By Keith Fitz-Gerald
Contributing Editor
“Will it be enough?”
That’s not a question. That’s the question. And it was being asked all around the world, in emergency sessions that started late last week and stretched into the weekend. It was being asked by central bankers in government offices, and by securities traders, hedge-fund managers and corporate executives who were gathered in their corporate boardrooms with their mahogany paneling.
The “it” refers to the staggering $275 billion the world’s central banks collectively injected into their respective financial markets last week, in an attempt to mitigate the fallout from the worsening U.S. credit mess [For a full news report on Friday’s developments, click here]. And whether “it” – this intervention – will be enough, depends on two factors:
- How much toxic financial “sludge” – in the form of sub-prime-mortgage notes — remains in financial portfolios around the world?
- How interbank-lending rates fare in light of what’s already known about this mess.
The Drudge of Sludge
Let’s consider the “sludge” factor first.
I can’t confirm it firsthand, but the word among my contacts on “The Street” is that the Securities and Exchange (SEC) and other regulatory agencies around the world had inspectors and investigators crawling through the offices of various brokerage houses and hedge funds with microscopes, trying to determine exactly how much of this “refuse” these outfits still have on their books.
This is a vital question to answer. The typical retail investor doesn’t realize this but believe me when I tell you that big banks and hedge funds are inextricably linked, since one provides badly needed credit to the other. Under normal circumstances – as part of the banks’ assessment of the risks they are taking with the loans they are making to the hedge funds – the banks’ risk managers conduct a very careful review of exactly what the hedge funds hold.
Just last week, France’s largest bank, BNP Paribas SA, dropped a bomb when it publicly stated that it was freezing several funds because it couldn’t properly value the mortgage-backed securities that the hedge funds held. Industry insiders had been concerned about this for weeks, but were hoping the problem would blow over because they knew if it came to light that there would be hell to pay in the markets.
Obviously, it didn’t blow over. And obviously, the markets cratered.
Here’s why.
To function in the short run, hedge funds have a huge appetite for capital from the many banks around the world. But when they can’t get that capital, or it’s otherwise not available, the hedge funds are forced to liquidate their positions.
And at the worst possible time.
When hedge funds can’t get this needed capital – or find that it’s otherwise unavailable – they are forced to unload their positions, or dump them, outright. Given the already-volatile markets, and given the dollar volumes involved, this creates massive market pressures.
Heads up on Hedge Funds
If the “hedgies” are unwinding long positions (meaning they are selling stocks, bonds or ‘derivatives’ that they own), it creates a downward push on the markets. If they’re covering big short positions, the scramble to “cover” their positions can ignite a rocket-ship ride known as a “short squeeze.”
While there’s naturally a lot more to it than this, this is a good overview at its most-basic level.
What you need to understand is this: When the hedge funds tumble into trouble, they frequently sell the best stuff they own first because they know these investments are the most liquid, and therefore are the easiest to sell. That means they can extract the most value from it
This is why a lot of the best stocks were pounded and actually led the way down last week. Just as interesting is this: At the same time they’re unwinding their long positions, the hedgies often take some of the proceeds and simultaneously begin covering their shorts to reduce margin exposure. These are typically in junkyard shares of lesser companies they’ve bet against which is why many small and mid cap shares got hammered, too.
At this point, the banks have to get involved because the markets have broken down. In other words, normal liquidity that preserves the status quo no longer exists – imagine a playground that’s gotten out of control. At some point the teachers have to come outside to break up the scrum.
Banks lend hedge funds money under normal circumstances at overnight banking rates (known as interbank rates) that are predicated on the acceptable valuation of the underlying risks associated with the hedge fund portfolios. When banks cannot accurately value risk, they will jack these interbank rates up from their normal 4% to 5%, all the way up to 6% or more under extreme conditions. This effectively locks the hedge funds out of the market because they cannot afford such expensive cash. Faced with such constraints, the hedge funds are forced to do everything they can – which is to sell everything but the kitchen sink in the open markets to raise cash. And that’s largely what happened last week.
Banks don’t like this any more than the hedge funds because now their best customers are, in effect, refusing to buy their “inventory” by not taking money at overnight rates. So they jack rates up further to compensate.
Normally, this process resolves itself. But in this case, it required a massive policy-level response when the banks turned to their respective governments to bail their sorry act out. And, for whatever reason, the Fed and other central banks around the world typically do this by using vast amounts of cash to flush the system out. In case, we’re talking about an injection of more than a quarter of a trillion dollars in less than 72 hours.
However, we have to keep in mind that injecting “liquidity” into financial markets that aren’t functioning properly is a double-edged sword. If they inject too much, they risk igniting global inflationary concerns. Any time you have too much money chasing too few goods, you get inflation or at least the risk of it, anyway.
Inject too little, and the system breaks down – again forcing yet another round of bailout injections.
You may not think this sounds healthy and, frankly, I’m not sure I like it either. In fact, I know I don’t. I’m not crazy about my tax dollars being put on the line to bail out a bunch of elitist hedge-fund managers who have screwed up, but this is the policy response we’ve been dealt.
What can we expect this week? We’ll know in short order when the markets open today. If the $275 billion that’s already been injected is enough, the markets will probably try to form a base, and may even try to step up a notch. If not, well, it’s back to the roller coaster for yet another wild, screaming ride around the circuit.
I’m optimistic, though. Even though I personally believe there’s a lot of wreckage yet to be revealed in the hedge fund arena, I saw some serious bottom-fishing going on late Friday, particularly in the mid-cap stock sector, which as we’d noted had sold off heavily as the hedge funds raised cash. Energy stocks and dividend plays also demonstrated some remarkable resilience late in the day, so it’s possible the markets will stabilize this week.
For now, however, all we can do is to take a deep breath and search out the truly high quality companies that feature a global perspective. History shows that they bounce back the fastest. Indeed, after that bounce, they tend to go far higher than they were to begin with.
About the Author
Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.