How the Sub-Prime Meltdown Spread To Equities

 |  Includes: DIA, IVV, SPY
by: Caleb Sevian

I hate to sound repetitive, but I am going to repeat something I said last week because it was an issue a week ago and a bigger issue today. Primebrokers, the custodians of the goliath hedge fund industry’s capital, have to value portfolios to determine risk every night. The problem they have been running into the past few weeks is, there are no bids to value CDO’s, and a host of exotic synthetic debt instruments. Best estimates are that some of these instruments are worth less than 30 cents on the dollar. This is forcing the hand of the primebrokers, they are tightening margin requirements and making margin calls where necessary.

Until last week many people had thought the carnage was contained to the debt markets, but as the week unfolded rumors the sub-prime markets claimed another victim had been confirmed. The latest casualties, market neutral quant funds using statistical arbitrage to determine correlations between equities and debt. Traditionally this has been a relatively safe bet because correlations had been relatively constant, but over the last six weeks correlations have become paired. If something about this sounds familiar it’s because analogous comments were made about correlations in spreads in 1998 when Long Term Capital Management’s stat arb models went haywire and almost took down the whole financial system.

The latest theory dubbed “Sub-prime StatArb Contagion Theory” is built on the premise that long short hedge funds are liquidating equity positions to reduce overall portfolio risk and mark downs on paired positions in debt. Because many Stat Arb funds tend to own similar positions the effect has been amplified by the crowds all trying to rush through the door at the same time. The list of casualties grows every day and is spreading from lesser known market neutral names like Black Mesa Capital and Highbridge Statistical Market Neutral to the most high profile long short players on The Street such as Renaissance Institutional Equities Fund, Goldman Sachs Global Alpha, AQR Capital Management, D.E. Shaw, and Tykhe Capital. The Renaissance Technologies fund, the biggest fund of these, managing over 26 billion is now reported to be down over 7% for the year, and the Goldman Sachs Global Alpha fund, which runs over 8 billion, is now rumored to be down over 26% for the year.

How bad is it? Jim Cramer already famous for the passion he approaches his work with took things up a notch last week when he completely lost it on the air when trying to express his frustration. Whether you like Jim Cramer or not his rant is worth watching, it’s sobering and likely only too true.

On Friday monetary banks from around the world including our own injected liquidity to the system the likes of which has not been seen since September of 2001. The US Federal Reserve dumped 38 billion dollars into the system trying to create bids for many of the debt instruments forsaken in the market. It was an impressive showing, but in my opinion it is a little like trying to use a pack of band aids to try and take care of an amputation.

True the Fed can fix this, one slash of the pen and interest rates could drop enough to make a great deal of the pain go away. All the stars seem to be aligning for this, the economy appears to be cooling, inflations seems to be stabilizing, oil prices, although still up 17% for the year, are showing year over year reductions as they trickle down to the pump, volatility seems to be peaking, but there are looming issues the make cutting rates extremely risking, chiefly the strength of the US dollar. A unilateral rate cut could cause a collapse in the US Dollar reeking further havoc on the debt markets. It should be an interesting week with CPI (est. 0.2%), PPI (est. 0.2%), and Housing Starts (est. 1.405 mill) all due out mid week.

If these number come in low enough the Fed may have room to move, but if they come in high the Fed may be forced to continue to be hawkish on inflation, making these perhaps the most important economic numbers of the year. This week is likely to be packed full of volatility, each day should be a two pack of Rolaids day.