Telegraph: Hedge funds' panic was behind worldwide market collapse

By Helen Power and Dan Roberts
Sunday Telegraph, London
Sunday, August 12, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/08/12/cnmark...

Panic selling by hedge funds has emerged as the hidden cause of the contagion spreading through the global financial system.

Billions were wiped from the value of listed companies around the world on Friday, with Britain's FTSE100 index experiencing its worst day in more than four years.

Initially, turmoil was limited to credit markets, but it quickly spread to global stock markets after central banks were forced to intervene to keep markets from collapsing completely.

As the world's stock markets pause for breath this weekend, it is becoming clear that hedge funds, which are supposed to help stabilise the financial system by diversifying risk and providing liquidity, were instead at the epicentre.

City sources said problems spiralled when top investment banks including Goldman Sachs, Lehman Brothers, and Merrill Lynch -- whose prime brokerage arms act as lending banks to the hedge funds -- insisted that the funds settle a greater proportion of their debts at the end of the day than they had done previously.

Other banks are said to have followed suit. "Everyone has hiked margin calls and anyone who says they haven't is lying," said one banker.

The increased payments forced hedge funds to sell assets to cover their losses. One London banker said both Thursday and Friday were characterised by remarkably light but very volatile trading in London with those who didn't have to sell staying at home while those who were forced to sell were badly punished.

"This is a one-in-a-100-year event in which there are extremely unusual correlations that no one prepared for," one banker warned. "We are in a situation where everyone is very scared."

Financial stability was further shaken as hedge funds' losses mounted, compounding fears that some funds could collapse. Goldman Sachs's Global Alpha fund, the US fund AQR, and New York-based Tykhe Capital were rumoured to be in particular trouble, although this could not be confirmed.

Many so-called quantitative funds with supposedly low-risk strategies involving investment in both debt and equities were particularly hard hit because weeks of turmoil in the credit markets made it impossible for them to sell debt, forcing them to sell more stable equity assets at a loss.

"In the last week people have had to meet margin calls by selling equity positions. The quant strats [quantitative funds] have been hit hardest and it's become a bit of a perfect storm. Prime brokerages are increasing margin requirements so you have a self-fulfilling prophecy and spiral down," said one senior banker.

"The black boxes [funds' computerised investment strategies] are all similar. They are getting completely crushed," added another.

It has also emerged that many funds had invested in the same companies, causing prices in otherwise unconnected companies to fall dramatically.

Because hedge funds borrow much of the money they invest from banks, the concern is that contagion could spiral again when the markets reopen.

Gavyn Davies, Prime Minister Gordon Brown's former economic adviser, warned yesterday that central bankers around the world would need to address serious deficiencies in the regulatory system once the crisis had blown over. Meanwhile the Financial Services Authority began to audit London banks to assess their exposure to the US sub-prime mortgage crisis and to highly leveraged corporate loans following a similar move by the US Securities and Exchange Commission.

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