating fixed income products where they can borrow short/lend long.
This explains why 10 yr treasuries tanked 5.14 points on Wed through Friday when the stock market was crashing the hardest. Normally, treasuries go bid when stock markets crash.
Another hedge fund problem is that they sold a lot of CDS paper, and the cost to sellers of LEH CDS paper is roughly $270 billion.
You will see tons of hedge funds roll over and die as a result because they have no reserve requirements to meet these obligations.
But yes, GS and other banks should be scooping up the cheap stocks out their after this weeks liquidation.
What is the size of Hedgies FUM? Or is total leveraged exposure more relevant?
Some one presented an outrageous number in another post today, which can’t possibly be right (but then again, maybe it is???)
I havent been able to google anything sensible.
Can anyone assist?