CNNMoney featured an excellent article called “Why the private equity bubble is bursting.”
It recaps the insane leveraged buyout fever of the past couple of years which caused some unintended consequences while fueling the stock market rise into record territory. It’s well written and gives you a better understanding of why the bubble is bursting.
There is some focus on the effects of the subprime debacle and why hedge funds will be hit in a big way as the final paragraph explains:
“The biggest losers, though, are likely to be the swashbuckling hedge funds that gorged on high-yield debt and did it in the most reckless way possible. To amp up their returns, they borrowed heavily to buy the bonds of already highly leveraged companies. That’s piling risk on top of risk in a rickety structure that a slight bump can topple. Wall Street firms promoted the practice. Not only did they sell high-yield bonds to the hedge funds, they also lent them money through their prime brokerage arms to buy the bonds on margin. It wasn’t uncommon for the funds to borrow 80% of the price of the loans. With that kind of leverage, for example, they could earn 18% or more owning bonds with a nominal interest rate of 10% or so.
The same leverage that magnified their returns will multiply their losses, with potentially dire effects. Here’s what the worst-case scenario might look like: As the hedge funds get margin calls from Wall Street, they’re forced to dump their holdings of loans and bonds to raise cash. The glut of distressed debt for sale crashes prices and pushes yields to towering levels. Then everyone holding high-yield debt, from Asian banks to small investors with money in junk-bond mutual funds, will take a horrendous pounding.
What we’re seeing here is simply sanity returning to the market. And as always in the aftermath of a bubble, sanity returns the hard way.”
The entire article, while lengthy, reads like a science fiction story and will definitely make you realize that, based on the bursting of the private equity bubble, the stock market may very well be the next victim. It’s hard to see at this time where the fuel for another rally will be coming from.
Recent violent market activity could possibly indicate the end of the uptrend, but we will wait to be sure, via the guidance that our Trend Tracking Indexes provide, before taking final measures to protect our portfolios.