Sunday, July 20, 2008

Hedge Funds role in the Hong Kong crisis in 1998

(from Roubini's "The Role of Larger Players in a Currency Crisis")

"In the view of the Hong Kong authorities, the `double play' proceeded as follows. First, HFs shorted the Hong Kong (spot) stock market as well as the Hang Seng Index futures. HFs allegedly `pre-funded' their Hong Kong dollar needs via swaps with multilateral financial institutions that had heavily borrowed in 1997 and 1998. Next, by using forward purchases of U.S. dollars and spot sales of Hong Kong dollars, they tried to induce a devaluation. Apparently, the size of the short positions of these HFs in the forex and stock markets were very large.

Suppose that, to defend the currency board arrangement, the Hong Kong Monetary Authority (HKMA) had intervened in the foreign exchange market only, drying up market liquidity and causing a correspondingly large increase in interest rates. The monetary tightening would have caused a sharp drop in equity prices, to the benefit of the HFs and other investors who had taken short positions in the stock market.

Suppose instead that, to avoid this stock market collapse, the HKMA had kept interest rates low, while allowing the exchange rate to devalue. Again, the HFs would have reaped large gains, this time through their positions in the currency markets. In either scenario, speculators would have gained from their positions in the stock market or in the forex market, or both.

The HKMA, however, chose a different and unconventional option, consisting of monetary tightening to prevent devaluation, and, in August 1998, sizeable interventions in the stock markets to support stock prices. In the view of the Hong Kong authorities, this radical action was necessary to inflict losses on speculators and give them sufficient cause to be wary of future attempts to corner the market. In the words of Financial Secretary Donald Tsang the speculative attack was a contrived game with clearly destructive goals in mind [to] drive up interest rates, drive down share prices, make the local population panic and exert enough pressure on the linked exchange rate until it breaks"

According to the local authorities (HKMA (1999) and Tsang (1998)),unsubstantiated rumors and false information about the health of the financial sector and the possibility of a devaluation were being spread in the local press and in financial market apparently to push down the stock market, spike interest rates and put pressure on the currency.

Among those taking short positions in the equity market were four large HFs, whose futures and options positions were equivalent to around 40 percent of all outstanding equity futures contracts as of early august prior to the HKMA intervention.

In the two weeks between August 14 and 28, 1998, the HKMA purchased approximately US$15 billion of stocks and futures. This represented about 7% of the Hong Kong market capitalization and about 30% of the free ­oat in the market.

Two HFs substantially increased their positions during the period of the HKMA intervention. At end August, four hedge funds accounted for 50,500 contracts or 49% of the total open interest/net delta position; one fund accounted for one third."

Even when the government intervened, the hedge funds thought they could break the HKMA, increasing their positions from 40 to 49%! So we have leveraged short term funds with 49%, and the patient long term holder, the government, with 30%.

The government wins. How big is the short base in US equities? We know it is tremendous.

So we have leveraged funds on one end, betting against long term investors. If home prices get a bid, and oil continues down, the short hedge funds are going to have to reconsider their positions.

But if hedge funds tried to bring down Hong Kong, by shorting 49% of the market, what do you think their positions were in the financials here in our market? That's why the rally in the financial stocks was so vicious.

How much naked shorting was done, and how much money was made on Bear Stearn's demise? That was the hedge funds blueprint to print money. In their greed, they lost their perspective.

And they forgot the lesson they should of learned in Hong Kong.

But our Fed didn't.