Dead Hedge Funds Don't Take Care of Themselves

How do you tell a naked hedge fund on a swim? When the tide rushes out. Or when the money dries up. While most of the press internationally is in full cover-up mode, the near collapse of the German "industrial credit bank" IKB has shocked some in Germany into recognizing the situation (see accompanying article). Jochen Sanio, head of the German banking regulatory agency Bafin, admitted, minutes before the IKB crisis was declared to be out of control, that this amounted to the "worst banking crisis in Germany since 1931." According to the Sueddeutsche Zeitung, the "whole German banking system" was in danger, which was obviously the reason for a temporary rescue action for the IKB by the German government and the State Credit Bank for Reconstruction, at the tune of 8.1 billion euro (over $11 billion).

But this is only the tip of the iceberg; more U.S. mortgage bankers, such as American Home Mortgage, are in serious distress. One reason for that lies in the practice of so-called "adjustable mortgages," a procedure whereby the buyers can acquire real estate, which is more expensive than their ability to pay, and in which, for a certain period of time rather low interest rates on the mortgages fall due, but then, after a prescribed period, at most two years, are automatically raised. If the higher rate goes into effect, the payments rise in the range of hundred of dollars (per month). This subprime mortgage market went into full swing in the spring of 2005, therefore an avalanche of increases in the rates has been unleashed precisely at the present time.

All in all, increases in the interest rates on adjustable rate mortgages affect 12 percent of all mortgages in the United States, raising mortgage payments by a trillion dollars, on at least 12 percent of all mortgages in the United States. In October alone mortgages will be jacked up by over 50 billion, at which point the bloodbath, which has already occurred in the subprime mortgage market, will be a proverbial picnic, and eventually all categories of mortgages will be threatened to be affected. According to Moody’s Economy.com, between 1995 and 2005 about 3.2 million householders bought houses on the basis of the secondary mortgages or similar credit-terms, and thus it is expected that about two million of these houses will be lost in the next months--as long as you consider only the situation in the housing market itself. The flood of housing sales has led to a dramatic collapse in real estate prices; because of the exposed position of the financial institutions, it will become considerably harder to get new mortgages, and the effect on the real economy, including jobs in the construction sector, will be catastrophic.

Much more dramatic than this situation itself is the fact that this collapse has been accelerated by another process with very much more far-reaching consequences, namely the drying-up of the paradise of cheap credit as a result of the end of the Japanese yen-carry-trade. With it dried up the wonderful source of liquidity, which permitted investors for years to borrow advantageously in yen at a zero interest rate, in order to invest in higher interest rate sectors around the world. The flood of liquidity from this source amounted to 500 trillion dollar, which has been as good as cut off. In the face of rising interest rates, now speculators who have contracted cheap yen-credit and were met with losses in the American mortgage market and in the hedge funds, have sought desperately to turn their investments into cash in order to pay back their yen-loans, which has led to an up-valuation of the yen. Again this raises the losses of the speculators. The reverse leverage leading to the collapse of the speculative pyramid is in full swing.