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Rehabilitating CDS (Credit Default Swaps)

http://www.economist.com/opinion/displaystory.cfm?story_id=12562363

Derivatives

Giving credit where it is due

Nov 6th 2008
From The Economist print edition

The credit-default swap needs reform, not abolition

FINANCIAL innovations tend to go through four phases. At first, they are hailed as proof of the brilliance of the bankers who devised them. Then they succumb to rampant speculation, as investors try to exploit them. And that leads to revulsion, as a crisis causes widespread losses. The question is: should the fourth phase be rejection or rehabilitation?

The latest innovation to pass through the cycle is the credit-default swap or CDS. Despite its forbidding name, the CDS is a simple idea: it allows an investor to buy insurance against a company defaulting on its debt payments. When it was invented, the CDS was a useful concept because more people felt comfortable owning corporate debt if they could eliminate the risk of the issuer failing. The extra appetite for debt helped lower the cost of capital.

But now investors are showing a greater disdain for risky debt - and fears about a looming credit crunch have shaken investor confidence worldwide. The Dow Jones industrial average plunged 311 points Thursday - its second-worst day of the year - and sent global stock markets reeling. The Dow opened lower Friday as well but later stabilized and was little changed in mid-morning.

Besides triggering a global stock selloff, the jitters are casting a shadow on the buyout boom and could slow down everything from private equity buyouts to corporate restructuring plans.

Housing slump gets longer, and longer …

The housing market, meanwhile, is still struggling to find a bottom. The subprime meltdown started the worries in credit markets - and the extent of the problems in the subprime mortgage market remains uncertain.

“The ultimate outcome of the decline in mortgage credit quality is not wholly predictable,” Moody’s Economy.com said in a July 26 report. While there are efforts being made to forestall the surge in foreclosures, “the downside risks outweigh the positives,” the report said.

Credit markets have been roiled as investors have begun shying away from risk, demanding better terms on corporate bonds and loans, meaning the old days of cheap, easy money for corporations may be past.

“This is part of a process of removing liquidity and increasing the expected returns required of people to tolerate risk,” Charles Diebel, an analyst at Nomura International, said about the turbulence in the market.

Tighter credit is troubling to investors for two reasons. It’s likely to slow the buyout boom that’s helped prop up stock prices. And it could raise the cost of borrowing for companies, hurting corporate earnings. To date, there have been roughly 20 buyout-related debt deals that have been postponed as credit markets have tightened.

The battle to be ‘King of the Street’

Earlier this week, Chrysler delayed a debt sale related to its takeover by Cerberus Capital Management. The sale of $12 billion in loans underwritten by JP Morgan (Charts, Fortune 500), Bear Stearns (Charts, Fortune 500), Goldman Sachs (Charts, Fortune 500), Citigroup (Charts, Fortune 500) and Morgan Stanley (Charts, Fortune 500) was put on hold, according to Reuters Loan Pricing Corp. - although Cerberus said its purchase of Chrysler would still be completed in August.

The wave of credit worries is also upsetting corporate plans in
Europe. British pharmacy giant Alliance Boots, which is being taken over by Kohlberg Kravis Roberts and an Alliance executive, ran into trouble financing its buyout earlier this week.

Britain’s Cadbury Schweppes said Friday it’s delaying the sale of its beverage unit because of troubles in the debt markets. The company said it pushed back the timetable of the sale “to allow bidders to complete their proposals against a more stable debt financing market.”

Now there are concerns the darkening mood in the debt market could hit other big deals in the pipeline. A number of high-profile buyouts still need to be financed, including the $28 purchase of wireless phone company Alltel (Charts, Fortune 500) and the $44 billion takeover of Texas utility TXU Corp (Charts, Fortune 500).

“Clearly, deals will get done. But capacity again has become an issue. Syndicating a $5 billion loan once again seems daunting, arrangers say, to speak nothing of a $10-15 billion credit,” Standard & Poor’s Leveraged Commentary & Data said in a note Thursday.

If financing for buyout firms dries up, overall deal activity would be hit hard. Private equity firms have announced about $782 billion in deals this year, or about a quarter of worldwide deal activity, according to Thomson Financial.

The weak conditions also come when buyout firms may start crowding the exit doors, which would make it more difficult for other deals coming along.

Given the length of the current merger wave, which started in 2003, the M&A market is already ripe for a drop off, according to Scott Moeller, a visiting professor of finance at Cass Business School.

“At some point, this market will go down, and because of the way liquidity has driven this merger wave, when we have the fall - it’s going to be steeper, and the drop is likely going to be faster than in the past,” he said.

Private equity firms typically hold their investments for three to five years. The question now is will they be forced to start unloading the firms scooped up in the recent buying spree sooner than they had wanted.

It remains to be seen what will trigger the selling wave among private equity firms, but when liquidity starts to dry up, “everyone is going to rush to the exits,” Moeller said.

So what’s the spread on the impending CDO disaster?

Jun 29 10:37
by Paul Murphy
Comment

A cool $125bn to $250bn, according to Bloomberg, which stated rather boldly on Friday that a failure on the part of rating agencies S&P, Moody’s and Fitch to downgrade securities backed by suspect home loans was masking burgeoning losses. More…

A cool $125bn to $250bn, according to Bloomberg, which stated rather boldly on Friday that a failure on the part of rating agencies S&P, Moody’s and Fitch to downgrade securities backed by suspect home loans was masking burgeoning losses.

Almost 65 per cent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to Bloomberg’s data.

“You’ll see massive losses from banks, insurance companies and pension managers,’’ Joshua Rosner, a managing director at New York investment research firm Graham Fisher, told the news service. “The longer they wait, the worse it’s going to be.”

Mr Rosner co-authored a study last month that said the main credit rating agencies understate the risks of subprime mortgage bonds. He estimates that losses related to collateralised debt obligations will hit $125bn. Meanwhile, Institutional Risk Analytics, a California-based company that writes computer programs for the four biggest accounting firms, says 25 per cent of the face value of CDOs is in jeopardy, or $250 billion.

Speaking up for the rating agencies, Brian Clarkson, Moody’s global head of the structured products in New York, told Bloomberg: “We’re taking action as we see it …We’re not doing knee-jerk responses.”

In: Capital markets

http://ftalphaville.ft.com/

S&P, Moody’s Hide Rising Risk on $200 Billion of Mortgage Bonds
By Mark Pittman

 

“For Sale” and “Open House” signs

June 29 (Bloomberg) — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody’s and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

“You’ll see massive losses from banks, insurance companies and pension managers,” said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody’s and Fitch understate the risks of subprime mortgage bonds. “The longer they wait, the worse it’s going to be.”

Loss Estimates

Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for the four biggest accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.

Executives at New York-based S&P, Moody’s and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.

