One of the major reasons the stock market continues to tank is forced selling by hedge funds. It works like this:
1. Investors give the fund managers $100m to invest;
2. Prime Brokers lend the fund managers an additional $900m "on margin" to invest;
3. In good times, this leverage allows investors to ramp up profits as a $100m investment grows on a $1B base;
4. In good times, all this "buying" power drives up prices.
5. In bad times (that would be now):
- As the fund "loses" money, it's leverage begins to grow, the lenders get nervous and want their money back and/or more collateral from the fund;
- As the fund "loses" money, the investors get nervous and pull their money out;
- The combination of lenders pulling back on loans and the redemptions by investors forces the fund to liquidate its holdings;
This combination forces prices down. As prices fall, they are forced to sell more investments. Essentially, it becomes a giant snowball of selling as all the funds are forced to liquidate.
While I tend to favor free markets, I think hedge funds add little to the greater good and actually harm the markets as they add volatility. For that reason, I am starting to think they should be banned. At the very least, their ability to leverage up their positions should be severely limited.
What do you think?