Global bond, equity and currency markets have all reacted wildly in recent weeks to an event that initially might have been expected to affect only a small number of funds directly exposed to sub-prime mortgages. The relevant sub-prime mortgages were those in the United States home loan market. As defaults occurred and the probability of future defaults rose, strategies exposed to sub-prime asset-backed securities saw their net asset value (NAV) fall. In itself, this type of investment loss is not unusual. To understand why the impact affected global markets it is important to understand long-short funds and leveraged strategies.
Long-short funds have both long (positive) exposure and short (negative) exposure to underlying assets. The short exposure can be obtained through selling securities borrowed from a prime broker or alternatively using derivatives such as forward contracts and swaps. In the former case, the prime broker will demand collateral of more than 100 per cent, generally in the form of the fund's long holdings plus cash. In the latter case, the counterparty will demand an initial cash margin to protect against default and will request further margin calls if the value of the exposure deteriorates.
Leverage can be defined in a number of ways. One definition is when the sum of the long exposures exceeds the NAV of the fund. Using this definition, all long-short strategies could be viewed as levered to some extent, with leverage increasing as the magnitude of the off-setting long and short exposures increases.
While the causes were no doubt a complex combination of forces, some possible reasons for the global impact from sub-prime mortgages include:
. When sub-prime mortgages fell in value, the NAV of levered strategies that invested in sub-prime mortgage securities fell. The more levered the fund, the greater the fall in NAV. This caused prime brokers to demand extra collateral against the short positions and make margin calls. Funds with little surplus cash for such events faced the following choices:
- Raise cash from the bond market. Funds purely invested in bonds must sell some of their long exposures (that is, sub-prime mortgages) and buy back (cancel) some of the short exposures (typically high-quality bonds). Selling sub-prime would realise cash and also reduce the risk of future exposure to these securities. Buying back short positions was necessary to re-balance the risk of the strategy. Additional selling of sub-prime and unwinding of long positions were undertaken as funds began to de-lever to reduce their risk. Selling sub-prime mortgages caused the sub-prime prices to fall further, triggering further margin calls and more selling.
- Raise cash from other markets. Multi-strategy and global funds that were invested in a wide range of assets could sell any of their long exposures and buy back (cancel) related short exposures. To avoid selling sub-prime mortgages at distressed prices, some funds looked to other liquid securities, initially US equities and then European, Japanese and also Australian equities. Selling equities they held long (those viewed as underpriced) and buying back those that they viewed as overpriced (short-positions), caused large cross-sectional volatility within equity markets.
Cross-sectional volatility (the variability in price changes across different stocks within a single market on any day) rose dramatically. Again, de-leveraging to reduce risk by these multi-strategy funds added to the trading volumes.
. Possible flow-on effects:
- The unwinding of positions and resulting cross-sectional volatility in equity markets mentioned above caused the NAV to fall in long-short equity funds that held similar equity positions to the multi-strategy funds. This resulted in fresh demands for cash and de-leveraging in some of these funds, particularly the more levered equity funds, triggering further trading in equity markets.
- This pattern had flow-on effects to all asset classes including currency markets. Macro strategies that had long-short exposures to currencies (such as a short position to the yen and long positions to currencies with higher interest rates, such as Australia) started to unwind some of these exposures to reduce their risk. Unwinding these exposures required buying yen and selling the other currencies. This is one reason for the dramatic fall in the Australian dollar in recent weeks.
The increase in credit spreads appears unlikely to reverse in the short-term. Whether these events will cause long-term repricing of risk in equity and currency markets is less certain. Repricing of equity risk would see equity prices generally fall, something that we have seen signs of in recent weeks. Much of the initial selling appears to be driven by an urgent need for cash by some funds and other funds choosing to reduce their risk (de-leveraging). If some investors start redeeming their holdings, those funds affected will have to raise cash, which could have a fresh impact on the markets. Against these trends, there is some trading by investors in the opposite direction, taking advantage of what they perceive is temporary mis-pricing in the markets.
It is difficult to predict whether or when the price changes will reverse, whether the changes will be fully or partially reversed and what fresh changes will occur. It depends on investors' perception on the future price of risk, market liquidity and numerous other factors. It will be worth revisiting this topic in three to four months when the longer-term effects are clearer.