`Knee-Jerk Responses’

Homeowners may be delinquent on mortgage payments for at least three months before foreclosure proceedings begin, and the process can be delayed if a borrower files for bankruptcy or fights eviction. Even when lenders repossess a home, the value of the mortgage isn’t written down until the house is sold. Bondholders only see a loss if the price of a house is lower than the loan used as collateral for debt securities.

“We’re taking action as we see it,” said Brian Clarkson, Moody’s global head of the structured products in New York. “We’re not doing knee-jerk responses.”

Ratings companies are postponing the inevitable and are dumping securities as defaults by subprime borrowers increase, investors say.

Lehman Brothers Holdings Inc., the biggest underwriter of mortgage bonds, sold $2.43 billion of Structured Asset Investment Loan Trust bonds a year ago. An $18 million portion of the bonds rated BBB- fell to 43 cents on the dollar from 98 cents in January, according to prices compiled by New York-based Merrill Lynch & Co.

Increased Delinquencies

More than 15 percent of the mortgages in the securities are at least 60 days delinquent and another 8 percent are in foreclosure, according to the bond trustee. Moody’s and S&P say they are considering downgrading the debt.

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

The increase in delinquencies means CDO investors, who sometimes use borrowed money to magnify their bets, may be holding securities that are riskier than their ratings indicate, said Bill Gross, chief investment officer at Pacific Investment Management Co., based in Newport Beach, California.

“The Petri dish turns from a benign experiment in financial engineering to a destructive virus,” Gross, who oversees the world’s biggest bond fund, said this week in a commentary on the firm’s Web site. The companies gave the mortgage bonds investment-grade ratings, duped by the “six-inch hooker heels” of collateral that can’t be trusted, he said.

No Disclosure

CDOs aren’t required to disclose the contents of their holdings to the U.S. Securities and Exchange Commission and most can change them after the bonds are sold.

Losses reflect the decline of the U.S. housing market, where the national median home sale price is poised for its first annual drop since the Great Depression, according to the National Association of Realtors.

Investors are responding by retreating from all sorts of riskier assets, threatening to reduce credit. Companies canceled at least $3 billion of bond sales worldwide in the past two weeks. U.S. Treasury notes snapped a six-week losing streak last week, pushing yields down from the highest in five years, as investors sought the haven of government bonds.

The subprime meltdown is sending shock waves through the capital markets in part because mortgage bonds are the world’s biggest debt market, according to the Securities Industry Financial Markets Association.

Thousands of Investors

Thousands of investors own mortgage bonds, ranging from fund managers such as Pimco, a unit of Munich-based Allianz SE, to the California Public Employees’ Retirement System, the biggest U.S. public pension fund, and foreign banks like Fortis SA in Brussels.

CDOs are created by taking bonds, loans and other securities, pooling them together and chopping them into new securities with ratings ranging from the safest AAA to ones so risky they have no rankings. Investors snapped up $500 million of the securities globally last year because they typically yield more than bonds with the same credit ratings. Sales of CDOs have risen five-fold since 2001, according to JPMorgan Chase & Co.

One reason for the higher yields on some CDOs is that subprime-related debt made up about 45 percent of the collateral backing the $375 billion of CDOs sold in the U.S. in 2006, data compiled by Moody’s and New York-based Morgan Stanley show.

Drexel Creation

Credit Suisse Group, based in Zurich, created a $1 billion CDO called Class V Funding III Ltd. in February by combining the A rated portions of 91 other CDOs that invest in debt backed by consumer obligations.

The biggest portion, or $859.2 million of bonds, is rated AAA and pays interest as low as 5.70 percent. The smallest piece, or $2.5 million, is ranked BBB and has a coupon of 10.61 percent, according to a May 22 report produced by the trustee for the CDO.

At the time of the report, AAA rated corporate bonds had an average yield of 5.45 percent, while BBB debt yielded 6.03 percent, according to Merrill Lynch index data.

Demand for CDOs, first used in 1987 by bankers at now- defunct Drexel Burnham Lambert Inc., is drying up as mortgage bond losses spread. Planned sales of CDOs that rely on high- rated asset-backed debt dropped to $3 billion this month from $20 billion in May, according to analysts at JPMorgan, the third-largest U.S. bank.

First Year Rankings

“A lot of these should be downgraded sooner rather than later,” said Jeff Given at John Hancock Advisors LLC in Boston, who oversees $3.5 billion of mortgage bonds. The ratings companies may be embarrassed to downgrade the bonds, he said. “It’s easier to say two years from now that you were wrong on a rating than it is to say you were wrong five months after you rated it.”

Fitch is “deliberate” in its actions, John Bonfiglio, the firm’s head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. “I would not say we were slow.”

The ratings companies point out they have downgraded bonds less than a year after they were sold, the first time that has ever happened. S&P has lowered a total of 15 subprime bonds sold in 2005, or 0.31 percent of the total, and 32 sold in 2006, or 0.68 percent.

“People are surprised there haven’t been more downgrades,” Claire Robinson, a managing director at Moody’s, said during an investor conference sponsored by the firm in New York on June 5. “What they don’t understand about the rating process is that we don’t change our ratings on speculation about what’s going to happen.”

Bear Stearns Jolt

Accurate rankings for mortgage bonds and CDOs become even more important because the securities rarely trade, so investors can’t immediately value their holdings when market conditions change. Instead, they often rely on sales of similar securities or computer models that use ratings and past performance of the underlying collateral to come up with a value.

CDO investors were jolted this month by the losses in the Bear Stearns hedge funds.

The funds, called High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, had borrowed $10 billion from securities firms and banks to make bets on CDOs, mortgage bonds and other securities. As the values of the holdings declined, creditors seized some of the collateral pledged for the loans and sold them through auctions.

Fire Sale

A concern was that a forced sale would slash prices on CDOs, providing new, lower benchmarks that investors would have to use to value their holdings, resulting in billions of dollars of losses.

“We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions,” debt strategists at Barclays Capital in New York said in a June 28 report. “The worry is that this will be large enough to trigger margin calls which, in turn, will cause other liquidations and so on.”

Merrill Lynch threatened to take and sell $850 million of bonds held as collateral for loans it had made to the funds. Lehman, JPMorgan and Cantor Fitzgerald LP, all based in New York, also pulled out.

Bear Stearns avoided an even worse fallout by offering to provide one of the funds with loans. The original $3.2 billion provision was reduced to $1.6 billion after the firm sold securities and lenders took some of the collateral.

UBS, Queen’s Walk

Other hedge funds are closing down or reporting losses because of subprime losses. Zurich-based UBS AG shuttered a hedge fund unit that saddled the biggest money manager for wealthy investors with 150 million Swiss francs ($122 million) of first-quarter losses.

Queen’s Walk Investment Ltd., a London-based fund, reported a loss of 67.7 million euros ($91.2 million) last week for the year ended March 31. Cambridge Place Investment Management LLP, another London money manager, said yesterday that it will close Caliber Global Investment Ltd., a fund that had $908 million of assets in March.

