Hedge Funds' Derivatives Exposure and Margin Calls Driving Stock Market Crash

Leading economist Nouriel Roubini explains in bullet-point form how hedge funds are driving the stock market collapse. Take careful note of how credit default swaps are a key factor in the stock market sell-off, and how another type of derivative - "collateralized fund obligations" - may be the next shoe to drop:

Oct 15: Lehman Brothers Holdings Inc.'s hedge-fund clients may have to pay more collateral on $65 billion of assets frozen when the investment bank went bankrupt a month ago--> "If your bank fails, you still have to pay your mortgage." Moreover, hedge funds are among the net sellers of credit protection in the $54 trillion credit derivatives environment and might be called to perform on their obligations wrt Lehman, WaMu, Kaupthing, etc.


• Oct 1: There are dozens of hedge funds whose Lehman prime-brokerage accounts were frozen when the company filed for protection from creditors on Sept. 15. "One executive who used Lehman as a prime broker -- and who asked not to be named because his firm is private -- estimates that hedge funds had between $50 billion and $70 billion in Lehman prime-brokerage accounts." Moreover, hedge funds had pledged equity securities as collateral that Lehman then loaned to other investors under a practice known as rehypothecation - PWC says in that case "clients may cease to have any proprietary interest in them."
  

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• Perfect Storm for Hedge Funds: Short-selling rules were altered in a flash, the implosion of brokerages reduces the possibility for borrowing money, they’re stuck with delevering, and to top it off, many are getting hit with redemptions as September comes to a close, marking the end of the year for many funds. (MarketBeat) Redemptions could lead to fire sales and vicious circle.
• FT Alphaville: Because so many firms hold similar positions, forced selling by one in response to redemptions can have ripple effects, forcing other funds to sell. More nimble hedge funds have sought to profit from the dynamic by taking short positions in securities known to be widely held by rivals --> HF adopt strategies to take advantage of competitors' unwinding positions

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• NYT: In the month of July, hedge funds experienced nearly $12 billion in outflows. September 30 is the deadline when many funds are scheduled to accept withdrawal requests for the end of the year. To pay back investors, some funds may be forced to dump investments at a time when the markets are already shaky thus fuelling a vicious circle--> some hedge funds are reported to block withdrawals.
• Attari/Ruckes: Redemption feature causes fundamental maturity mismatch with borrowing short term and lending/investing long-term and illiquid e.g. in leveraged loans--> when redemptions increase, hedge funds have no other choice than liquidate assets thus fuelling a negative spiral. Evidence from leveraged loan market shows that this is unravelling is underway.
• cont.: Rating agencies start to downgrade collateralized fund obligations (C.F.O.) which are the hedge fund equivalent of mortgage-backed securities: securities backed by hedge funds. Some have a 7-year lock-up period. While few in number, C.F.O.’s represent a broad swath of the $2 trillion industry.

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• About 350 were liquidated in the first half of the year and if the trend continues, the number of closures would be up 24 percent this year from 2007.
• Seides (InvestorsInsight): Hedge funds are sellers of 32% of all CDS, insuring exposure of $14.5 trillion. Recent estimates indicate that the entire hedge fund market is approximately $2.5 trillion in net assets under management. Thus, hedge funds are bearing risk in excess of their ability to pay the piper if anything goes wrong--> risk might well land again with former investment banks and broker dealers.
• Roubini: “one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences.”

For more on how hedge fund margin calls may be leading to the run on the stock market, see this.