Derivatives Disaster, Hedge Fund Monsters?

By: David Chapman | Fri, Nov 11, 2005
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The only time the general public hears about derivatives or hedge fund problems is after the fact when the blow-up has occurred. Long Term Capital Management (LTCM), Nick Leeson, Orange County and many others only became news after it was revealed that they had lost millions of dollars in a derivatives disaster (Leeson, Orange County) or that they had become a hedge fund monster (LTCM). Of course there have been stories about the huge derivatives positions of J.P. Morgan Chase (JPM-NYSE) or even Fannie Mae (FNM-NYSE). But unless they become the news they are deep in the background.

Both derivatives and hedge funds have grown sharply particularly in the past decade. Since Alan Greenspan took over as Fed Chairman in August 1987 derivatives outstanding according to the ISDA reports that international interest rate and currency derivatives outstanding grew from $865 billion in 1987 to $201.4 trillion in 2005. According to the Office of the Comptroller of the Currency Administrator of National Banks (OCC) second quarter report Commercial Banks in the US had $96.2 trillion of derivatives outstanding. Of this the largest by far and the largest in the world as well is interest rate swaps totalling some $60.9 trillion. Futures and forwards make up $11.9 trillion, options $19.3 trillion and finally the major growth area credit derivatives $4.1 trillion. Credit derivatives were barely a thought as 1998 got under way.

Hedge fund growth has been equally phenomenal. Since 1996 to 2004 hedge funds grew four times from roughly $200 billion to over $800 billion in capital. Today there are over 8000 hedge funds and they have grown to over $1 trillion. The number of hedge funds has more than doubled since 1999. LTCM was a highly leveraged hedge fund estimated to have had at its peak capital of $4.8 billion, a portfolio of $200 billion and derivatives of $1.2 trillion. Incredible leverage. Hedge funds are expected to grow even further to an estimated $3 trillion by 2010.

Hedge funds are unregulated. Numerous hedge funds are run in off-shore banking centres such as the Cayman Islands in order to avoid regulation. So why would individuals, pension funds, banks and others risk their money in hedge funds? Simple, returns that have consistently exceeded those available in the markets through traditional investments in stocks and bonds and certainly better than the returns generated by mutual funds. Unlike traditional investments hedge funds carry out any number of strategies from conservative convertible bond arbitrage to actively managed long-short funds, convergence plays and managed futures using huge leverage. Many of the largest hedge funds are run by former bank/investment bank dealers who left often with the blessing of their former employer. Many of the same funds would then be placed with the hedge funds and the banks provide the leverage capital to allow the hedge funds to grow even faster in a more unregulated environment.

The hedge funds employ derivatives as well in their strategies making them excellent counter parties with the banks. As we noted many of the hedge fund dealers were former employees of the banks themselves. Fees are extremely lucrative. In an era when brokerage commissions have fallen as have fees from corporate finance, the fees generated from hedge funds are extremely lucrative. Management fees of 2% and 20% payouts on profits are not unusual. Many of the funds have stringent lock up periods as well. Oddly though as the hedge fund business has mushroomed returns have actually declined but still remain ahead of traditional bond/equity funds.

Because of the huge size of the hedge funds coupled with the huge capital available to dealers like Goldman Sachs these funds are often over half the daily trading in the equity markets. These firms can if they wish move the Dow Jones 300 points if they so please using a wide array of futures, options, ETF's and other leveraged hybrids. These firms are exempt from up-tick rules and margin requirements. Front running orders are not uncommon. Many of the firms are also responsible for the huge market buy/sell programmes whether it comes intra-day or "market on close".

Michael Jenkins (Stock Cycles Forecast) is a renowned Technical Analyst. He spent many years in the banking and mutual fund industry and understands how the Street works. In his newsletters he often recounts stories on "how the Street works" and his lessons and observations have been invaluable. Having spent nearly 25 years myself as a money market/foreign exchange/derivatives dealer/manager I was also constantly amazed as to how the Street worked. Back in the 1980's I recall a time we worked on winning for the bank I was employed with at the time the largest Forward Rate Agreement ever done on the Street at the time. Trouble was we also had to dispose the position as quickly as possible as our view on the market was opposite to the position and we did not wish to disrupt our books overall position. Bottom line was that we did not want to get caught with it.

In order to try and rid ourselves of the position (profitably of course) we pushed the Euro futures market higher by taking the offers on small lots. As the market slowly ticked higher it allowed the pricing to kick in for the counter party that was willing to take on our rather large position. Egos play a big role in these transactions. As soon as the counter party agreed we immediately sold out our accumulated futures positions plus more that started an avalanche in late afternoon thin trading. The market wound up several points lower.

On another occasion I was roused at 2AM in the morning by a Singapore futures dealer expressing concern to me about the potential for rising interest rates. Agreeing I roused one of our other dealers and a broker and by 6AM we had raised over a billion Eurodollars in the one year term primarily from Japanese banks. By 10:30AM with yields sharply higher and the Euro Futures market in disarray and fielding calls from other banks desperately looking for money we picked up a rumour that some large Canadian bank had cleaned out the market earlier. That was in February 1987 and was the start of huge rise in interest rates that did not end until the day after the stock market crash on October 19, 1987.