A sweeping downgrade of bonds would lead to sales of assets by investors, banks and pension funds who operate under rules that would cause them to adjust their portfolios to reflect the new ratings. S&P, Moody’s and Fitch have restricted their ratings changes on BBB- rated mortgage bonds to 1.3 percent of those outstanding, according to Credit Suisse analyst Rod Dubitsky in New York. About 80 percent of the remainder will eventually have their ratings reduced, he said.

Abandoned Criteria

“We’re talking about massive, massive downgrades here,” Dubitsky, the No. 2 asset-backed real estate debt analyst in last year’s Institutional Investor magazine poll of researchers, said in a telephone interview.

S&P abandoned seven-year-old criteria for determining a bond’s protection against default in February.

Under the old guidelines, S&P said a bond’s “credit support” must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.

The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn’t have automatically resulted in a downgrade, he said.

$200 Billion

Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.

Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.

All but five of 120 securities in BBB or BBB- rated portions of the mortgage-backed securities would have failed S&P’s criteria, according to data compiled by Bloomberg.

None have been downgraded, though S&P and Moody’s have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.

`Warrant Our Attention’

“Don’t misunderstand me: I’m not saying these others are performing great,” Robert Pollsen, a director in S&P’s residential mortgage surveillance in New York, said in an interview last month. “And they certainly might warrant our attention several months from now, which obviously we’re going to do.”

Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody’s maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.

“That’s like saying these trees are just fine as there’s a forest fire on the other side of the hill,” said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net .

Last Updated: June 29, 2007 00:00 EDT

http://www.bloomberg.com/apps/news?

pid=20601087&sid=aN4sulHN19xc&refer=home

 

The quest for alpha

Chris Skinner on developments in cross asset trading and the search for liquidity.At a recent conference, one of the speakers started by saying: “Alpha is what it is all about.” He got this look of interest from half the audience and confusion from the other half. After all, much of what goes on in the investment markets is about as understandable as Greek, excluding those of you living in Greece of course. Alpha is all about finding liquid markets to gain higher margins and increased returns. Liquid markets are becoming harder to find as technology opens access for all, and the search for alpha is all about the search for liquidity. What are the major trends in this area?

It is probably worth saying that the chap at the conference who was discussing alpha was me. I had been tasked with presenting the logic for multi-asset class trading, or cross-asset class trading as some refer to it.

I define cross-asset class trading as the ability to trade in equities, fixed income, futures, options and foreign exchange in a single transaction.

Not everyone agrees with that definition as we are currently a long way away from the ability to deal in all markets globally across all instruments today, but this is surely where we are striving to get to.

How this is delivered is also open to question. For example, some people talk about multi-asset trading as being in a single transaction on a single screen using a single platform. Again, that is taking things further than I would push them, as some people do not want a single screen and others think, in today’s world of service oriented architectures, a single platform is not required either. Therefore, I will stick to my definition of trading in as many instruments as I want globally in a single click. That is what cross-asset class trading means to me.

The reason people want this from their technologies is due to the search for alpha - the search for the most liquid markets and the highest returns. In particular, hedge funds have driven this trend.

Hedge funds are becoming the leaders of the pack in terms of setting the buy-side trends. As one asset manager said to me recently, “I used to compete with tracker funds and indices, then with Merrill Lynch Investment Management and now with the merged BlackRock” who, as it happens, recently merged with Merrill Lynch Investment Management.

BlackRock is a mixture of fund management, hedge fund and fund of fund, and is one of the largest asset managers. “As of June 30, 2006, BlackRock’s pro forma assets under management totalled $1.045 trillion across fixed income, liquidity, equity, alternative investment and real estate strategies.” In other words, BlackRock is providing cross-asset class fund management.

BlackRock is not alone. For example, one of the largest hedge funds is Citadel whose home page says: “Our team of professionals allocates investment capital across a highly diversified set of proprietary investment strategies in nearly every major asset class.”

Question: Why are the hedge funds so focused upon multiple asset classes?

Answer: The search for liquidity.

What is actually happening is that the markets worldwide are automating the easy using cross networking index-tracking technologies. In other words, the traditional fund manager now has the low-cost technology infrastructure in place to provide passive fund management that purely keeps track of the FTSE’s and S&P’s of this world. What the institutional investor wants is therefore humans traders involved in designing asset allocation strategies and portfolio analytics that are far out-stripping the general stock indices. They are challenging traders to really deliver value-add; and the value-add is higher returns with lower risk. That is what they expect, and are getting, from the hedge fund and other alternative investment market players and that is why more and more investment is being pooled through the hedge fund markets.

You only need to look at these two statistics to see what is happening:

• Assets under management of the hedge fund industry totalled $1.225 trillion (Q2, 2006) up 19% on 2005 and twice the total of 2003;
• Hedge funds account for 32% of credit-default swap sellers and 28% of buyers, up from 15% and 16% in 2004.

Hedge funds are driving the markets, the investment pools, the liquidity, because hedge funds are delivering higher returns with lower risk to the institutional investor.

Just look at the volatility of active fund managers dealing primarily in equities versus hedge fund managers dealing in all asset classes. The active equity manager delivers higher returns on some occasions, but lower returns at others. There is also little predictability. Meanwhile, the hedge fund manager buys equity and hedges it with a buy-write, an option that offsets the risk. As they do this, they are delivering higher returns more consistently, more predictability, more reliably.

To illustrate the point, TowerGroup analysed the market movements between 1998 and 2005 in the USA. Equities delivered an average performance of 3.78% with volatility of 18.26%, whilst hedge funds delivered 12.23% performance returns with only 12.06% volatility. Which would you prefer?

That is why the hedge fund markets are soaking up institutional investors’ assets, as the buy-side moves from active equity fund management towards alternative investment strategies using hedge funds to manage the portfolio.

How do the hedge funds deliver such returns with low comparative volatility?

Arbitrage.

What the hedge fund manager does is finds arbitrage opportunities. For those unfamiliar with the area, arbitrage is a fundamental of derivatives, hedge funds and the capital markets, and is basically finding price differentials between assets so that you can make a quick buck.

Rather than making up my own example of how it works, here’s one from Wikipedia:

“Suppose that the exchange rates in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $12. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage.”

That is a very basic version of arbitrage. In fact it is so basic, it hardly ever happens as hedge fund managers push these strategies further and further. The first push was through black box algorithmic and program trading strategies where the hedge funds put all of these complex rules into trading engines that look for real-time arbitrage. An example would be:

(i) if Microsoft’s price drifts 2% outside the Volume Weighted Average Price (VWAP) during any fifteen minute period; followed by
(ii) the S&P500 moving by 0.5%; whilst
(iii) dollar:yen spread pricing moves up or down by 0.05%
(iv) all within a two-minute period; then
(v) buy Microsoft with a Dollar spot-forward option

Even that’s nowhere near as complicated as some of the hedge fund multi-asset trading strategies being used today. In fact, the hedge funds are heading towards multi-everything - multi-asset, multi-venue, multi-country, multi-broker … in real-time, 24*7, globally.

