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5 PATHOLOGY OF
DEBT PART 1: Banks as vulture
investors Henry C K Liu
Vulture restructuring is a purging cure
for a malignant debt cancer. The reckoning of
systemic debt presents regulators with a choice of
facing the cancer frontally and honestly by
excising the invasive malignancy immediately or
let it metastasize through the entire financial
system over the painful course of several quarters
or even years and decades by feeding it with more
dilapidating debt.
But the strategy of
being your own vulture started with Goldman Sachs,
the star Wall Street firm known for its prowess in
alternative asset management,
producing spectacular profits by manipulating debt
coming and going amid unfathomable market
anomalies and contradictions during years of
liquidity boom.
The alternative asset
management industry deals with active, dynamic
investments in derivative asset classes other than
standard equity or fixed income products.
Alternative investments can include hedge funds,
private equity, special purpose vehicles, managed
futures, currency arbitrage and other structured
finance products. Counterbalancing opposite risks
in mutually canceling paired speculative positions
to achieve gains from neutralized risk exposure is
the basic logic for hedged fund investments.
Hedge funds The wide spread in
return on investment between hedge funds and
mutual funds is primarily due to differences in
trading strategies. One fundamental difference is
that hedge funds deploy dynamic trading strategies
to profit from arbitraging price anomalies that
are caused by market inefficiencies independent of
market movements, whereas mutual funds employ a
static buy-and-hold strategy to profit from
economic growth. An important operational
difference is the use of leverage. Hedge funds
typically leverage their informed stakes by
margining their positions and hedging their risk
exposure through the use of short sales, or
counter-positions in convergent or divergent
pairs. In contrast, the use of leverage for mutual
funds is often limited if not entirely restricted.
The classic model of hedge funds developed
by Alfred Winslow Jones (1910-1989) takes long and
short positions in equities simultaneously to
limit exposures to volatility in the stock market.
Jones, Australian-born, Harvard- and
Columbia-educated sociologist turned financial
journalist, came upon a key insight that one could
combine two opposing investment positions: buying
and selling short paired stocks, each position by
itself being risky and speculative but when
properly combined resulting in a conservative
portfolio that could yield market-neutral outsized
gains with leverage. The realization that one
could couple opposing speculative plays to achieve
conservative ends was the most important step in
the development of hedged funds.
The
credit guns of August Yet the credit guns
of August 2007 did not spare Goldman’s high-flying
hedge funds. Goldman, the biggest US investment
bank by market value, saw its Global Equity
Opportunities Fund suffer a 28% decline, with
assets dropping by US$1.4 billion to US$3.6
billion in the first week of August as the fund’s
computerized quantitative investment strategies
fumbled over sudden sharp declines in stock prices
worldwide.
The Standard & Poor’s 500
Index, a measure of large-capitalization stocks,
fell 44.4 points or 2.96% on August 9. On August
14, the S&P 500 fell another 26.38 points or
1.83%, followed by another fall of 19.84 points to
1,370.50 or 1.39% on August 15, totaling 9.4% from
its record high reached on July 19 but still
substantially higher than its low of 801 reached
on March 11, 2003.
Goldman explained the
setback in Global Equity Opportunities in a
statement: ''Across most sectors, there has been
an increase in overlapping trades, a surge in
volatility and an increase in correlations. These
factors have combined to challenge many of the
trading algorithms used in quantitative
strategies. We believe the current values that the
market is assigning to the assets underlying
various funds represent a discount that is not
supported by the fundamentals.'' The statement is
a conceptual stretch of the meaning of
''fundamentals'', which Goldman defines as value
marked to model based on a liquidity boom rather
than marked to market, even as the model has been
rendered dysfunctional by the reality of a
liquidity bust.
The market value in
mid-August of two other Goldman funds: Global
Alpha and North American Equity Opportunities also
suffered big losses. Global Alpha fell 27% in the
year-to-date period, with half of the decline
occurring in the first week of August. North
American Equity Opportunities, which started the
year with about US$767 million in assets, was down
more than 15% through July 27. The losses had been
magnified by high leverage employed by the funds'
trading strategies. Goldman said both risk-taking
and leverage in these two funds had since been
reduced by 75% to cut future losses. Similarly,
leverage employed by Global Equity Opportunities
had been reduced to 3.5 times equity from 6 times.
The three funds together normally managed about
US$10 billion of assets.
Feeding on
one’s own dead flesh Facing pending losses,
Goldman chairman Lloyd Blankfein was reported to
have posed a question to his distraught fund
managers: if a similar distress opportunity such
as Goldman’s own Global Equity Opportunities
presented itself in the open market outside of
Goldman, would Goldman invest in it as a vulture
deal. The answer was a resounding yes. Thus the
strategy of feeding on one’s own dead flesh to
survive, if not to profit, took form.
Goldman would moderate its pending losses
by profiting as vulture investor in its own
distressed funds. The loss from one pocket would
flow into another pocket as gains that, with a bit
of luck, could produce spectacular net profit in
the long run if the abnormally high valuations
could be manipulated to hold, or the staying power
from new capital injection could allow the fund to
ride out the temporary sharp fall in market value.
It was the ultimate hedge: profiting from one’s
own distress. The success of the strategy depends
on whether the losses are in fact caused by
temporary anomalies rather than fundamental
adjustment. Otherwise, it would be throwing good
money after bad.
