Credit Bubble: More Hedge Funds Hit, Don’t Own Financial Assets

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The credit bubble appears to be well and truly collapsing. Not a day goes by without news that some new hedge fund or asset management unit of a major bank finds itself in distress, facing margin calls, denying investors access to capital, and confronted with outright liquidation. So this is what the term liquidity crisis means, then?

It’s really more of a slow-motion crisis, without the effects of the subprime implosion moving up the credit-quality ladder to other housing-backed bonds and even the corporate bond market. Once you get a bondfire going, it’s hard to put out. The world’s largest insurer, AIG, says it may lose as much as US$2.3 billion on bad subprime bets.

And then there are the hedge funds, all 9,000-plus of them. 717 hedge funds closed their doors last year. U.S. investor Jeremy Grantham reckons more will follow, and soon. Grantham says, “Probably the most stretched silly credit that ever walked the face of the earth was subprime, and that was the start of it…And then you started to see more of the fixed-income market getting contagion.” They were “piling on risk of different kinds and presenting it as outperformance…In a weak world, they pay the price of all the risk they’ve taken. And that is, they melt down…These guys are in a big hole…Most of the money going into private equity today will be a total loss.”

What about that third Bear Stearns fund which finds itself infected with this plague of bad debt? “There are no plans to shut down the fund,” says Bear spokesman Russell Sherman. “We believe the fund portfolio is well positioned to wait out the market uncertainty. And we believe by suspending redemptions, we can ensure the best long-term results for our investors. We don’t believe it’s prudent or in the interest of our investors to sell assets in this current market environment.”

When a bank tells you the best thing for your money is for them to keep it—after you’ve asked for it back—be very afraid. The bank is hoping to obscure from the public an emerging dynamic described yesterday in the Wall Street Journal.

“It’s a crisis of confidence among backers,” says Mr. Murdoch’s new asset. “The process can feed on itself. The funds being hit by redemptions from investors or so-called margin calls from bankers — requests for additional cash or collateral — can be forced to sell their holdings at reduced prices, further lowering the market value of these assets. That in turn hurts other investors who hold similar assets.”

What’s the solution? Don’t own similar assets, e.g. financials and brokerage stocks. Despite closing in the red yesterday (like everything else), Rio Tinto still trades at just over AU$91.00. The company’s earnings and cash flow are correlated to the growth of China, not the collapse of America. The same could be said for most of Australia’s resource sector.

In a world of integrated financial markets and a synchronised bull market in all asset classes (fed by the credit bubble), you can expect all assets (even iron ore) to correct as the bubble collapses. But the good thing about metal is that it’s hard. It goes clunk when it hits the ground. Tangible assets will find a floor sooner than financial assets because resource companies are backed by demand in the real economy. The real economy will chug along in fits and starts, even while the financial economy goes up in flames.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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