This is because hedge funds are increasingly being driven to deliver greater and greater returns to their clients and so it’s all about the search for alpha - the search for liquidity.

The thing is though, that the arbitrage strategies outlined above - where you are trading across multiple assets and markets with multiple data streams involving complex, time-critical event sequences under real-time constraints - would have been impossible a few years ago.

What has happened?

Technology.

The technology drive is delivering cheapness of processing, networking and connectivity, combined with increasingly powerful application solutions and services. And many of these solutions can be dropped in anywhere through SOA.

This means that the hedge funds are pushing the boundaries of what technology can do more and more each day. They have to, in order to find liquidity. That is why it is no longer good enough just to have a black box algorithmic trading strategy. Hedge fund managers want rocket science, not black boxes (for more on this see Tools of the trade).

That is also why the markets are moving towards multi-asset dealing … because they can. The fact is that the markets are no longer bounded by execution venue, exchanges, geographies, brokers and dealers. There are no boundaries in today’s markets. The markets are liquid and trading moves to where liquidity is highest.

That is why the sell-side is responding by extending their services to cover all the bases required for liquidity. That is why many of them have acquired Execution Management Systems (EMS) in the last year or so, such as Goldman Sachs’ purchase of RediPlus, Citigroup’s buyout of Lava Trading, Lehman Brothers’ absorbing RealTick and Nomura’s recent swallowing of Instinet and Chi-x.

In fact, Order Management Systems (OMS) and EMS is all becoming blurred as we move into Advanced Execution Systems (AES). AES tries to deliver a truly integrated buy and sell side through technology. That is why trading, dealing and execution are all becoming seamless, as brokers place execution engines into exchanges through co-location services across integrated OMS and EMS. The result is that the dealers who can provide liquidity by placing business the fastest in real-time will be the winners.

The thing is though, that the sell-side may be placing a nice veneer over their systems by acquiring, combining and front-ending but, behind the scenes, many are desperately trying to keep up with the demands of today’s markets.

As hedge fund managers demand high-speed, low latency connections across all execution venues of choice, sell-side players are struggling.

The trouble is that a lot of these broker-dealers are sitting with old structures and processes still in place. So, we talk about multi-asset trading and you look under the roof of most brokerage houses and find they have an integrated multi-asset dealing desk … but underneath the desk are all the old cables, pipes, silo’s and functions. In other words, an integrated dealing desk backed up by a multi-platform, multi-function middle and back office.

This will not deliver on the promise that the hedge fund folks are after. They want truly integrated globalised markets, not some fudged together sticking plaster with a patchwork quilt of technology behind it. Added to which, the more that systems are front-ended and non-integrated, the more latency in the systems. And latency is what it’s all about. Those who shave off the nanoseconds are winners.

That is why the winners will be the Tier 1 broker-dealers, who are now leveraging their technology budget to build truly integrated capabilities across all execution venues, including their internal ‘dark pools’. Dark pools are financial markets not available or visible to the general public, such as orders on a broker’s internalisation engine made available through an electronic cross network (ECN), with a great example being the recent dark pool launched by Instinet and Credit Suisse.

This means that the heavyweight players - UBS, Citigroup, JPMC, Goldman Sachs, HSBC, Merrill Lynch and so on - will all be able to leverage their multibillion dollar technology budgets whilst the rest will be struggling. After all, if you cannot provide liquidity with low latency across global markets and instruments, what can you provide? That is the question being asked of the exchanges.

The stock exchanges were fine as liquidity pools for trading in the equities of their national markets a decade ago, but today - in this globalised cross-networking cross-asset class, multi-everything world - what is the role of an exchange?

That is the question and challenge being raised from all angles. By regulators through MiFID and RegNMS. By markets, through multi-everything hedge strategies and sell-side pressures to deliver anytime, anywhere execution. And by technology providers as they develop new algorithmic, all-singing all-dancing order management and execution management systems. No wonder we are seeing the bloody battles amongst exchanges to increase their critical mass for liquidity.

The most aggressive player appears to be the NYSE who not only has expanded their geographic footprint through the purchase of Euronext, alongside investments in the India’s National Stock Exchange (NSE) and possible deals with Japan, but has also expanded its offer from pure equities trading through to multiple products and trading platforms covering cash equities, exchange traded funds (ETFs), options, bonds and other new businesses.

This is the nature of the new world of multi-everything.

Exchanges are competing with sell-side for liquidity and execution, whilst the buy-side are being led by complex globalised hedge fund strategies as investors seek the funds that deliver the highest returns with the least volatility. All of this being driven and supported by low latency, low cost, highly networked and globalised technologies, applications and systems which interconnect and deal continuously in real-time,

In some ways, I cannot believe that I wrote that last paragraph because, ten years ago, the fund management world was being rattled by low-cost automated tracker funds that followed the market indices. That was nothing compared to what we see today, with hedge fund globalised arbitrage trading across all asset classes, brokers, markets, venues, exchanges, networks.

The technology deployed ten years ago was the leading-edge at the time, but was nothing compared with the grid, blade, IP networked, real-time world we deal with today. Almost like comparing the first space rockets with the space shuttle, the tracker fund computing of 1997 is antiquated when compared with hedge fund algorithmic computing of 2007.

Ten years from now, will this force for complexity continue?

Probably.

The longer-term will see more specialisation of boutique brokers around technology plays which allow direct connectivity for rocket scientist fund managers to create the most automated, globalised, macro-trading arbitrage strategies around micro-market, micro-volume block executions.

The day of the multi-everything fund is already here. The day of the multi-everything at a micro-level fund is the next game. The game of trading in fractions of markets using pieces of instruments in faster and faster volumes. The game of using nanosecond arbitrage to deliver alpha returns. The game of searching for alpha: the game of searching for liquidity…

…either that or someone will pull the plug on all the systems and we will all return to open outcry.

Chris Skinner is CEO of Balatro, chairman of the Financial Services Club, and a director of TowerGroup.

Web links: www.towergroup.com, www.fsclub.co.uk, and www.balatroltd.com

Author’s email: Chris Skinner

http://www.finextra.com/fullfeature.asp?id=861

http://www.phptr.com/articles/article.asp?p=704314&seqNum=6&rl=1

Hedge Funds Ate My Money: Facts and Fantasies in Alternative Investments

 

• By Satyajit Das.
• Article is provided courtesy of Financial Times Prentice Hall.
• Date: Mar 9, 2007.

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Article Information

 

 

Contents

1. In Fashion?
2. Keeping Up with the Joneses
3. The Rise and Rise of Hedge Funds
4. Style Gurus
5. Fees for All
6. Risk? What Risk?
7. “Embedded”
8. More Money Than You Know What Do With?
9. Woodstock for Hedge Funds
10. The Fall of Hedge Funds?
11. Whos in Charge?
12. Hedge Funds Ate My Lunch?
13. References

 

Article Description

Hedge funds have been around for 50 years, but they’re not well understood. Satyajit Das removes some of the murk from this corner of the financial universe, clarifying what you need to know about the history and the reality of hedge funds (and hedge fund managers).

