ANALYSIS:"WE ARE past the point of danger where we were last week, where we could have had a fundamental systemic meltdown of the core plumbing of the world financial system," said the chairman of Britain's Financial Services Authority yesterday, writes Prionsias O'Mahony.
Why then, even after last weekend's co-ordinated efforts by global authorities to deal with the credit crisis, are equity markets continuing to exhibit greater volatility than at any time since 1929?
Global recession fears and continued hesitancy in the credit markets are undoubtedly factors. Perhaps more important again is the massive stress being experienced by the hedge fund industry.
Hedge funds are enduring their worst year, falling by an average of 19.9 per cent since June. According to TrimTabs Investment Research, $43 billion (€32 billion) was withdrawn from US funds in September. October outflows are likely to be even larger. Even the biggest and best have been suffering.
Citadel Investment Group, which has averaged returns of 18 to 20 per cent over the last two decades, this week admitted that September was the "single worst month, by far" in its history.
Another big player, the $10 billion Tontine Partners, admitted last week it was down 65 per cent this year. Rumours abound that the firm is on the verge of liquidation. The $33 billion Highland Capital Management said this week it was closing its flagship fund. Gradient Capital Partners, one of London's best-known hedge funds, is also rumoured to be on the verge of closure after suffering losses of 42 per cent in September alone.
A recent report by Credit Suisse analysts estimated that as many as one-third of hedge funds might close in the next two years, a figure repeated this week by Morgan Stanley chief executive John Mack.
The tsunami of redemptions hitting the industry is likely to lead to outflows of $150 billion over the next year, according to JPMorgan. Because hedge funds take leveraged positions, the firm estimates that assets sales of $400 billion are likely.
That has implications for markets. Hedge fund manager Dinakar Singh recently told investors that "selling has begat selling as risk reduction and unwinding create spillover pressure on other funds with overlapping holdings". Investors are worrying about a vicious circle - funds sell equities to meet redemption requests, thereby depressing prices, which leads to further redemption requests.
American equity strategist Ed Yardeni said this week that "funds are raising cash by selling their positions in everything they can in one of the greatest firesales in financial history".
It is a "bonfire of insanity", Yardeni said, the "mirror opposite of irrational exuberance".
The desperation of some hedge funds to sell is revealed by the fact that Highland Capital Management this week settled for 30 cents in the dollar for $20 to $30 million in bank loans that it was looking to sell for 60 cents in the dollar last week.
This week's extraordinary volatility is almost certainly related to hedge fund goings-on.
Just two days after the biggest single-day rise in 15 years (a jump of 11 per cent), Wednesday saw US markets plunge to their worst one-day decline since 1987 (a 9 per cent drop). After heading lower in early trade, Thursday saw an intraday reversal of 9 per cent. Despite the huge bounce, it only brought markets back to where they were trading on Wednesday.
Thursday's action marked the ninth consecutive session where the day's high and low were more than 5 per cent apart.
"You can miss a 500-point move in a walk to the water cooler" said an analyst at Bespoke Investment Group.
Investors with strong stomachs might be tempted to take advantage of weakness induced by hedge fund selling. Warren Buffett yesterday said that "bad news is an investor's best friend" and, while he hadn't the "faintest idea as to whether stocks will be higher or lower a month - or a year - from now", equities would likely rise by a "substantial degree" over the next decade.
Ironically, the current market chaos has been exacerbated by the restrictions placed on short-selling last month, which killed strategies that depend on hedging. Citadel founder Kenneth Griffin said the change was "driven more by populism than policy" and had "disrupted our ability to assume and manage risk".
Might hedge fund difficulties lead to systemic financial collapse, as nearly happened in 1998 with the downfall of the hugely-leveraged Long Term Capital Management?
Nouriel Roubini, who has been warning for weeks of a run on hedge funds, has said no one fund is as leveraged as LTCM. Several are much larger, however, and "one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences".
Roubini said that another bailout was not "politically feasible", which was confirmed by treasury secretary Hank Paulson this week when he said that authorities are focused on helping "regulated financial institutions". However, a large-scale private sector rescue, as happened with LTCM, is possible, Roubini said.
Venture capitalist, writer and blogger Dr Paul Kedrosky writes that forced selling of stocks is not the only consequence of the "great hedge fund unwind".
Kedrosky is worried by funds choosing to add to losing positions in the hope that "a sharp move will cut their losses before clients yank out all the capital anyway".
Such funds, Kedrosky warns, are "ticking time bombs, like a skein of LTCM-lites, all roiling markets in their death throes".
