Page 2 of 5 PATHOLOGY OF
DEBT PART
1: Banks as vulture
investors Henry C K Liu
year.
There was real danger of a rush of redemptions
from nervous investors that would force the funds
to sell securities in a market that had all but
seized up, forcing down asset prices to fire sale
levels. Global Equity Opportunities investors were
entitled to pull their money monthly with a 15-day
warning, meaning notices for August 31 were due on
August 16. Global Alpha investors could redeem
quarterly, and certain share classes also were
required to
notify
the fund by the week of August 13.
Hedge
funds are private, largely unregulated pools of
capital whose managers command largely
unrestricted authority to buy or sell any assets
within the bounds of their disclosed strategies
and participate in gains but not losses from
investment. The industry has been growing over 20%
annually due to its above-market performance.
Still, Carhart and Iwanowski, both in their early
forties, had not been able to take any of their
20% incentive fees since Global Alpha fell from
its 2006 peak. They would have to make good about
60% of their previous incentive fees from profit,
if any, in future quarters before they could
resume taking a cut of the fund’s future gains.
The Fed wavered By August 16,
the DJIA fell way below 13,000 to an intraday low
of 12,445, losing 1,212 points from its 13,657
close on August 8. The next day, August 17, the
Fed, while keeping the Fed Funds rate target
unchanged at 5.25%, lowered the Discount Rate by
50 basis points to 5.75%, reducing the gap from
the conventional 100 basis points by half to 50
basis points, and changed the rules for access by
banks to the Fed discount window.
In an
accompanying statement, the Fed said: ''To promote
the restoration of orderly conditions in financial
markets, the Federal Reserve Board approved
temporary changes to its primary credit discount
window facility. The Board approved a 50 basis
point reduction in the primary credit rate to
5-3/4 percent, to narrow the spread between the
primary credit rate and the Federal Open Market
Committee's target federal funds rate to 50 basis
points. The Board is also announcing a change to
the Reserve Banks’ usual practices to allow the
provision of term financing for as long as 30
days, renewable by the borrower. These changes
will remain in place until the Federal Reserve
determines that market liquidity has improved
materially. These changes are designed to provide
depositories with greater assurance about the cost
and availability of funding. The Federal Reserve
will continue to accept a broad range of
collateral for discount window loans, including
home mortgages and related assets. Existing
collateral margins will be maintained. In taking
this action, the Board approved the requests
submitted by the Boards of Directors of the
Federal Reserve Banks of New York and San
Francisco.''
The Fed panicked A
month later, on September 18, brushing aside a
DJIA closing at a respectable 13,403 the day
before even in the face of poor employment data
for August, the Fed panicked over the unemployment
data and lowered both the Fed Funds rate target
and the Discount Rate each by 50 basis points to
4.75% and 5.25% respectively. The rate cuts gave
the DJIA a continuous rally for nine consecutive
days that ended on October 1 at 14,087. Obviously,
the Fed knew something ominous about the credit
market that was not reflected in the DJIA index.
The Global Equity Opportunities fund, now
with about US$6.6 billion in asset value, was
using six times leverage before the capital
infusion. Like many other managers, Goldman was
experiencing the same problems with its so-called
quantitative funds. Quant funds use computerized
models to make opportunistic investment decisions
on minute statistical disparities in asset prices
caused by market inefficiency. When the short-term
credit market seized up, the quant models turned
dysfunctional.
Funds caught with
significant losses in credit and bond investments
had to sell stock holdings to lower the risks
profile of their overall portfolios, and the herd
selling in the stock market magnified the price
shift in a downward spiral. Stocks that were held
long fell in price, and stocks that were held
short rose, exacerbating losses.
Opacity fueled market rumors As
required, quant fund managers have been disclosing
losses to investors but they are not required to
disclose to the market. The opacity fueled the
rumor mill. Renaissance Technology’s US$26 billion
institutional equities fund was reportedly down 7%
for the year. Some of the funds that Applied
Quantitative Research (AQR) managed were down as
well, as were quant funds at Tykhe Capital,
Highbridge Capital and D.E. Shaw (of which Lehman
now owns 20%).
Vulture Opportunities in
distressed funds At Goldman, quant funds
made up half of the US$151 billion of alternative
investments under management, and half of which
was the sort of long-short equity quant funds that
had been having trouble. But Goldman executives
began to see opportunities in distressed funds.
The highly respected AQR was raking in new funds
to invest in distressed situations, as were other
astute fund managers. ADR is an investment
management firm employing a disciplined
multi-asset, global research process, with
investment products provided through a limited set
of collective investment vehicles and separate
accounts that deploy all or a subset of AQR's
investment strategies. These investment products
span from aggressive high-volatility
market-neutral hedge funds, to low-volatility
benchmark-driven traditional products. ADR’s
founder is Clifford S. Asness, an alumni of
Goldman where he was Director of Quantitative
Research for the Asset Management Division
responsible for building quantitative models to
add value in global equity, fixed income and
currency markets. He was another of Fama’s
students at the University of Chicago.
Goldman was putting its own money down
alongside that of select outside investors, an
expression of its faith in the fund’s ability to
recoup. The situation differed from that of Bear
Stearns, which had to loan US$1.6 billion to bail
out one of two internal hedge funds that had big
problems with exposure to mortgage-related
securities.