 

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Risk? What Risk?

Hedge fund returns are hot. Based on the fee structure, you paid for a Ferrari—not some anemic, environmentally correct hybrid!

Some hedge funds have shown high returns. There are wide divergences between the best- and worst-performing funds. Long-run returns are clouded by the “survivorship bias”—that is, many hedge funds have perished along the way. High returns require that you select the better-performing funds.

You need to consider the sustainability of returns. Macro funds were beneficiaries of the confluence of specific factors: the integration of emerging economies into global markets, the end of communism in Eastern Europe, the growth of world trade, and deregulation of financial markets such as currencies and interest rates. These epochal events were once-in-a-lifetime occurrences that created trading opportunities. For example, Soros’ triumph in breaking the pound was predicated on the collapse of a highly flawed system of currencies. In 1997-98, hedge funds made substantial returns when similarly pegged currencies fell apart. This can be seen in the varied fortunes of macro funds in recent years. Some have prospered, but many funds, included the fabled Quantum and Tiger Funds, have restructured or disappeared.

Relative-value hedge funds were beneficiaries of similar events. LTCM’s early success was linked to opportunities related to the creation of a single European currency and tax arbitrage opportunities. Relative-value funds benefited in the 1990s from the introduction of new and innovative products that few understood and fewer had the skills and systems to value. The shrinkage of opportunities has forced relative-value funds to migrate into new areas—credit being the major one.

Hedge funds may offer investors 15–20% p.a. returns with minimal risk—but such funds are far riskier than the risk statistics reveal. The systems used don’t actually capture the real risks. Investors use Sharpe or information ratios to measure performance. Assume that Treasury bills yield 5% p.a. Further assume that hedge fund A has an annualized return of 20% with a volatility of 10%, and hedge fund B has a return of 15% with a volatility of 5%. The Sharpe ratios, are, respectively:

• Hedge fund A = [20% – 5%] / 10% = 1.5
• Hedge fund B = [15% – 5%] / 5% = 2.0

Hedge fund B, despite its lower absolute performance, provides the investor with greater returns relative to risk than hedge fund A.

Sharpe ratios are flawed. They are ex post (based on actual risk) rather than ex ante (expected risk). Actual risk return achieved should be compared to the risk that was known to be taken at the time the position was taken. This generally shows higher risk and lower risk-adjusted returns.

There are alternative risk models. The Sortino ratio, a variation of the Sharpe ratio, focuses only on adverse price changes, using deviation below a specified level. A personal favorite is “drawdowns”—a euphemism for actual losses incurred and the cash that must be found to cover a peak-to-trough change in the fund’s position.

The real risks of hedge funds are correlation risk, liquidity risk, and complexity or model risk. Unsurprisingly, traditional systems are poor at capturing these risks. Traders, whether in hedge funds or otherwise, are extremely skilled in arbitrage—internal arbitrage. Traders arb the internal risk metrics to inflate risk-adjusted returns on which their bonuses are based. Nature abhors a vacuum.

• Correlation risk. Hedge funds should show low risk—remember, they’re simultaneously long and short securities. If the prices move identically, then the gains and losses will cancel out, leaving zero return where the portfolio of long and short positions are perfectly balanced. For the fund to make money, the price relationship between the long and short securities must change—correlation has to shift. Correlation may move unfavorably—the asset where you’re long falls in value and the asset where you’re short rises in value, triggering losses. Many hedge fund strategies are effectively correlation positions, where the risks are not properly captured.
• Liquidity risk. Liquidity risk is the inability to sell out of or continue to finance positions. Hedge fund trading assumes liquidity risk. The position may be large. The assets held are illiquid. The liquidity risk is compounded by leverage. Hedge funds generally trade on margin—putting up a small fraction of the value of the asset as collateral. If prices fall, the hedge fund is required to post more collateral. If losses on the leveraged position exceed the hedge fund’s ability to meet margin calls, the position is liquidated, realizing losses. This severely limits the holding power of hedge funds. Risk models assume “perfect” liquidity.
• Complexity or model risk. Hedge funds now use complex securities and derivatives in their trading. They use computers and sophisticated quantitative models to value and hedge positions. The models are highly subjective. They’re sensitive to minor changes in parameters and inputs. There may be no transparent market in inputs, making them difficult to value. Mark Twain provides the definitive view on “model risk”: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”A number of hedge funds have suffered terminal losses in mortgage-backed securities. Model failure was a factor in many of these losses. Currently, some funds trade CDO²—that is, a CDO of a CDO, a complex instrument. Different funds use different models. Recently, I had to get market prices for some CDO² securities. There was no market to speak of, and wide variation in prices. Masters of the Universe don’t measure model risk when quantifying risk.

Many hedge fund trades seek to buy or sell “mispriced” securities. The position is hedged by an offsetting trade using similar securities. The idea is that the values will converge. The market prices may correct, allowing the trader to unwind his trades at a profit. If the market prices don’t correct, the trader must hold the position through to maturity to realize the profit. The holding period can be long, very long—on the order of 30 years. Hedge funds have short risk horizons—no longer than 6–12 months. Changes in mark-to-market values, the resulting margin calls, and the investor’s right to redeem capital periodically make it difficult to manage this risk. Leverage, liquidity risk, and complexity are lethal companions.

LTCM liked to arbitrage small value differences between similar securities. The returns were small, so LTCM typically leveraged the trades to increase returns. After the Asian crisis, credit spreads (the margin above government bonds for additional risk) blew out well above what was needed to cover the actual risk of people not paying up. LTCM wanted to lock this in and leverage the position.

LTCM entered into interest-rate swaps where they received fixed rates, getting government bond rates plus a margin (credit spread). Then they went short government bonds on the other side, paying the government rate. LTCM effectively locked in the credit spread. They leveraged the position massively. The game depended on the spread getting smaller (convergence) or holding the position to maturity (10 years). Unfortunately, the spread kept getting wider. Interest rate swaps rose, and government rates fell. LTCM now had losses on both legs of the trade. They had to find cash to cover their losses, and they ran out of money. The LTCM principals witnessed firsthand the truth of John Maynard Keynes’ observation: “There is nothing so disastrous as a rational investment policy in an irrational world.”

In 2006, emerging markets took a hit. Market-neutral hedge funds losses mirrored the fall in the market. A short memory and a rising market generally passes for investment genius. One hedge fund manager explained: “Everything in the market was a compelling buy. We could find nothing to short.”

Over 50% of the hedge funds that fund-of-funds managers invest in have been in existence for less than 2 years. The majority of hedge funds are small—less than 10 staff. The operational risk and key personnel dependency is high.