The Fed held firm on
inflation bias The Fed, in its Tuesday,
August 7 Fed Open Market Committee (FOMC) meeting,
defied market expectation and decided against
lowering interest rates with a bias against growth
and focused instead on inflation threats. In
response, the S&P 500 index, with profit
margin at 9% against a historical average of 6%,
fell 44.4 points or 2.96% to 1,427 on August 9.
The Dow Jones Industrial Average (DJIA) dropped
387 points to 13,504 on the same day, even as the
Federal Reserve pumped US$62 billion of new
liquidity into the banking system to help relieve
seizure in the debt market.
On the
following Monday, August 13, Goldman announced it
would injected US$2 billion of new equity from its
own funds into its floundering Global Equity
Opportunities fund, along with another US$1
billion from big-ticket investors, including CV
Starr & Co., controlled by former American
International Group (AIG) chairman Maurice
''Hank'' Greenberg, California real estate
developer Eli Broad, who helped found SunAmerica
and later sold it to AIG, and hedge fund Perry
Capital LLC, which is run by Richard Perry, a
former Goldman Sachs equity trader.
The
new equity injection was intended to help shore up
the long/short equity fund, which was down almost
30% in the previous week, to keep the fund from
forced sales of assets at drastic discount long
enough for markets to stabilize and for the fund
to get out of the tricky leveraged bets it took
before the credit markets went haywire in
mid-August. Global Equity ''suffered
significantly'' as global markets sold off on
worries about debt defaults credit draught,
dragging the perceived value of its assets down to
US$3.6 billion, from about US$5 billion.
Goldman chief financial officer David
Viniair on a conference call with analysts was
emphatic that the move was not a rescue but to
capture ''a good opportunity''. After more than a
week of panic over the disorderly state of global
capital markets, Goldman Sachs pulled a kicking
live rabbit magically out of its distressed asset
hat.
On a conference call to discuss the
additional equity investment in the US$3.6 billion
Global Equity Opportunities fund, Goldman
executives insisted the move would not add to
moral hazard (that is, encourage expectations that
lead investors to take more risk than they
otherwise might because they expect to be bailed
out), but would merely reflect the firm’s belief
that the value of the fund’s underlying assets was
out of whack with ''fundamentals'' and that sooner
or later the losses would be recouped when an
orderly market returned.
''We believe the
current values that the market is assigning to the
assets underlying various funds represent a
discount that is not supported by the
fundamentals,'' Goldman explained in a statement.
A day later, on August 14, the S&P 500 fell
another 26.38 points or 1.83%, followed by another
fall of 19.84 points or 1.39% on August 15,
notwithstanding that a chorus of respected voices
were assuring the public that the sub-prime
mortgage crisis had been contained and would not
spread to the entire financial system.
But
Goldman did not injecting equity into two of its
other funds, Global Alpha and North American
Equity Opportunities, that had also suffered sharp
losses. Goldman said it was reducing leverage in
the funds, a process that was mostly complete, but
added that it was not unwinding Global Alpha, down
27% this year through August 13, about half of
that in the previous week alone. Unlike Global
Equity Opportunities, Goldman did not bolster its
Global Alpha quantitative fund. Investors had
reportedly asked to withdraw US$1.6 billion,
leaving Global Alpha with about US$6.8 billion in
assets after forced liquidation to pay the
withdrawals.
Ireland-registered Global
Alpha, originally seeded in 1995 with just US$10
million and returning 140% in its first full year
of operation, was started by Mark Carhart and
Raymond Iwanowski, young students of finance
professor Eugene Fama of the University of
Chicago. Fama’s concept of efficient markets is
based on his portfolio theory, which states that
rational investors will use diversification to
optimize their portfolios based on precise pricing
of risky assets.
Global Alpha soon became
the Rolls Royce of a fleet of alternative
investment vehicles that returned over 48% before
fees annually. Hedge funds usually charge
management fees of up to 2% of assets under
management and 20% of investment gains as
incentive fees. Global Alpha fees soared to US$739
million in first quarter of 2006, from US$131
million just a year earlier and boosted earnings
rise at the blue-chip Goldman Sachs by 64% to
US$2.48 billion, the biggest 2006 first-quarter
gain of any major Wall Street firm. Goldman is one
of the world’s largest hedge fund managers, with
US$29.5 billion in assets under management in an
industry that oversees US$2.7 trillion globally.
Goldman reported in October 2006 that its asset
management and securities services division
produced US$485 million, or 21%, of its US$2.36
billion in pretax profit for the fiscal third
quarter.
For 2006, Global Alpha dropped
11.6% through the end of November and ended up
dropping 9% for the year yet still generating over
US$700 million in fees from earlier quarters. That
was the first annual decline in seven years and
followed an almost 40% gain for all of 2005. The
fund took a hit in misjudging the direction of
global stock and currency markets, specifically
that the Norwegian krone and Japanese yen would
decline against the dollar. Global Alpha lost
money partly on wrong-way bets that equities in
Japan would rise, stocks in the rest of Asia and
the US would fall and the dollar would strengthen.
Before August 2007, the fund had lost almost 10%
on wrong bets in global bond markets.
Goldman’s smaller US$600 million North
American Equity Opportunities fund had also hit
rough waters, losing 15% this
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