Institutional Investor's Alpha Magazine - March 2008 - (Page 42) holding collateralized debt obligations, a hodgepodge of securitized consumer loans parsed into investment- and subinvestment-grade tranches, including, among other products, subprime mortgages. “The combination of investors and banks suddenly needing to get risk off their books was overwhelming,” says James McKee, director of hedge fund research at San Francisco–based consulting firm Callan Associates. “The speed and size of this unwind was extraordinary.” Perhaps most troubling was that many of the losses occurred without any significant change in underlying market fundamentals, leaving onlookers like Randall Dodd, a senior financial expert in the monetary and capital markets department at the International Monetary Fund, to wonder how “a 3-percentage-point jump in serious delinquency rates on a subsection of U.S. mortgages [could] throw a $57 trillion U.S. financial system into turmoil and cause shudders across the globe.” Yet the dangers were starkly apparent in a spectacular reversal of fortune at London-based hedge fund firm Peloton Partners, which was up an impressive 87 percent in 2007 but abruptly collapsed in late February after it was overwhelmed by mortgage investment losses. Peloton closed its $2 billion asset-backed-securities fund and froze redemptions on its $1 billion multistrategy fund. In a letter to investors, the fi rm blamed its woes on credit providers: “Because of their own well-publicized issues” lenders had been “severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet our margin calls.” Likewise, in early March, Focus Capital, a $1 billion Swiss hedge fund, announced it would liquidate its holdings because it could not meet margin calls from banks. Most of Focus’s investments were midcap Swiss equities. What has become painfully clear in the several months since the liquidity crisis began is that the extreme complexity of esoteric financial products like collateralized debt obligations, better known as CDOs — in combination with the opaque, underregulated and highly leveraged hedge fund industry — helped exacerbate the confusion that created a lemminglike rush to liquidation. Despite the apparent good intentions of both government and private sector agencies, which sought to stem the tide through rate cuts and infusions of capital, the hedge fund industry may yet need to make a major reassessment of how credit products are priced and how much leverage is reasonable. It may also need to become more transparent. 42 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2008 EXPERTS ENVISION A THREE-PART APPROACH to making the hedge fund industry simultaneously more accountable and more stable. It starts with greater transparency. Although he acknowledges that hedge funds are an important source of capital, the IMF’s Dodd says legitimate concerns about their potential to destabilize markets persist, making them more dangerous than the industry’s total assets would suggest. Most hedge fund activity, of course, occurs beyond the scrutiny of the broader investment community; hedge funds can be black holes into which credit markets can be sucked without fully realizing it. From the point of view of even the biggest lenders in the world, at the heart of the hedge fund industry is darkness. The subprime meltdown and the shockwaves it created also suggest how little has been learned from past financial debacles. A paper co-authored in November by MIT Sloan School of Management finance professor Andrew Lo, “What Happened to the Quants in August 2007?” found similarities between the $4.6 billion collapse in 1998 of hedge fund Long-Term Capital Management — in which widening credit spreads generated margin calls, causing the unwinding of illiquid portfolios, resulting in further losses and additional margin calls, leading ultimately to ruin — and the more recent shocks at fi rms like Bear, Stearns & Co. as well as Sowood and dozens of other credit-sensitive hedge funds. (For more on Lo’s paper, see “Summer Solstice,” page 22.) What is different this time around, and of greater cause for concern, is that hedge fund losses, particularly among quantitative long-short, market-neutral funds, occurred more or less all at once. Lo says that because such correlations exist in greater numbers than they did in 1998, the chances for widespread contagion are much greater today. But the cycle of lessons learned, lessons forgotten goes back at least a century. In his new book, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm, Robert Bruner, dean of the Darden Graduate School of Business Administration at the University of Virginia, suggests that many of the elements that preceded that crash are evident today. One of the most relevant features, he says, is what he calls an “asymmetry of information” that is at the core of every liquidity crisis. The opacity of instruments like CDOs, which can be difficult to value, leaves investors vulnerable and increases across-the-board volatility. “It’s a good example of how complexity creates information asymmetry for anyone nowadays,” cautions Bruner. “It’s very difficult to know what is really going on.” On the other hand, Jacki Zehner, founding partner of Circle Financial Group, a New York–based private wealth management firm, argues that the past is of little consequence this time around. Given the size of hedge funds, “and the lack of transparency as to who owns what, we really have no idea about the financial impact caused by the deterioration of the underlying assets,” Zehner explains. “The system is so complex and interconnected
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.