The first wave of
warnings Goldman, one of the world’s
premiere financial companies, had joined Bear
Stearns and France’s BNP Paribas in revealing that
its hedge funds had been hit by the credit market
crisis. Bear Stearns earlier in the summer
disclosed that two of its multibillion dollar
hedge funds were wiped out because of wrong bets
on mortgage-backed securities. BNP Paribas
announced a few weeks later it would freeze three
funds invested in US asset-backed securities.
The assets of the two troubled Bear
Stearns hedge funds had been battered by turmoil
in the credit market linked to sub-prime mortgage
securities. On June 20, 2007, US$850 million of
the funds’ assets held as collateral was sold at
greatly discounted prices by their creditor,
Merrill Lynch & Co. The assets sold included
mortgage-backed securities (MBS), collateralized
debt obligations (CDO) and credit default swaps
(CDS). JP Morgan, another Bear Stearns creditor,
had also planned an auction for some of the
collateralized assets of the Bear Stearns funds,
but cancelled the auction to negotiate directly
with the Bear Stearns funds to unwind positions
via private transactions to avoid setting a market
price occasioned by market seizure.
The
two Bear Stearns funds - High-Grade Structured
Credit Strategies Enhanced Leverage Fund and
High-Grade Structured Credit Strategies Fund, run
by mortgage veteran Ralph Cioffi - were facing
shut-down as the rescue plans fell apart. The
funds had slumped in the first four months of 2007
as the subprime mortgage market went against their
positions and investors began asking for their
money back. The High-Grade Structured Credit
Strategies Enhanced Leverage Fund sold roughly
US$4 billion of subprime mortgage-backed
securities in mid-June, selling its highest-rated
and most heavily traded securities first to raise
cash to meet redemption requests from investors
and margin calls from creditors, leaving in its
portfolio the riskier, lower-rated assets that had
difficulty finding buyers.
Collateral
debt obligation crisis CDOs are illiquid
assets that normally trade only infrequently as
institutional investors had not intended to trade
such securities. Demand for them is not strong
even in normal times. In a credit crunch, demand
would become extremely weak. Sellers typically
give investors one or two days to price the assets
and bid in order to get the best price. Bid lists
were now sent out for execution within roughly an
hour, which was unusual and suggested that sellers
were keen to sell the assets quickly at any price.
Bear Stearns’ High-Grade Structured Credit
Strategies Enhanced Leverage Fund sold close to
US$4 billion worth of AAA and AA rated securities.
The fund was started less than a year ago with
US$600 million in assets, and used leverage to
expand its holdings to more than US$6 billion. But
subprime mortgage trades that went wrong left the
fund down 23% in the first four months of 2007.
The fund was selling its highest-rated and most
tradable securities first to raise cash to meet
expected redemption requests and margin calls.
Buyers were found for the bonds but the fund still
had to retain lower-rated subprime mortgage-based
securities that had triggered its losses earlier
in the year.
Bear Stearns was highly
leveraged in an illiquid market and was faced with
the prospect that its funds were going to start
getting margin calls, so it tried to sell ahead of
being in the worst spot possible. Subprime
mortgages were offered at low initial rates to
home buyers with blemished credit ratings who
could not carry the adjusted payments if and when
rates rise. This was not a problem as long as
prices for houses continued to rise, allowing the
lenders to shift loan repayment assurance from the
borrower’s income to the rising value of the
collateral. Thus subprime mortgages lenders were
not particularly concerned about borrower income
for they were merely using home buyers as needed
intermediaries to profit from the debt–driven
housing boom. This strategy worked until the debt
balloon burst. Rising delinquencies and defaults
in this once-booming part of the mortgage market
had triggered a credit crunch earlier in the year
that left several lenders bankrupt. Many hedge
funds had generated big gains for several years on
this unstainable liquidity boom. The premature
bears who shorted the market repeated lost money
as the Fed continued to feed the debt balloon to
sustain the unsustainable.
As
delinquencies and foreclosures rose finally,
losses first hit the riskiest tranches of subprime
mortgage-backed securities (MBS). The losses were
subsequently transmitted to collateralized debt
obligations (CDOs) that invested in the
higher-rated tranches of subprime MBS that did not
have an active market, since they were bought by
institutions with the intention to hold until
maturity. Such securities were super safe as long
as their ratings remained high.
Hedge
funds have become big credit-market players in
recent years, and many firms trade the riskiest
tranches of subprime MBS and higher-rated CDO
tranches to profit from the return spread. While
some funds, such those managed by Cheyne Capital
and Cambridge Place Investment Management, had
suffered sudden losses, some hedge funds made
handsome gains in February 2007 betting that a
subprime mortgage crisis would hit.
As the
number of market participants increased and the
packaging of the CDOs became more exoteric over
the liquidity boom years, it became impossible to
know who was holding the ''toxic'' tranches and
how precisely the losses would spread, since the
risk profile of each tranche would be affected by
the default rates of other tranches. The
difficulty in identifying the precise locations of
risk exposure caused a sharp rise in perceived
risk exposure system-wide. This sudden risk
aversion led to rating downgrades of the
high-rated tranches, forcing their holders to sell
into a market with few buyers.
The Federal
Deposit Insurance Corporation, which monitors risk
in the banking system, tracks bank holdings of MBS
but not specific
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
