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     Nov 27, 2007
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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

Continued 1 2 3 4 5 


The Complete Henry C K Liu


1. Bin Laden talks of victory, not defeat

2.  The general has no uniform

3. Israel, the hope of the Muslim world
4. Leave, or we will behead you

5. Warning shot for Iran, via Syria

6. Eyes back on Fed for emergency rate cut

7. Muslim democracy: An oxymoron?

8. Bush administration conquers Washington

(Nov 21-25, 2007)

 
 


 

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