Paul Le Page, portfolio manager at FRM, Guernsey’s largest hedge fund manager, shares his perspective on the markets THIS month marks the anniversary of a chain of events which ultimately led to the liquidation of one of the world’s largest hedge funds, Long Term Capital Management.

It is therefore somewhat ironic that nine years later we have seen a chain of events that have once again stress-tested global financial markets.

On Wednesday 25 July Cerberus Partners, a highly regarded, blue chip hedge fund and private equity firm, failed to secure financing for its $12bn acquisition of the Chrysler division of Daimler Chrysler.

This left the underwriting banks with a large amount of debt to absorb on their balance sheets.

While $12bn is not a large sum in relation to the banks’ collective balance sheets, investment banks have an underwritten pipeline of in excess of $300bn of debt and leveraged loans to fund a number of high-profile acquisitions this year.

This sum is a multiple of the market capitalisation of a number of leading banks.

Capital markets suddenly woke up to the possibility that investment banks might end up with rather more debt on their books than they would like.

In parallel with developments in the US, European financial institutions stopped buying highly leveraged collateralised debt obligations.

These CDOs had effectively been the largest marginal buyers of leveraged loans and investment grade debt.

A number of CDOs had also invested in sub prime mortgages to enhance the yield that they could pay to investors and this led to concerns over the structuring and rating process applied to these products.

The new issuance market for debt effectively closed in Europe and the US. In addition, investment banks have a large inventory of debt that they have warehoused prior to issuing CDOs and this further exacerbated the supply and demand imbalance for debt.

To meet their financing commitments, investment banks began to de-leverage their proprietary trading books, which are typically run at levels of leverage substantially in excess of hedge funds.

This resulted in a sharp sell off in equity markets.

In a somewhat ironic twist, the most liquid and highest quality equities tend to be sold first in any de-leveraging cycle.

As a result of this selling activity, fundamental statistical arbitrage hedge funds began to experience substantial losses in their long books.

This caused them to sell high quality names from their long books and buy in lower quality names to close out short positions.

Trading activity by fundamental managers was in turn picked up by technical managers. These managers sought to capitalise on the pricing anomalies created by the unusual market activity.

Unfortunately the de-leveraging flows overwhelmed a number of managers who were stopped out.

These managers in turn added to the selling pressure in high quality names and the buying pressure in lower quality ones.

Equity long-short managers have also been impacted by the de-leveraging cycle as deep value fundamental managers have similar exposures to statistical arbitrage funds.

Growth/momentum managers with a shorter term trading orientation should, however, ultimately benefit from the trading flows caused by de-leveraging and ultimately re-leveraging, too.

De-leveraging is ultimately an indiscriminate process that causes many unrelated markets, financial instruments and strategies to move in lock step.

It remains unclear what will bring about the end of this current cycle.

The US and European central banks have injected liquidity into the banking system as a short-term solution and have clearly learnt valuable lessons from the 1998 de-leveraging cycle.

In the meantime, the technical market dislocations in equity and debt markets that have occurred as a result of de-leveraging, while painful in the short term, should ultimately set hedge fund managers up for a strong run of performance.