In 2006, Amaranth, a multi-strategy hedge fund with around $9 billion under management, lost $6 billion in natural gas trading. [4] In 2005, Brian Hunter, a 32-year-old Canadian, made a bet that natural gas futures would rise. Surging gas prices following Hurricane Katrina made large trading gains for the fund, and Hunter was named head of Amaranth’s energy trading operations.

He placed a similar bet in 2006, but natural gas prices fell sharply, triggering losses. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures. Amaranth ultimately discontinued operations. A spokesman for the hedge fund made the following observation regarding the losses: “We did not expect that the market would move so aggressively against our positions!”

“Embedded”

In his book Hedge Funds: The Courtesans of Capitalism, [5] Peter Temple compares hedge funds to courtesans—high-class prostitutes whose clients are drawn from the wealthy or upper classes. If hedge funds are the prostitutes (the girls), then the banks are clearly the pimps and bordello keepers.

Creating hedge funds to house trading activities “off balance sheet” solves many problems for banks. The introduction of capital controls on trading in 1994 made it punishable for banks to hold trading positions on balance sheet. Hedge funds also alleviate the problem of attracting and remunerating “gun” traders. Bank shareholders, regulators, the public at large, and bank CEOs react negatively to large payments to traders, especially when it exceeds their own salaries. The hedge funds are also able to leverage more than the banks themselves.

Banks help set them up hedge funds, invest in them, and trade with them. A whole new service, “prime brokerage,” combines settling and clearing hedge fund trades, execution services, and financing hedge funds. Investment banks have set up “incubators” to help budding traders create hedge funds. The services include training in etiquette and investor relations to communicate properly with investors.

Banks also design products around hedge funds, such as capital-guaranteed hedge fund investments for risk-averse investors—you can’t lose your principal, although you may end up earning nothing on your investment for 10 years. This type of investment helps explain why, in the words of Groucho Marx, many investors in hedge funds “work [themselves] up from nothing to a state of extreme poverty.”

Dealers love hedge funds. Dealers earn from hedge funds at around 30–40% plus of their total earnings. The bulk of earning is from lending money to hedge funds. No bank, at least I think, would lend to hedge funds. Lending is made possible through repurchase agreements (repos) and derivative trades.

In a repo, the bank lends money against the value securities held or sold short by the hedge fund. The value of the security (collateral) secures repayment. Derivatives don’t require initial investment, just a promise to perform in the future. The promise is secured by the hedge fund’s lodging cash or securities. The collateral is increased or reduced as market prices change to ensure adequate coverage. This is no-risk lending—regulators don’t require banks to hold capital against these transactions.

If a position moves adversely, the bank will require the hedge fund to lodge more collateral—a margin call. What happens if they can’t come up with it? In order to reduce risk, banks use a “haircut”—over-collateralization to ensure that it has a buffer if the hedge fund cannot meet a margin call. Banks are under competitive pressure to reduce the haircut. LTCM didn’t require any haircut at all; it was “special.” Writing in the Wall Street Journal, Holman Jenkins observed, “Would hedge funds even exist without a fatty dollop of moral hazard somewhere along the great protein chain of lending?” [6]

The setting of the haircut is flawed. To cover their risk, banks must estimate the worst-case daily change in value of the positions. This is art, not science. Hedge fund strategies have “event” risk when the value of the position could change a lot.

The relationship between dealers and hedge funds is littered with moral hazards. Senior executives at many banks were personal investors in LTCM. Some were involved in negotiating the bailout. It’s all part of the “special” relationship.” [7]

Banks love dealing with successful hedge funds so they can copy from the “best and brightest.” Banks have internal hedge funds that work closely with special sales desks that service hedge funds. Some had been created specifically to serve LTCM. They worked out LTCM’s trading strategies and then did the trades for their own account. When risk limits were full, they marketed the same strategies to other banks and hedge funds.

When the storm hit in mid-1998, all the traders found that they had put on the same trades. LTCM were perhaps the only ones who were not aware of this. Louis Bacon, the principal of Moore Capital, once remarked, “There are those who know that they are in the game; there are those who don’t know they are in the game; and there are those who don’t know they are in the game and have become the game.” [8] In the end, LTCM was the game.

Under stress conditions, prices are affected by illiquidity. Sometimes, prices are unavailable. The valuation of positions are often very conservative, triggering larger mark-to-market losses, necessitating more collateral. Mark Twain observed, “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” To this day, LTCM swears that the banks manipulated the prices to force them out of business.

Even if the hedge fund goes under, banks can make money by buying the positions at an “undisclosed” (read: “distressed”) price. They make money from unwinding the position. Banks provide a true cradle-to-grave service for hedge funds.

8. More Money Than You Know What Do With?

More Money Than You Know What Do With?

Hedge fund managers are the new elite. Brian Hunter, responsible for energy trading at Amaranth before it imploded, earned $75–$100 million in 2005. This, by the by, only ranked him a middling 29th-highest paid in his profession, according to Trader Monthly. [9] One hedge fund manager earned $1 billion in 2005! [10] Apparently money isn’t important; it’s just a scorecard of success.

Having more money than you can possibly spend creates new challenges for the Masters of the Universe. Billionaire hedge fund managers bid up the price of luxury apartments and modern art. Michael Steinhardt owns a large estate containing exotic wildlife. He was seeking to collect every duck and swan variety in the world.

Hedge funds managers are often generous donors to charities—tax deductible, of course. There is the paradox of charity—how enrichment by a variety of means paves the way for conspicuous generosity. George Soros supports free markets and democratic initiatives in Eastern Europe. Detractors question whether it has anything do with the fact that hedge funds are beneficiaries of the opening up of these economies. Some “donations” are also “involuntary,” to settle antitrust and securities charges.

Hedge fund managers are generally secretive. Paradoxically, some hedge fund managers brazenly seek acceptance as “thought leaders.” George Soros has written many books—The Alchemy of Finance: Reading the Mind of the Market, Staying Ahead of the Curve, The Crisis of Global Capitalism: Open Society Endangered. He thinks of himself as a “financial and philosophical speculator,” says Peter Temple. [11]

The centerpiece of Soros’ musings is “reflexivity.” Markets don’t tend toward equilibrium; markets feed on their own misconceptions to produce exaggerated price changes until they reach an “inflexion point” when it changes. Soros suggests following the trend and selling as it reaches the peak. This advice takes about 400 pages. In the December 1998 issue of The Economist, the following review of The Crisis of Global Capitalism appeared. [12]

Because of who he is there will always be buyers for his books, publishers for his books, and cash-strapped academics to say flattering things about his books. None of this alters the fact that his books are no good…. A remarkable thing happens to money when it passes through Mr. Soros; it emerges multiplied, but otherwise unchanged. With other inputs the results are more disappointing—to be blunt, more in line with biology. Mr. Soros gorged on chopped philosophy, mashed economics, and fact and figures swimming in grease. It was too much. Before he knew what was happening out rushed this book.

