Allow me to give you a quick lesson called Hedge Fund Debt 101.
The problem is this: According to Bloomberg the debt held by the largest US Hedge Funds total about USD 1 trillion. Don’t you just hate it when people write a big figure and expect you to goo “Oooh, wow!” How can anyone do any “Ooohing” let alone any “Wowing” unless the number in question has been a) put into context b) the consequences of the context are understood.
Drum roll please. The Banker will take care of it for you right now. No need to take a number and wait in line. Bear with me here, you’ll enjoy this. Honestly you will, or your money back!
According to to the same article the net assets of the largest hedge funds are around USD 1.5 trillion. Now comes the bit you need to understand: Collateral value (for the sake of simplicity I’ll ignore the fact that not all the investments of these hedge funds are in stocks and the article refers to net assets)
When loaning out money to someone a bank places a collateral value on the assets that the client places as collateral for the loan. The collateral value is a percentage of the assets. In stock exchange listed equities it tends to be around 70%. The reason for this is that if the stock market goes down, the bank can still liquidate the client's holdings without taking a loss for the bank.
This is how it works: Let’s stay with the numbers from the Bloomberg article and pretend that all of those assets are based in listed blue-chip stocks (they aren’t) that would mean that the collateral value of those assets would be USD 1.05 trillion (USD 1.5 trillion X 70%) HOLD ON! What’s that? It’s only a little bit above the debt of these funds. Remember the debt was USD 1 trillion.
Exactamundo! These scenarios are what give ulcers to risk controllers in banks.
Let’s further pretend that the stocks held by the hedge funds lose 5% in value. Not an altogether impossible scenario I am sure you’ll agree. What would be the collateral value of the assets then? Let’s do some math: USD 1.5 trillion X 95% = USD 1.425 trillion. The collateral value would be USD 1.425 trillion X 70% = USD 0.95 trillion.
Now we have a scenario in which the collateral value of the assets is below the debt. When you get into this kind of situation all kinds of things start to happen in a bank. A bit like this:
Risk controllers call team leaders. Team leaders scream at their sales people to do something. Sales people call their clients asking to sell some shares to bring the collateral value in line. Clients tell the sales people to F**k Off! Sales people tell their team leaders that the client wants to hold on to the stock for strategic reasons. Team leader tells risk controller no dice. Risk controller calls top management to complain. Top management doesn’t know what collateral value means. Top management calls a meeting between team leaders and risk controllers. Emails are sent back and forth. Everyone screams at the sales people. The sales people call their clients again saying now they have to sell. The client doesn’t answer because he’s jumped off a ledge or emigrated to the Bahamas. The bank decides to liquidate and starts throwing stocks overboard triggering a big sell off. Trading algorithms from high frequency automated traders smell something is up and pull liquidty out of the market speeding up the decline. Now the big institutions can see that we are heading south and start dumping their massive holdings causing an almighty crash.
Scared yet? Because one single newsworthy event can trigger this. It has happened before.
Be afraid, be very afraid.