What now? Ignore big investors

Doubling down, dimly

So what did the big boys do next? They decided to try to make up their losses by hoping to fill that inside straight. Now that they've started to unwind these even riskier bets, we can start to see what cards they bet on:

Currencies. Two big Chinese companies, China Railway Group (CRWOF, news, msgs) and China Railway Construction Group (CWYCF, news, msgs), have announced that they lost $350 million in the currency markets when a bet that the Australian dollar would climb went south. This follows a huge loss on a similar currency trade at Citic Pacific (CTPCY, news, msgs), which has lost $2 billion on leveraged positions in the Australian currency.

Controladora Comercial Mexicana (CRXBF, news, msgs), Mexico's third-largest retailer, declared bankruptcy Oct. 9 after failing to raise cash to meet margin calls on $1.1 billion in peso derivatives. Brazilian pulp maker Aracruz Celulose (ARA, news, msgs) took a $1 billion loss for the third quarter as a result of a bad bet on currency futures. These losses, caused when the dollar unexpectedly strengthened against Mexico's peso and Brazil's real, are much bigger than what you'd expect if a company had been simply hedging its exposure to global currencies. For example, Gruma (GMK, news, msgs), the largest producer of corn flour in Mexico and the biggest tortilla maker in the United States, showed currency derivative losses of $684 million as of Oct. 8. The company's quarterly revenue ran at just a little more than $1 billion in the second quarter of 2008.

Distressed buyout loans. In recent months, money managers such as Bain Capital, Blackstone Group (BX, news, msgs) and Carlyle Group bought into these loans, issued by banks to fund buyout deals. That's been just in time to see the loans move down from trading at 88 cents on the dollar to 70 cents on the dollar, according to the Standard & Poor's index of leveraged loans. As usual, the big boys used leverage (borrowing the capital to buy these loans) on these bets in the hope of increasing their returns. Some of that money was raised through something called a total-return swap. The crucial thing to know about these is that they are set up by lenders to require more collateral from borrowers if the value of the loans purchased with the borrowed capital falls.

Commodities. The big boys are still busy liquidating long positions in commodities. As the price of everything from oil to tin has tumbled, hedge funds and other investors, such as pension funds, have found themselves with big losses and have been liquidating positions in the commodities themselves and in commodity stocks. Some of these positions aren't very old. CalPERS, a huge California public-employees pension fund, announced in February that it was going to increase its exposure to commodities over the next two years. The fund lost just 5.1% in the fiscal year that ended in June 2008 and then reported losing $48 billion more, about 20% of assets, from the end of June through Oct. 10.

That big loss corresponds pretty well to the period when commodity prices went through the floor. About 450 commodity hedge funds held $80 billion in assets as of Sept. 23, up 14% from the end of March, according to Barclays Capital. Investments in commodity indexes reached a record $175 billion at the end of June. Long positions have been unwinding lately even faster than they were built up, however. Net long positions on the commodity futures markets in New York and Chicago fell to just 7% of total open futures contracts Sept. 23, from 14% on March 25, Barclays Capital reported. Outstanding contracts for the 17 commodity futures traded in New York and Chicago were down 26% from a peak Feb. 29, according to Bloomberg.

Proprietary trading. Some banks, even some banks that are seeking to burnish their conservative financial reputations, have pushed even deeper into trading in an attempt to fill that inside straight. Credit Suisse Group (CS, news, msgs), for example, announced a third-quarter loss of $1.5 billion from its trading desk. The biggest loss, about $600 million, came as the "conservative" investment bank wasn't able to lay off the risk of its positions in convertible bonds because major global markets have temporarily banned short-selling. Many of the trades that have gone bad were bets that market volatility would fall after hitting recent highs. Instead, this measure of the size and speed of market moves has gone on to set new highs. One measure of volatility, the CBOE Volatility Index ($VIX.X), hit an all-time high Oct. 24.

Derivatives. Yes, let's not forget derivatives, the source of so many of the losses that drove the first round of panic selling by the big guys. Some big guys have returned to the market for swaps designed to lock in interest rates or lay off risk because the prices for this kind of insurance seemed so low. In fact, swaps were priced so cheaply that the mathematical models on Wall Street said they couldn't get any cheaper. Hah! If there's one thing the meltdown in financial markets should have demonstrated beyond doubt, it's that a fool (one who believes a mathematical model) and his money are soon parted.

On Oct. 23, the spread on the 30-year swap on U.S. government debt turned negative. At that price, the market was saying it's more likely that the U.S. government will default than a private counterparty such as JPMorgan Chase (JPM, news, msgs) will. Spreads in Europe and in the United Kingdom had turned negative earlier this month.

If this market is this panicked over debt from the U.S., the United Kingdom and Europe, imagine what's going on in the markets for debt from Hungary or Pakistan. That level of fear has led to the wholesale liquidation of anything not denominated in dollars. That has produced a huge dollar rally, killing investors in other currencies and depressing the prices of commodities that include but don't stop at gold, oil and copper.

Bottom wishing

So when does the selling stop? I think we're nearing an end to the second round of panic selling by the big boys. The smartest of the smart money, a very temporary title that this year goes to the three hedge funds managed by John Paulson -- up 15% to 25% in 2008 through mid-October -- is now 50% in cash. (Paulson, based in New York, had $28 billion under management at the beginning of 2008.)

I'd guess the rest of the big boys have made significant moves in this direction, although they're not nearly as far along. And the dumbest of the "smart" money is becoming less important day by day as the values of portfolios drop and these managers have less ability to move the market with their selling.

This week will bring important clues. Watch to see how the financial markets react to what the Federal Reserve says Wednesday at the regular meeting of its Open Market Committee. Right now, Wall Street expects an interest-rate cut of half of a percentage point. If the market gets what it expects, will it tank because the cut confirms that recession is on the way? Or will volatility start to come down because the Fed's action has added some badly needed confidence to the market?

On Thursday, the government will release the first numbers on gross-domestic-product growth for the third quarter. Right now, the Wall Street consensus expects the economy to show a 0.5% drop in growth. Anything much larger than that will start tongues wagging again about the end of the world. Anything less than that, even if it's negative, will be reassuring. In fact, the level of uncertainty is so high right now that any number will be reassuring to the most spooked of investors. The end of the week will bring the end of uncertainty about investor withdrawals from hedge funds. The funds have varying rules, but most require investors to notify them by Sept. 30, Oct. 15 or Oct. 31 whether they intend to withdraw funds on Jan. 1. The end of this period will give the hedge funds a little time to catch their breaths before the next round of redemption notices begins in mid-January.

What I'd like to see this week is a drop in volatility. That's more important right now for setting a temporary bottom under the market than even a few days of rallies. A decline in volatility would both reduce panic among the big boys and reduce the chance that they'll put on new, even riskier bets that will produce another round of losses over the next few weeks.

Continued: Updates to Jubak's Picks

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