Woodstock for Hedge Funds

The hedge fund industry’s search for acceptance has reached new realms. In 2006, the industry staged “Hedgestock.” [13] The title paid homage to Woodstock—the historic three days of peace, love, promiscuity, music, drugs, and shockingly bad dancing. Hedgestock was to be two days (nobody could afford three days in this time-challenged age) of networking and finance. Adam Smith understood networking: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in conspiracy against the public, or in some contrivance to raise prices.” [14]

The hippies had celebrated their counterculture movement at Woodstock. Hedge fund managers are keen to advertise that they were the vanguards of the “alternative” movement—”alternative investments,” that is! It was the dawning of the age of hedge funds, not the age of Aquarius.

The Fall of Hedge Funds?

Hedge funds have underperformed more traditional asset classes such as equities in recent years. Investors always chase yesterday’s returns. Adjusted properly for risk and the absence of liquidity, hedge funds return at best no more than—and frequently less than—traditional assets.

A recent study found that hedge fund performance doesn’t appear to deliver alpha consistently. [15] There are exceptions, but they’re few and far between. Many of the really good hedge funds are closed to investors. Even where you can invest, the flow of funds into better-performing funds rapidly erodes returns. Too much money is chasing too few opportunities. Clever people can make money if there are only a few clever people and lots of opportunities. This is scalability—what works on a small scale cannot work on a larger scale. In 2004, Hilary Till argued that the maximum size of the hedge fund industry was 6% of institutional (and high net worth) assets. [16] There are other constraints. Some hedge fund strategies need liquid markets and a complete set of instruments. There are few such markets.

Ultimately, if you make money from inefficiency, someone—other investors—must supply the inefficiency. We cannot all exploit inefficiencies, as nobody would be supplying the market inefficiency in the first place. To be “alternative,” there has to be a majority; the alternative cannot be the majority.

Hedge funds with certain areas of expertise began to trade in other markets as opportunities became limited, creating “style drift.” LTCM had drifted from their métier—relative-value trading in fixed income—into volatility trading, credit-spread trading, and merger arbitrage. Lack of disclosure meant that you didn’t know how far the ship was off course until it was on the rocks. Cases of fraud and other common crimes had also begun to surface.

Smart investors know that there’s no money to be made from investing in hedge funds. In investing, the majority is always wrong. The focus is now “incubators”—venture capital for hedge funds. They identify traders, seed startups, and allow them to establish a track record. Once established, the hedge fund seeks third-party funding, allowing the original investors to exit. They retain the real money—a free carry or shareholding in the general partner or fund manager. Incubators are only open to the really rich and connected.

The hedge fund universe is overheated. At the suggestion of a “bubble,” one hedge manager bristled that hedge funds weren’t an “asset class,” and therefore there was no “bubble” to burst—only asset classes experienced bubbles. Another hedge fund apologist argued that all funds managers in the future would be hedge funds. The semantics aren’t reassuring.

Hedge funds are also under attack from clones. Hedge fund performance doesn’t depend significantly on skill, nor is it as distinctive as the Masters of the Universe claim. In fact, hedge fund returns can be replicated using readily available instruments such as equity index futures and corporate bonds. [17] Banks are starting to clone hedge funds using precisely these instruments. [18] The advantage for investors is lower fees, with the risk of blowups like Amaranth or LTCM. The clones are not the real thing—they’re cheap reproductions. Some analysts argue that the replication models are flawed, though they have their own version that works.

Who’s in Charge?

As John Kenneth Galbraith observed, “In central banking as in diplomacy, style, conservative tailoring, and an easy association with the affluent count greatly and results far much less.” Regulators see hedge funds as providing essential liquidity and distributing risk more efficiently, reducing risks of a major financial shock. There is also a ideological element. In the aftermath of the Asian crisis, economist Robert Wade wrote, “[Greenspan] and other U.S. officials see it as imperative to make sure that the troubles in Asia are blamed on the Asians and that free capital markets are seen as key to world economic recovery and advance; the idea that international capital markets are themselves the source of speculative disequilibria and retrogression must not be allowed to take root.” [20] Bailouts of troubled banks in developed countries are naturally not contrary to free market principles.

In theory, hedge funds remove risk from regulated banks. But banks are deeply embedded in the hedge fund industry. The only significant control is on lending to or entering into derivative trades with hedge funds using collateralization to manage risk. Writing in the Motley Fool Internet Bulletin Board, Lou Corrigan noted, “Alan Greenspan was mistaken in believing that the largely unregulated hedge fund industry can be effectively controlled by regulating creditors. […]Creditors can be just as prone to greed as the latest wizard of Wall Street, but they are often the last to understand the risks that would ordinarily help fear counterbalance greed.” [21]

Benign neglect is giving way to concern. Timothy Geithner, president of the Federal Reserve Bank of New York, has warned that the changes in markets may make financial crises less common but more severe. Australia’s Reserve Bank governor Glenn Stevens has speculated that, in crises, hedge funds are users rather than providers of liquidity. The UK’s Financial Services Authority has identified conflicts of interest as well as operational risks in the relationship between banks and hedge funds.

Hedge Funds Ate My Lunch?

There is a temptation to dismiss the Masters of the Universe, their culture of risk, the hedge funds, and the extreme money games as peripheral to “real life.” After all, fast and foolish money will always find a way to play extreme sports. Isn’t it just a case of a few rich investors playing around with their courtesans and getting more excitement than they bargained for?

Not really. Hedge funds affect all of us—directly and indirectly. Your money—your savings, your retirement funds, the money you invest in banks—increasingly finds it way into the hands of hedge funds. Corporate or government pensions and defined-benefit schemes are a thing of the past. The investment performance of hedge funds—preservation of capital and returns—will shape your senior years and the ability of your company pension funds to meet their liabilities.

Hedge funds also affect us indirectly. In 1997, attacks on the overvalued currencies of Asian countries helped bring about deep recessions, resulting in the collapse of companies, massive unemployment, and social unrest. Malaysia’s prime minister Mahathir blamed hedge funds. “It was greed; a kind of greed that cares nothing for the destruction caused for the collapse of perfectly healthy and prosperous economies, greed that thrives on the misery of others.” [22]

Mahathir did not refer to the poor government, crony capitalism, and corruption that created the conditions for the problems. But the activities of hedge funds undoubtedly exacerbated the severity of these problems. Hedge funds may have colluded in manipulating markets to maximize their returns. In the event of a major shock, hedge funds will sharply increase volatility and the severity of any adjustment.

Any major problems in the hedge fund industry will ultimately affect the stability of the banks and the financial system itself. Hedge funds trade with banks. Banks provide the leverage that hedge funds use. Hedge funds don’t really disperse risks. They increase and concentrate them.

In recent years, there have been warnings: the turmoil in the credit market in 2005 when General Motors and Ford were downgraded; the emerging market correction in mid 2006; the collapse of Amaranth in 2006. Commentators have seized these situations to illustrate the robustness of the system. Banks and financial systems emerged seemingly unaffected.

