Monday, September 24, 2007

Haircut Contagion

As Dave Barry would say, it sounds like a great name for a band. But really it's the name for what the International Monetary Fund says is going to kill this stock market. It ain't earnings, it ain't P/E ratios, it ain't declining margins -- it's haircut contagion. To wit:

"The IMF is particularly concerned about a phenomenon it dubs "haircut contagion".

A fall in value in assets in a hedge fund provokes a margin call, forcing the fund to sell assets to bring leverage back to its initial level. However, the lender now imposes a higher margin, or "haircut", as the assets are now riskier. This in turn forces further borrowing and further sales." (The Australian, 9/25/08)

Can you believe the IMF thinks hedge-fund managers will ratchet their leverage back up to previous levels? If the managers would just listen to the market and accept lower returns, we'd be OK. But the IMF rightly recognizes that hedge funds aren't structured to adapt to lower returns. They've promised big returns so they can get paid big. Lots of hedge funds will lose money if they have to accept lower returns. Then they're gone.

So the IMF apparently believes that hedge funds are inextricably linked to leverage. They have to have leverage, no matter what it costs. They can't trade lower leverage for lower costs. One more comment from the same article, then we'll tell you how we found it:

"The IMF believes there were $US300 billion in leverage loans planned in the second half of this year, although the market for them has now collapsed. "In the near term, financial institutions are exposed to potential syndication risks, with unsold bridge commitments contributing to an overhang in the market."

We found this article on http:/ It's the best financial-news aggregator we've come across. It's the first website we check every day once we decide to get down to serious business. Highly, highly recommended.