There will be some slaughter in the markets
today. As Nouriel Roubini explains:
[T]oday any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1.
Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
When a bank calls a debtor, be it a hedge fund or some individual, and tells it to pony up more cash or its overextended credit line will be cut off immediately, the debtor will have to sell some stuff out of its portfolio.
The stuff then sold is usually unrelated to the original credit problem. A fund with credit problems because of some leveraged mortgage papers will not get any good price for these right now. But it may also have some GE shares that are still near their purchase value. Those will now be sold just to regain some cash that can support its credit line.
General stocks and speculative commodities like oil are falling as more and more funds need to sell out. Bad economic news like decade low housing starts reenforce the downtrend. The falling value of general stocks leads to overextentions of other debtors with leveraged derivatives, who then have to start selling too.
From there on it really gets interesting …
All of this is was not unforseen. In his 2002(!) letter to investors Warren Buffett wrote (pdf) about derivatives (p12ff), leveraged financial instruments, and linkage which are both major parts of the current unraveling:
Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.
[…]
Derivatives [..] create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay
off much of their business with others. In both cases, huge receivables from many counterparties tend to
build up over time. […] A participant may see himself as prudent, believing his large credit
exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous
event that causes the receivable from Company A to go bad will also affect those from Companies B through
Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more
tranquil times.
[…]
Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event […] Linkage, when it suddenly surfaces, can trigger serious systemic problems.
[…]
The derivatives genie is now well out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their toxicity clear. […] [T]he derivatives business
continues to expand unchecked. Central banks and governments have so far found no effective way to
control, or even monitor, the risks posed by these contracts.Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our
owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and
that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives
contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view,
however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are
potentially lethal.