But banks and hedge funds sustained significant losses in each episode, which were absorbed by profits or gains in other activities. Low cost of money allowed the problems to be handled without a meltdown. The markets also recovered, helped by traders’ increasing positions, assuming the correction was a “buying” opportunity at “better price levels.” Banks sometimes merely bought the portfolio from the distressed hedge fund to avoid potential losses from a forced liquidation of the position. The bank was getting the positions at attractive price levels and hoped they could trade their way out of it.

The greatest concern is concentration of risk. Shortage of trading opportunities means that traders—both in hedge funds and banks—focus on “events”—the emergence of the BRIC economies; commodity prices; corporate actions (mergers, leveraged buyouts, and bankruptcy). There are innovations—volatility swaps (bets on the level of volatility), correlation swaps (bets on correlation), and gamma/dispersion swaps (bets on both volatility and correlation). Hedge funds use them to further leverage up their bets on the “big” stories. The tremendous volatility created by relatively minor events points to the explosive buildup of risk concentration.

Matthew Lynn, writing in UK’s Sunday Business, warned, “[T]he risk to the stability of the world’s financial system posed by the existence of these massive vehicles has not gone away. We have chosen, in the main, not to think about it—in the same way that wives sometimes choose not to think about whether their husbands are really working late at the office. The implications of thinking about it are just too scary.” [23]

Courtesans have played pivotal roles in the rise and fall of empires. Hedge funds may yet play such a role. If a major event occurs, the effect on the Masters of the Universe and the extreme money games may seriously damage financial systems and economies, and taxpayers will bear the losses. Australian economist Ian Macfarlane commented, “Hedge funds have become the privileged children of the international financial scene, being entitled to the benefits of free markets without any of the responsibilities.” [24] Yet the popular investment consensus is that hedge funds, alternative investments, should be a part—indeed, a growing part—of your investment strategy.

Huge structural imbalances in the world, an excess of investment capital chasing returns, and the gradual withdrawal by central banks of the liquidity that has fed recent growth are capable of triggering the problem. How far off is that event? Economists only exist to make climatologists look good. I’ll tell you after the event.

In any major global city today, you can find homeless people sleeping rough. They are the dark underbelly of capitalism. If you look into their eyes, you see resignation, hopelessness, despair, and occasionally defiance. Why are they there? Substance abuse, mental illness, just sheer bad luck. But I fear a future when many us will be on the streets. Etched into the tattered piece of cardboard will be our story: “Please help. Hedge funds ate my money!”

References

[1] Martin Baker, A Fool and His Money: How to Understand the Money Markets and Those Who Work in Them (Orion Publishing, 1995).

[2] Tom Wolfe, The Bonfire of the Vanities (Bantam, 1987).

[3] Alan Kohler, “Hedging Your Bets for a Life Less Ordinary,” Weekend Edition Sydney Morning Herald, 5–6 August 2006.

[4] See “Flare-up,” The Economist, 21 September 2006.

[5] Peter Temple, Hedge Funds: The Courtesans of Capitalism (John Wiley & Sons, 2001).

[6] Holman W. Jenkins, “How a Cat Becomes a Dog,” Wall Street Journal, 5 April 2000.

[7] Merrill Lynch, Bear Stearns, and Paine Webber senior executives are understood to have invested in LTCM. See Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (Random House, 2001).

[8] Quoted in [5].

[9] See [4].

[10] The manager is reputed to be Jim Simons of Renaissance Technologies; see [3].

[11] See [5].

[12] Quoted in [5].

[13] See Stephen Schurr, “Hedge Funds Jump on Hippie Bandwagon,” Financial Times, 3–4 June 2006; Penny Wark, “Selling Themselves Short,” The Times, 9 June 2006; The Economist, “Tune On, Tune In, Meet Clients,” 10 June 2006.

[14] Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations (Methuen and Co., Ltd., 1776).

[15] William Fung, et al., “Hedge Funds: Performance, Risk, and Capital Formation,” 19 July 2006.

[16] Hilary Till, “On the Role of Hedge Funds in Institutional Portfolios,” Journal of Alternative Investments, Spring 2004.

[17] See Jasmina Hasanhodzic and Andrew W. Lo, “Can Hedge-Fund Returns Be Replicated? The Linear Case,” 16 August 2006.

[18] See H. Kat and H. Palaro, “Who Needs Hedge Funds? A Copula-Based Approach to Hedge Fund Return Replication,” “Replication and Evaluation of Fund of Hedge Fund Returns,” “Superstars or Average Joes? A Replication-Based Performance Evaluation of 1917 Individual Hedge Funds,” “Tell Me What You Want, What You Really, Really Want! An Exercise In Tailor-Made Synthetic Fund Creation Alternative,” all working papers of the Investment Research Centre, Cass Business School, City University, London.

[20] Robert Wade, “The Asian Economic Crisis and the Global Economy,” quoted in [5].

[21] Quoted in [5].

[22] Quoted in [5].

[23] Matthew Lynn, “Financiers Play with Fire Again,” Sunday Business, 9 April 2000.

[24] Quoted in [5].

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Commodity Hedge Funds - Dealing with Liquidity, Market, Credit and …

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liquidity, market, credit and operational risks for. hedge funds trading commodities. 1. Controlling liquidity risk. Particularly since the dramatic fall of …

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Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information

WOLFGANG BÜHLER
University of Mannheim - Department of Business Administration and Finance
TIM O.H. THABE
University of Mannheim October 2006EFA 2006 Zurich Meetings Paper
Mannheim Finance Working Paper No. 2006-13

Abstract:
In a structural model for credit risk we endogenize inability to pay as a second independent reason for default besides overindebtedness. Inability to pay is triggered by rational behavior of incompletely informed outsiders. The firm needs to raise additional cash via secondary equity offerings in order to service it’s coupon payments. Underpricing of secondary equity offerings is explained as necessary for these offerings to be successful. In addition to Duffie/Lando (2001) we find that the liquidity risk has a strong impact on the current firm value and the optimal leverage. Credit spreads of debt in the primary market depend on the degree of liquidity risk. They can be lower or higher than in case without liquidity risk.Our results have a number of additional, interesting consequences. Contrary to Duffie/Lando (2001) incomplete information of outside investors has an impact on the default probability of the firm and therefore on the optimal capital structure which is determined in the primary market. The debt-equity ratio is typically lower than in the Duffie/Lando (2001) model that operates under complete information in the primary market and can result in lower credit spreads.
Keywords: Bond Default, Credit Spread Modelling, Incomplete Accounting Information, Optimal Capital Structure, Seasoned Issue Underpricing

JEL Classifications: D82, D92, G12, G13

Working Paper Series

---

Suggested Citation

Bühler, Wolfgang and Thabe, Tim O.H., “Credit Risk, Liquidity Risk, and Optimal Capital Structure under Incomplete Accounting Information” (October 2006). EFA 2006 Zurich Meetings Paper Available at SSRN: http://ssrn.com/abstract=906988

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=906988