from Follow the Money

So will the proliferation of hedge funds end with a bang or a whimper

June 6, 2005

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The number of hedge funds is about the only thing that has been rising faster than the price of residential real estate (at least in some markets). Probably not a coincidence: hedge funds and real estate both rely on leverage and are fueled by low interest rates.

Both are candidates for the cover jinx. Real estate from Time; hedge funds from the Times.

If the current hedge fund boom ends in another LTCM style bang, it will presumably because a big firm that employs a fair amount of leverage bets wrong in a big way -- or because a group of firms that employs a similar strategy all bet wrong. Indeed, that, in a sense, is what happened to LTCM, since --as Lowenstein points out -- lots of investment bank prop desks had rather similar positions to LTCM, and all were scrambling in the fall of 1998.

The reason L.T.C.M. shook Wall Street was that many investment banks held the same positions that the fund did, setting the stage for chain-link losses.

If hedge funds end with a whimper, it will be because they have arbitraged out all the easier profits. If too much money chases the same opportunity, the opportunity goes away. Meager returns will lead institutions and wealthy individuals to conclude that the substantial fees hedge funds charge -- often 2% of the investment a year and 20% of the profits -- are not justified by no-longer stellar returns.

Most funds deliberately try to hedge their bets (thus the name) by going both long and short -- that is, betting that one asset will rise while a related one falls. They are thus designed to be less volatile than ordinary stocks, which is why they are so fashionable. The risk isn’t meltdown but mediocrity, a glimpse of which may be seen in the industry’s recently lackluster returns.

The Times leans toward the whimper.

Lowenstein argues that the problem is not so much hedge funds as the "hedge" -- too much insurance leads people to take too many risks, or to think that they have more insurance than they really do.

To take an example from LTCM: if you are betting on the convergence of the price of a 29 and 30 year Treasury bond -- shorting say the on-the-run 30 year and going long the off-the-run 29 year -- you are hedged against rising interest rates, but not against a widening of the differential between the price of a 29 and 30 year Treasury bond. Protection against one kind of risk may introduce other kinds of vulnerabilities, particularly if protection against one kind of risks leads to bigger, more leveraged bets.

Lowenstein concludes:

Since the 1980’s, Wall Street has marketed derivatives as a tool for making risk more palatable, and Alan Greenspan has consistently praised them for enabling firms to spread, or ’’manage,’’ their risk. For instance, a bank can hedge against the risk that one of its loans will sour. It simply -- well, not so simply -- purchases a ’’credit default swap,’’ which entitles it to a payoff if a specified company, G.M. for instance, goes into default or suffers a material downgrade in its credit rating. The party on the other side might be a hedge fund that is more sanguine on G.M.’s bonds or has a way (it thinks) to hedge that risk. ... Credit-default swaps, for instance, didn’t exist a decade ago; today there are $8 trillion of them. No one has any idea of the losses that could ensue from a panic; credit-default swaps ’’have never been stress-tested,’’ notes the analyst James Bianco.

Neither the Fed nor the S.E.C. has ever really clamped down on derivatives or insisted on a form of disclosure that would tell folks what is going on. So forget hedge funds; if you’re searching for the next financial storm, try derivatives. ... There is a paradox here. A vehicle developed to help reduce individual risk has heightened risk to the system.

(Continues)

I remain worried that "the whimper" will lead to a bang -- hedge funds seeing declining margins on the core trades may gear up, and in effect take bigger, and more risky, bets to try to generate the returns needed to justify their fees. That in a sense happened to LTCM. By 1998, LTCM was not just doing convergence bets on BTPs (Italian Treasuries bonds) and Bunds (Germany bonds), and on the off-the-run and on-the-run long-term Treasuries. They were also dabbling in mergers, and in Russian T-bills.

But I also share some of Lowestein’s broader concerns. A lot has changed in 1998, or 1987, and no one really knows how all sorts of complicated bets would perform under real conditions of stress. To take an example -- admittedly far-fetched -- in all past crises, there has been a flight to quality, and quality has included the dollar and dollar denominated Treasuries. But at some point, investors -- maybe in Asia, maybe elsewhere -- may conclude the currency and debt of a country with enormous trade and current account deficits no longer represents quality. Past relationships may break down.

That, indirectly, leads me back to the collateralized debt obligation (CDO market) and most recent case when "historical relationships" broke down. Kerkorian’s bid for GM changed the game. Rather than falling along with GM’s debt, GM stock rose. That, and a much more complicated bet on the relative performance of different tranches of CDOs also seems to have gone bad, at least in some instances.

Let’s take a simple example. Assume that five different credits are bundled together into a CDO (for a CDO and credit default swap primer, read this), and the CDO is split into two tranches, a junior tranche and a senior tranche. The junior tranche takes all the losses if one of the five credits defaults. But the junior tranche can only be used up once. If two or more credits default, the senior tranche also takes losses.

Buying the junior tranche thus can be thought of as a bet that none of five "credits" that make up the CDO will default.

But then someone clever realized that if you buy the junior (equity) tranche and go short the senior tranche, you are in effect making two bets. Either none of the credits default, and you win on the junior or equity tranche (which yields more than the senior tranche) or many of the credits default, in which case you "win" by shorting the senior tranche. But you lose big time if only one of the five credits default. In effect, going long the junior tranche and short the senior tranche is a bet that the performance of the five credits will be highly correlated. Either none of the credits will default, or all of them will.

Bingo. The market suddenly starts to trade on something -- correlation -- that no one paid much attention to previously. Presumably expected future correlations are divined from past correlations. That worries me.

Maybe the presence of so many firms trading correlation will start to change correlations. Short-covering and other market dynamics can take hold where they previously did not exist.

Or maybe correlations change in ways that simple models don’t pick up.

Let me give two examples, both drawn from a world -- emerging markets -- that I know far better than corporate credits.

Russia defaulted on much of its external debt (though not its Eurobonds) in 1998; Ecuador defaulted on its international bonds in 1999. There was a reason why their defaults were correlated. Both export oil, and oil wasn’t worth much in the immediate aftermath of the Asian crisis. Does that mean that Ecuador and Russia will remain correlated? I would argue not. Putin, if nothing else, has been financially prudent: he is paying down Russia’s external debt and adding to its reserves. In his mind, financial stability is linked to Russia’s sovereignty and policy independence. Ecuador could well default (and dedollarize) even if oil stays high; it is almost certain to default (and dedollarize) if oil falls. Adopting the dollar did not change Ecuador’s internal politics -- and its still high external debt load is starting to chafe.

Or to take another example -- the correlation between movements in the secondary market price of Russia’s eurobonds and Brazil’s eurobonds. Both have experienced their share of crises since 1997, but neither formally defaulted on their eurobonds (Russia, again, defaulted on everything else). Russia is an oil exporter. Brazil is not. Both Brazil does export commodities (iron ore, soybeans) and like Russia, it has benefited from the pressure on commodity prices created by China’s demand.

Perhaps their performance is correlated. At times it certainly has been. Russian and Brazilian bonds both did well when all emerging market bonds did well in 96 and 97, and again from 2003 on. Russia and Brazil fell in tandem (though Russia fell far more) in the 1998-99 crisis.

But in 2002, Brazil had a crisis and came close to defaulting while Russia was cruising along. Despite the similarities created by a common dependence on commodities and the common exposure of all emerging economies to the US interest rate cycle, Brazil and Russia have different domestic politics and different domestic debt dynamics. I sure would not want to base a bet on the future correlation of Brazil and Russia solely on their past performance ...

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