World Economic News

Euro Central Bank: Hedge Funds Threaten Financial Stability

Hedge Funds are threatening global financial stability, warned the latest semi-annual "Financial Stability Review" by the European Central Bank (ECB) June 2. For the first time, the report includes a special chapter on the hedge-fund sector. The report warns that an "idiosyncratic collapse of a key hedge fund or a cluster of small funds" poses one of the key risks for new shocks that could trigger fresh disruptions in financial markets. In addition to "potentially high leverage," there is another area of grave concern: the fact that hedge funds increasingly tend to use exactly the same kind of strategies.

"In fact, the levels reached in late 2005 exceeded those that had prevailed just before the near-collapse of Long-Term Capital Management (LTCM), a very large hedge fund, in September 1998," the report states. This "raises concerns that a triggering event could lead to highly correlated exits across large parts of the hedge fund industry." Already last year, during April and then again during October, a number of hedge funds suddenly suffered heavy losses, with the April 2005 events triggered by the downgrading of GM and Ford. A particular section of the hedge-fund sector—those specializing on "convertible arbitrage strategy"—thereby on average "lost about 40% of capital under management in 2005." A possible trigger for new turmoil could be an "unexpected end of the recent global search for yield," due to the "tightening of global liquidity conditions." This could "cause investors to withdraw their money abruptly, thereby exerting funding liquidity pressures on individual hedge funds. This could trigger substantial sell-offs and challenge perceptions regarding the degree of liquidity prevailing in affected markets. Moreover, hedge funds could flood their prime brokers with large and simultaneous credit demands at a time when brokers themselves could be suffering from corrections in overextended markets."

While the ECB report refers to an overall emerging market sell-off as a possible scenario for future hedge-fund trouble, this process has of course already been going on since early May. Between May 9 and May 31, the Morgan Stanley index for emerging-market stocks has plunged by 15%, with stocks in Turkey crashing by 30% and those in Brazil, Pakistan, and India by 20% on average.

Mexican Central Banker Denies Parallel to 1994 Blowout

There is no relationship between today and the 1994 blowout of the Mexican debt, Mexican Central Bank chief Guillermo Ortiz defensively insisted on May 8, in an interview with the Financial Times. When a Central Bank insists that "the situation today is very, very different," you know there's trouble!

The "difference" between December 1994, when Mexico required a $50 billion bailout to stave off a default which threatened the global financial system, and today is fast shrinking. "The specter of default" is rising again in Ibero-America, a Bloomberg wire warned on May 30, as "investors" decide debt defaults in Brazil, Mexico and Peru, in particular, are "no longer unthinkable." Credit default swaps on Brazilian bonds have become the third-most active such derivative contracts after GMAC and Ford Motor Credit Co.; the price of insuring $10 million in Brazilian bonds rose by $83,500 in May.

The capital flight by foreign investors out of Brazil's so-called "domestic" debt bonds—specifically, the long-term NTN-Bs, which offered an interest rate of 7.5% plus inflation—became a "panic" at the end of May, and collapsed the market for these bonds, forcing the Brazilian Treasury to step in and buy the bonds back. Brazil announced also that in June, it will once again sell so-called "post-fixed" debt, which carry interest rates which vary; fluctuating with the benchmark SELIC rate. When that benchmark rate—currently a usurious 15.75%—goes up again as the global panic hits, Brazil's debt load goes through the roof, too.