A salutary tale of leverage and central banks…

One of the biggest leveraged hedge funds in the world got hit with a 2×4 during the 4^th Qtr. This fund has a mixed bag of assets, but was heavily exposed to big FX positions. 

The fund made a big “bet” recently when they went short EURYEN. This turned sour in a very big way; the EURYEN moved an incredible 14 big figures against them in just 60 trading days.

Street players, who know of this currency spec, refer to it as a “Size” position. At the end of Q3, it came to a lumpy short $40B. There were rumors that the fund added to the short during the Q (not confirmed yet). But even if the book was kept static, the mark-to-market loss comes to $5+B. That’s serious money to anyone. 

Note: The short EURYEN book is looking terrible for this fund. The new Japanese Prime Minister is forcing a devaluation of the currency. The Japanese Central Bank is doing its best to achieve that devaluation. It’s possible that the fund will have to cover the short. If so, it could turn that “paper” loss into a cash loss.

I think the well-paid managers of the fund are kicking themselves in the ass over this speculation. They got creamed on this stinker, and this could be just the beginning of the losses.  

Adding to the carnage was a monster sized bet short EURUSD. Last reported, this mega-position was $220B short! It’s possible that this number is now close to one-quarter trillion. It was a good Q for the EURUSD, and that means a bad Q for the fund. The 6+ big figure move up in the Euro versus the dollar translates into a paper loss of a staggering $11b! 

All in, the losses from FX come to $16.5B. The fund has reserves of about $50b, so the quarterly swing is not a crisis, but it’s an eye-opener. 30+% of those reserves went out the window in one Q.  

The fund in question has a strong capital base and loyal investors. But the management will have to explain to those investors how it managed to lose such a large percentage of its “cushion” in such a short period of time. Those investors will, no doubt, ask the very pertinent question: “Why is the fund making such big FX bets?” 

Management is also going to have to address the issue of leverage – this fund is now running at 10 to 1. The high level of leverage, and the mega billions involved (much of which is tied up in derivatives), makes this fund a high risk/return player. Investors will have to ask themselves, “Do we still want to be on this roller coaster?” 

So who is it that is running such a big FX book? And who are the investors that are on such a wild ride? 

That would be the Swiss National Bank. The “investors” are the Swiss people. 

I know, I know. Central Banks aren’t hedge funds, and they can’t take losses because they can always print more money. I respond to this by saying that the SNB is acting very much like a leveraged hedge fund. It’s making currency “bets” with the people’s money. It’s taking some very big risks. In an attempt to diversify one risk, they are just adding different risks, and that effort is backfiring. 

Like the US Fed, the SNB sends its annual profits back to the people (Treasury in USA, Cantons in Switzerland). The book losses at the SNB will reduce the amount of the payouts to the Cantons, so the losses will be felt. 

Switzerland is a small country with a GDP of about $600B. If the FX losses at the SNB were applied to the US economy, it would translate into a half-trillion dollar loss. That would be a very big deal indeed. The FX losses since September come to $2,000 for each and every Swiss citizen. The word “Shellacking” comes to mind. 

I bring up this story to make a point. (Don’t worry about the SNB) What happened at the SNB is because the SNB absorbed risk from the Swiss economy (the currency peg). As the SNB absorbs risk, it will, by definition, have to take losses from time to time.

The SNB has absorbed currency risk; other central banks have taken credit, liquidity and duration risk out of their respective markets. In the aggregate, the risk transfers have been massive. That’s why the global capital markets are so “calm”.