More Pain No Gain

Since I wrote about hedge funds Peloton and Focus failing and Carlyle and others in margin call trouble, it appears that my gloomy talk has, unfortunately, played out. As an aspiring money manager, I personally am sad to see others in the business fail. However, we should treat this as a learning opportunity to understand the underlying problems and hopefully gain some insight into the future state of the markets. Most importantly, we should be honest with our assessment of their problems.

Here is a list from the last 4 weeks:

1. Citigroup funds: ASAT Finance (municipal bonds), MAT Finance (municipal bonds), Falcon Strategies (MBS), CSO Partners (corporate debt).
2. Blue River Asset Management (municipal bonds).
3. Carlyle Capital Corp (Bonds, CDO's).
4. Tequesta Mortgage Fund (Mortgages).
5. Focus Capital (swiss small cap).
6. Peloton Partners (ABS and multi strategy).
7. Sailfish Capital (fixed income).
8. Deephaven Event Fund (event driven).

Call A Spade A Spade

I have argued elsewhere that the problem facing funds today is very different from the LTCM crisis. LTCM's strategy was, fundamentally, selling tail risk. A tail event in the form of Russia's default which caused a flight to quality and wider spreads worked against their positions. Since they were highly levered, their capital base was unable to ride out the event and a bail out was necessary. There are three major differences today:

1. Macro environment is not a tail event. I believe that the current problems in financial markets are not a tail event that is causing unforeseen behavior. Many commentators that I have been reading for the past few years have predicted exactly what we are seeing. They have even carefully explained why. For anyone paying attention, the housing crash and the following subprime issues, and now Alt-A, jumbo, muni's, etc. were all perfectly predictable. Unfortunately, however, the macro environment is currently quite murky. That the US is in a recession is a foregone conclusion. Harvey Feldstein has finally admitted what has been obvious for many months. I predicted in December that January will be recognized officially as the start of the recession and I stick by that prediction. However, depending on where you get your data, the case can be made for earlier.
   
   The real question is how severe the recession will be, and whether it will be deflationary or inflationary. My guess is extremely severe since there are simply too many variables that need to pan out perfectly in order for this to be a soft landing. For example, solvency issues at major banks, credit withdrawal, housing prices in the major speculative areas, people walking away from underwater mortgages, problems in muni's, problems in ARS, monoline concerns, global wage arbitrage, contracting service sector, and others.
   
   Whether the recession is inflationary or deflationary is a much harder question to answer. Thanks to the analysis of mish and the folk over at Minyanville, I am leaning towards the deflationary side. Surprisingly, the Fed seems to be on our side. They seem quite reluctant to inflate the money supply, hence the unorthodox approach to monetary policy. The interest rate decision in a few days, I think, will signal their intent more clearly as it has become clear since their last meeting that growth is negative and credit is being destroyed left and right.
   
   The implications for hedge funds is that all those who were relying on rising house prices, the goldilocks economy, or permanent credit market liquidity will be faced with more losing positions and margin calls. I don't mean to imply that all those that failed in the last few weeks were naive. Some were simply highly levered and failed for reason 2 (below). Others did make investments that were unsound and are facing the consequences. Whether LTCM's strategy was sound or unsound I refrain from commenting on, but it ran into problems very different than what the markets are currently experiencing. Many funds, especially those long structured products such as CDO's, CLO's, MBS's, etc, even if not levered at all, will fail because their investments are fundamentally unsound.
   
   
2. Exposure to other hedge funds. Unlike 1998, the hedge fund industry today has tremendous exposure to others within the industry. Assets under management are close to $2 trillion, a number far far larger than 1998. We already saw the ramifications of this in August/November where positions that one might consider sound performed badly simply because other hedge funds were in the same positions and were experiencing problems elsewhere. If you have a pairs trade in Toyota and GM, but so do 20 other hedge funds, then for all intensive purposes you have bought a single security that is the spread between the two.
   
   Given the deteriorating macro environment, if a certain fund finds itself in trouble because of illiquid credit instruments, it will be forced to liquidate its liquid positions in equities or precious metals to meet margin calls. Thus a fund with absolutely no CDO/CLO/MBS/etc exposure, by virtue of its investment in other markets and other funds' presence in those markets, can indirectly have exposure to all this so called "toxic waste." If you think you cannot be hit because you are not exposed to credit instruments, I urge you to look at the example of the funds that failed this month and reconsider the risk profiles of your positions. As mentioned, August/November already demonstrated how trouble in credit markets adversely affected more liquid markets simply because funds had to trim positions elsewhere to meet margin calls. If forced to trim a position, the natural choice is the liquid market.
   
   To re-iterate, one should be careful about the risk assumptions they make on their positions. Deteriorating conditions in one market can have adverse effects on other more "sound" markets simply because a large number of hedge funds have exposure to many different markets. In a sense, hedge funds form a conduit through which trouble in one market can easily spread to other markets. Should this occur again, leverage will be the enemy, and may result in many more failures.
   
   
3. Badly understood positions/risks. In the case of LTCM, the positions they took (on-the-run/off-the-run treasuries) and the reason for the widening spreads was very well understood. Today, however, there are vast amounts of derivatives floating around the system that no one can fully describe the risk characteristics off. The models used to price these instruments are just that, models. They are simplified in order to be tractable, and sometimes the inputs are not clear. If one cannot understand the risks, or describe the instruments with a good model, then one cannot possibly be hedged. In short, there is much more uncertainty today about who is exposed to what risk.
   

Conclusion

There exist significant downside risks in all markets. The big question of whether the Fed can successfully inflate this time again should be answered quite soon. In the interim, I remain partially short the market, but mostly on the side lines as capital preservation, I think, is the most important concern going forward.