Market De-leveraging?

The Woes Continue

Since my previous post on Peloton, it appears as though another EuroHedge award winner, Focus Capital, has been forced to close shop. According to reports (2), Focus lost 80% of its $1bn investing in Swiss midcap stocks. Again, the culprit was leverage:

In a letter to investors, the founders of Focus, Tim O'Brien and Philippe Bubb, said it had been hit by "violent short-selling by other market participants", which accelerated when rumours that it was in trouble circulated.

Focus returned 112% in 2006 and 33% in 2007.

Recall that with Peloton, the culprit also was leverage:

With the credit crunch draining away cash, the company was unable to finance the exposure and was forced to find buyers at any price. With no buyers, it was forced into what appears to have been a fire sale.

Both Peloton and Focus appear to have been quite highly levered. When trades moved against them, their capital base was quickly eroded and margin calls forced them to engage in fire sales. In both cases, the founders have blamed others (market participants and lenders) for the forced liquidation. This may be true, but one should consider whether without the high leverage they would have found themselves at the mercy of others unable to ride out their setbacks (if that was even possible)? And on the flip side, would they have made the phenomenal returns in 2006/7 that earned them their EuroHedge awards?

Given that not one, but two EuroHedge award winners have now found themselves succumbing to excessive leverage in illiquid markets, it begs the question whether other funds are in trouble as well. Sure enough the WSJ is reporting that Carlyle Capital Corp., an investment subsidiary of the Carlyle Group has been faced with margin calls on a book levered 32 times. Their $21.7bn portfolio is supported by only $670m in equity. That's a mere 3%. Carlyle Capital Corp. finances purchases of their Fannie and Freddie securities through short term repo's. Essentially, they are borrowing short and lending long. Given the duration mismatch and the complete seizing up of credit markets, this does not bode well.

Mish has more to say on this topic. And care of Mish, we also find that the Bank of Montreal recently missed margin calls and Thornburg Mortgage received a few of their own.

This is in addition to Falcon Strategies, an MBS fund at Citigroup that was bailed out by their parent after losing 52% in the fourth quarter of 2007.

De-leveraging?

As far as I know, these are the major outfits of the past 2 weeks that have wound down or are in serious trouble. What's most curious is the wide spectrum of asset classes involved. Granted, both Peloton and Focus would not have been liquidated had they not been so highly levered, that still does not mean they would have recovered completely. It's hard to say. What seems easy to say, however, is that given the recent events, many other highly levered funds will be wondering if they are safe in their leverage. Market conditions have not materially improved since the beginning of the year, and even look to be worsening. It would be unwise to assume that any asset class is safe from large volatility. Even precious metals that I am very bullish on have shown tremendous volatility this week; down a few points, up a few points, and down again a few points, all in the span of 3 days. If that kind of volatility isn't enough to knock one out of a highly leveraged position, I don't know what is.

The short of it is that I would not be surprised to see many funds taking precautionary steps to avoid following in Peloton and Focus' footsteps. I cannot say what impact this de-leveraging will have as I have no data indicating what scale to expect. The next few weeks will be very interesting. I am highly inclined to say that the market will decide its path soon. It will either put in a nice bottom before breaking above 13,000 again, or if 12,000 is decisively breached, I expect 10,000 to follow. I suspect the latter, unless the Fed can successfully inflate, something it seems oddly reluctant to do as 3 month T-bill rates are still quite a bit below the Fed Funds rate. Given that, I would not be surprised to see a 75bp cut at the March meeting.

I also argued in my previous article that what we are witnessing is not an LTCM style tail event, but a systemic crisis.