The point to consider here is that with large amounts of capital available to these large dealers/banks/hedge funds large sums can move the markets quickly in a manipulative manner. If after manipulating markets in a direction you wish to go and there is no follow through the next day you can immediately start dumping your position and the market falls just as precipitously in the opposite direction. The talking heads on TV are left babbling platitudes about this or that number trying to come up with an explanation for the volatility. The public are often just bewildered. We are now moving into the Christmas season and many mutual fund and hedge funds have December 31 year ends. This, as much as anything else, determines the seasonal tendency of the markets to rally into year end as the huge institutions play for their bonuses. Once year end passes and into the first week of January they then dump their positions. If one examines the record they will discover that the first week of January has been a high particularly in the past number of years as the giant hedge and mutual funds grew in size and market power.

Concern has grown that given the volatility in the markets and daily stories of bankruptcies, terrorist attacks, and natural disasters that an unexpected event out of the blue could occur shaking the markets and causing a blow up somewhere in the hedge fund/derivatives world. Where dealers get caught is having large exposure in market direction or in loosely connected hedged positions that go awry due to a shock. The record is there in the past for dealers to get caught out with unexpected events that throws dealers books for a serious loop. Last spring it was the unexpected downgrades of General Motors and Ford to junk status that caught some large hedge funds with long-short trades' long GM/F debt and short GM/F stock. When Kerkorian came in to buy up GM stock in a takeover attempt the hedge fund dealers were caught with their long GM debt falling and their short GM stock rising. Losses were in the hundreds of millions.

Speaking of natural disasters the three lady hurricanes Katrina, Rita and Wilma have set up a potential huge problem in 2006. AS Michael Jenkins pointed out in a recent newsletter the banks, brokers and insurance companies holding billions of dollars in mortgages gave all the hurricane victims a 90 day grace period on paying their monthly mortgages. When that comes off in early 2006 they could in theory buy another 90 days before potentially having to write off ten's of billions of dollars of defaulted mortgages due to the hurricanes. The first 90 day period gets them past year end bonus time and knowing that the 2006 certainly looks precarious as long as the conditions are okay the temptation will be there to ensure the markets go up into year end to help those year end bonuses even more. This is why both we believe we could in theory see a market that runs to new highs before the year is finished.

It also be after Christmas that the consumer wakes to the realization that given the new bankrupt laws that they can no declare bankruptcy with the former ease and that their minimum payments have doubled. January is going to bring a lot financial surprises as well as paying higher heating costs. It will be double whammy time.

But it may be more than defaulting mortgages and consumers suddenly realizing they have a debt problem. The housing market is now clearly rolling over given the recent announcement from Toll Brothers the US's largest luxury home builder who is cutting his 2006 forecast. The housing market has been the primary driver of the markets over the past few years and without this component the markets could be in trouble. If the slowdown turns into a panic then a lot of housing investors and even new homeowners are going to be left holding a lot of busted housing stock and high mortgages as interest rates rise.

The prime beneficiary of defaulted mortgages besides the bank that lent the money could also be Fannie Mae and even Freddie Mac (FRE-NYSE). The regulator of the giants has contacted Fannie Mae that there could be more accounting issues. The issues centre on internal control and manipulation of income and expense. Both Fannie and Freddie are also large derivatives dealers. Issues have been raised about their accounting of their hedges. A falling housing market that results in a large number of defaulted mortgages could very easily come back to haunt Fannie and Freddie and their accounting and derivative problems. Numerous investors are holders of large quantities of agency bonds of which Fannie and Freddie would constitute a large share of that.

There is huge concentration of derivatives in a few banks. In the US five banks hold 96% or $92.6 trillion of all derivatives positions held by US banks. These banks are J.P. Morgan Chase (JPM-NY), Bank of America (BAC-NY), Citibank (C-NY), Wachovia (WB-NY) and HSBC Bank USA. JPM is the largest holding $46.6 trillion of derivatives against $973 billion of assets. On average the credit exposure of the top 5 banks to risk based capital is over 300% but netting agreements would reduce this exposure by upwards of 85%. Remember that derivatives are notional amounts only and unlike a loan of $1 million a notional $1 million derivative represents only a small charge to risk based capital and not the entire amount. Quarterly write offs by banks on derivatives are typically small although there has been spikes seen at the time of LTCM in 1998 and again in early 2002 following 9/11 and Enron and others collapses.

While the odds of a major banking collapse due to a derivatives is low because of netting agreements and the hedge nature of the banks books individual collapse could still occur at numerous hedge funds or on an individual basis elsewhere. Given the thousands of hedge funds out there the major banks are partners with them. . The unregulated nature of how they act leaves open the potential for another LTCM especially in the event of uncontrollable event like another 9/11 or a pension fund collapse due to bankruptcies. The Delphi bankruptcy is threatening numerous other players including the aforementioned GM. The other major risk lies with Fannie Mae and Freddie Mac and a collapse in the housing market. Even Alan Greenspan has expressed concern here. Otherwise Greenspan was seeing no problem with the huge derivative positions of the financial institutions and hedge funds because of what is know as the "transmission of risk" through netting agreements and the dealers offsetting positions with comparable correlated instruments.

If derivative disasters and hedge fund monsters are going to be avoided then it does become important that the current housing slowdown be just that, a slowdown that does not turn into a collapse, and that global events do not get in the way with a sudden surprise. The risks are certainly out there. It reminds us once again that the safe haven of last resort remains gold. With both gold and the US Dollar both rising of late we know that gold is telling us something is going to happen. Potential nightmares in derivatives and hedge funds are just another area to watch.


David Chapman

Author: David Chapman
Technical Scoop

Charts and technical commentary by:
David Chapman of Union Securities Ltd.,
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David Chapman is a director of Bullion Management Services the manager of the Millennium BullionFund

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