The Great Deleveraging

The exceptionally low equity prices and high level of volatility is largely being driven by the deleveraging of hedge funds, something I am writing a paper on right now. It is interesting to see how this effects the overall market, but the basics are this:

Hedge fund leverage largely comes from financing from prime brokers. And there is less than a lot expect, probably about 1.5 to 4 to 1, with some estimates higher, some lower. With prime brokers going belly up and spooked (as they should be) about their own credit ratings, they decide to cut back the leverage they offer to their hedge fund clients.

The hedgie gets his margin call, looks around, and says "what can I sell to cover the margin call?" The answer? Blue chips and defensive equities. Gold was way way up when the hedgies thought it was going to go up, but now that the market is taking, gold is tanking. Which does not make a damn bit of sense, except for the fact that all the HF are selling out of their gold holdings. And the reason behind all of this? The HF are all holding a lot of stuff (some junk, a lot actually pretty good quality) which cannot currently be traded because of illiquidity, market fears, etc. So instead of selling off their derivatives at 5c on the dollar, they sell of their blue chip equities and their gold.

The nasty part is what this falling equity price does. It shrinks the balance sheet of prime brokers and the personal wealth of hedge fund's clients. They, in turn, cut back funding further and clamor for redemptions. Redemptions on top of margin calls? The hedge fund is screwed.

Basically, a large percentage of the hedge fund industry will not make it through the current crises, and what will remain will be very different. No longer will a $10 billion fund have a $80 billion trading position.

And for right now, you can just sit back, and hope for the best, with the best thing to do buying those undervalued defensive securities: when a little more sensibility reigns, they will be some of the first to recover.