Published October 25, 2008

Dynamics of a financial tsunami

Hedge funds dump their holdings; shadow of corporate bankruptcies looms

By VIKRAM KHANNA

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YESTERDAY might be remembered as another Black Friday. Within minutes of opening, the Dow was more than 400 points down. The financial tsunami is here. And like a real tsunami that washes away everything in its path, the tidal wave of selling on global stock markets has become indiscriminate. Stocks have been dumped, irrespective of corporate fundamentals.

It matters little whether a company has a good product, brand, management or prospects - although, of course, some are dumped more aggressively than others. Not only stocks, but oil and other commodities have also been hit, and several currencies. It's as if someone has yelled 'Fire!' in a theatre - forget the movie, no matter how good it may be; just make for the exit. What we're witnessing, in short, is panic in motion.

We saw it before, during the Asian crisis 10 years ago. But this time, it's global. Most Asian stock markets are down 50-60 per cent year to date in US dollar terms. Korea is reeling from a 68 per cent decline, having dropped 20 per cent just in the last week.

But Asia isn't alone. Investors in Eastern Europe and Russia have taken an even bigger hammering. The Russian market is down more than 75 per cent. Ukraine has been battered 82 per cent. And the stock market of Iceland has lost 95 per cent - an almost total meltdown there.

Emerging market currencies have also, naturally, come into the firing line. The Korean won, in particular, but also the Indian rupee, the Brazilian real, the South African rand and all the Eastern European currencies have plummeted. But so has the British pound and the euro.

Apart from recession and earnings concerns, the dynamic of the moment is hedge funds and other institutional investors dumping their holdings as they face margin calls and redemptions. Most of these entities are dollar-based, except for those from Japan, some of which are yen-based. Essentially, the funds are engaged in fire sales to repatriate the money home to repay panicked investors and banks. And so it is that the US dollar and the yen are soaring. This is a dramatic unwinding of the carry trade - the borrowing in a low-yielding currency to invest in higher-yielding assets - in both dollars and yen.

There is no telling how much further there is to go. The size of hedge fund positions, and how much has been unwound so far, is unknown. But it does look possible that hundreds more hedge funds will fail, including some big ones, which could entail systemic risks. In that event, central banks will have to orchestrate 'bail-ins' of these funds by already stretched banks, perhaps along the lines of the 1998 bail-in of the failed hedge-fund Long Term Capital Management (LTCM) - except, this time, on a vastly larger scale.

Also feeding the panic is the possibility of major corporate bankruptcies, including that of one (or more) of the big US carmakers - General Motors, Ford and Chrysler. Apart from being heavily in debt, which they find hard enough to service even in better times, these corporate behemoths have huge vehicle financing operations that have seen their funding dry up.

Politicians from the US state of Michigan, where these companies are headquartered, have written to Federal Reserve chairman Ben Bernanke and US Treasury Secretary Henry Paulson asking for emergency assistance. Investors might well ask: after the Detroit carmakers, who's going to be next and how many more will there be?

These are extraordinary times in the markets which call for extraordinary measures, including further interest rate cuts and more. Eventually the markets will recover, perhaps sharply. But for now, the ball is in the court of the policymakers.