The Great Deleveraging: by the numbers

Working this out for my paper, thought I would put it up for general review.

 

 

 

1) the aggressive fund of 18months ago, a fund running 5 to 1 leverage.

An investor takes $100,000 and puts it in a Fund of funds investment vehicle. That FoF then leverages the assets 3 to 1 to enhance returns. This was standard practice. The fund itself is running 5 to 1 leverage provided by a prime broker -- high, but still very plausible. The fund takes the money and invests it in CDOs, which are built with leverage, commonly 9 to 1 leverage.

Where does that get you?

 

135 to 1

 

It takes only a 75bps (0.75%) drop to wipe out the original capital.

 

Looking at a perhaps more realistic example, a similar fund with a none too unusual asset allocation model:

 

Percent Loss to lose the principal	2.041%
Total Leverage Ratio	49
Sum	$ 7,350,000,000.00
Cash	$ 3,150,000,000.00	$        2,100,000,000.00	$   350,000,000.00	$  1,750,000,000.00
Allocations	CDOs 9x	Derivatives 3x	Equities 1x	Commodities/Futures 5x
	20%	40%	20%	20%
Hedge Fund	5	1,750,000,000.00
Fund of funds	3	300,000,000.00
Investment	1	100,000,000.00	Regular Investment	50,000,000

 

What this is saying is that with $50 million from retail investors and $300 million from a FoF (a pretty standard state of affairs a little while ago), and a 5x leverage ratio split into a overly simplistic asset allocation model will leave you in near as damnit in the end to a 50 to 1 leverage ratio. This is exactly what happened.

 

Now, to again be simplistic, I will run this for the industry. I am going to say that of the $1.8trillion in the HF industry, $600billion is in leveraged funds of funds, probably too high. Then, taking a more realistic asset allocation, I put 40% into equities and 205 into the others (simplistic is hardly the word for my 'asset allocation,' more like 'made by a 4 year old' but I threw this together in 2 mins to work out the idea, so it goes). You get US HF worth $7 trillion before investing. After the inherent leverage of derivatives etc, you end up with $26.6 trillion trading position controlled by the HF. That is pretty damn big, and slightly more than the $26trillion estimated to be in mutual funds.. Globally.

 

The numbers:

Percent Loss to lose the principal	6.015%
Total Leverage Ratio	16.625
Sum	$ 26,600,000,000,000.00
Cash	$ 12,600,000,000,000.00	$  4,200,000,000,000.00	$ 2,800,000,000,000.00	$     7,000,000,000,000.00
Allocations	CDOs 9x	Derivatives 3x	Equities 1x	Commodities/Futures 5x
	20%	20%	40%	20%
Hedge Fund	2.5	7,000,000,000,000.00
Fund of funds	3	1,800,000,000,000.00
Investment	1	600,000,000,000.00	Regular Investment	1,000,000,000,000

 

So then, lets cut back the leverage to what I expect right now. I will adjust the investment for the $50 billion recently pulled out. Then take down the CDO etc allocation, bump up the non-leverage allocation (accounting for cash being held), and then cut the leverage ratio of the HF to 1.4, which is what I expect moving forward.

 

Percent Loss to lose the principal	17.295%
Total Leverage Ratio	5.782
Sum	$   9,251,200,000,000.00
Cash	$     705,600,000,000.00	$  2,352,000,000,000.00	$ 2,273,600,000,000.00	$     3,920,000,000,000.00
Allocations	CDOs 9x	Derivatives 3x	Equities and other 1x	Commodities/Futures 5x
	2%	20%	58%	20%
Hedge Fund	1.4	3,920,000,000,000.00
Fund of funds	3	1,800,000,000,000.00
Investment	1	600,000,000,000.00	Regular Investment	950,000,000,000.00

 

Take a look at the sum. $9.25 trillion vs. $26.6 trillion. That is $17.35 trillion pulled out of the market.

 

Consider that the global market cap in May of 2008 was roughly $57.5 trillion, and today $40 trillion.

 

Obviously my numbers right now are just rough estimates, but for the back of an envelope, I think they shed some light on why equities fell so low a little while ago that by traditional P/E pricing methods we would basically have to have been facing the Great Depression in order to justify the prices.