Drama unfolds in Europe

We now face a deleveraging spiral of massive proportions. After watching market-based positions on borrowed money unravel, investment houses are cutting their losses.

The early fall last night in Europe was a sign that a new drama is unfolding on global markets – deleveraging by investment houses and brokerage firms. Later the selling stopped after some good news in the US and Wall Street moved into positive territory, but then lunged deeply into the red. This deleveraging process is destined to produce more wild swings in coming days and is the latest twist in the year long downward spiral in global stock markets. Much of the initial deleveraging came from the hedge fund selling of equities and commodities to meet redemptions.

We are now looking at the massive deleveraging of the investment banks and brokerage houses. Large amounts of money were borrowed and invested in the stock market by the major houses. Those same houses also backed former employees into hedge funds. If you look at the CV’s of most of the hedge fund operators you will find that they cut their teeth trading for the big investment houses.

Many of the hedge fund newcomers – but certainly not all – lost their shirts. Now the investment houses that for decades have been taking positions in the market based on borrowed money can see that their losses are just too great and so they are selling. They are being joined by private investors who invested in global and Australian markets using borrowed funds – the so-called margin loans.

These investors are totally sick of being 'SMSed' or called on their mobile phone asking for money to top up their security. They're tired of the never ending losses. Many now have to sell their investment properties and holiday houses.

So what we are now seeing is deleveraging of share markets around the world. And the same applies to commodity markets like oil and copper. Important reading on this topic is Stephen Bartholomeusz’s explanation of why the Australian dollar is falling (Dollar support dwindles October 27). Obviously the fall in commodities plays a part in the Australian dollar's fall but much of the rise was caused by an Australia-Japan leverage game which is being unwound.

When markets are deleveraging value goes out the door but when it finishes there will be a huge bounce.

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