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Confessions of a Money Manager: Ultimate margin call hits global markets

Ray Unger  —  10/13/2008 8:13 am

At a recent luncheon with close friends, the discussion naturally turned to the stock market and its gyrations that preceded and followed the $700 billion bailout bill. One friend asked, "What's causing these wild swings?" The other chimed in with, "Could we be headed toward another Great Depression?"

My response was to ask them a question: "If you knew that the chair you were sitting in was worth $10, but a guy came rushing in and said he had to sell a whole bunch of similar chairs RIGHT NOW, how much you would offer him?

"Five bucks!" snapped my friend.

"Does this mean a Great Depression's ahead?" I replied.

Obviously, this contrived example doesn't do justice to the depth and scope of this financial crisis, but it does illustrate a key element behind today's market meltdown. The root cause stems from forced sales. But what would force a guy to sell a bunch of chairs instantly? Maybe his bank loan came due and he had to sell something -- anything -- to raise cash to pay down his loan.

If you were the CEO of the bank Wachovia, and $16 billion of deposits were withdrawn over a three-day weekend, you need cash, and quickly. That means you have to sell assets -- loans, mortgages, bonds, etc. You can sell the bonds, but you need some to cover your reserve requirements at the Federal Reserve. The mortgages are a major problem because no one is buying mortgages these days. So you have to call in some loans. Maybe one of those loans was to the chair dealer and that prompted him to rush to sell instantly to the highest bidder -- which was you and you bought them at half the current market value.

Now guess who might also have loans outstanding at the major banks? How about hedge funds? Last year it was reported by various industry sources that hedge funds had some $1.5 trillion in equity -- money invested in the funds by investors. Since the industry is virtually unregulated, these figures are quite fuzzy. What's also uncertain is the leverage they employ, that is, the amount borrowed against the hedge fund's equity. If they're levered 5 to 1 (if the hedge fund has borrowed five times the amount it has in equity) the outstanding investments of these funds could be as high as $7.5 trillion. But if they're levered 10 to 1, the asset base of the hedge funds could be $15 trillion. Who knows for sure?

What we do know, however, is that Treasury Secretary Henry Paulson thinks the U.S. Treasury needs to step in to "unlock frozen credit markets." What the heck does that mean? Well, it means that credit is not being extended as usual: banks are not lending to other banks; corporations are not buying as much commercial paper from other corporations; and brokerage firms are making margin calls on their investment clients who borrowed on their stock and bond portfolios. In other words, credit that is normally extended to cover day-to-day business activity has been sharply reduced. So if credit isn't available, the borrower MUST sell assets.

What if you're a hedge fund manager and your friendly banker-brokerage firm that allowed you to borrow 10 times your investment to buy stocks, bonds, gold or oil calls and says: "We need you to repay a few billion on your loan -- NOW," the hedge fund manager must sell. So he sells what he owns. Maybe he owns oil futures or technology stocks, or municipal bonds. My lunch friend isn't in the investment business, but he could be because his instant reaction to a forced seller is to make a ridiculous bid and watch the seller squirm.

Earlier this week, I spoke with a representative of Penn West Energy (PWE $15.73), one of Canada's largest and most-respected energy trusts. Last month they distributed 34 cents (Canadian dollars) or 32 cents (U.S. dollars) per trust unit. This is a monthly distribution. My questions concerned the trust's balance sheet, and its ability to continue making such distributions. Thirty-two cents per month translates to $3.84 per year for a current annual yield of 24 percent based on the trust's current price. Is this possible? Can Penn West actually yield such an obscene amount of money? I asked this representative who would sell at such a crazy price? He said that the institutional selling has been two to three times more active than usual. He further said that several hedge funds have been selling.

"Why?" I asked.

He didn't have a definitive answer, but his banking sources tell him that many hedge funds are being pressured to pay down on their enormous debt. Being levered 10 to 1 or even 5 to 1 is quite risky, so the banks are "suggesting" they reduce this leverage. That means they have to sell whatever they own. If they own oil futures, or energy trusts, whatever, they must sell. That could explain why we've seen oil futures fall so abruptly.

Loosely translated, the phrase, "frozen credit markets," means either making no new loans or calling in existing loans. That means investors who are on margin (loans against their portfolio assets) are required to sell assets to meet a margin call. For the small investor, this is an inconvenience. But if those calls are on trillions of dollars of investments held by hedge funds, banks, mutual funds or brokerage firms, such an ultimate margin call on the global market is catastrophic. This doesn't necessarily signal a recession or depression, but it does mean we'll see continued market weakness until credit is restored.

Ray Unger  —  10/13/2008 8:13 am