Speculation Away From Subprime, Part 3

07.30.07

Posted in Bonds, Stocks, Portfolio Management, Macroeconomics, Pensions, Structured Products and Derivatives, Speculation, Real Estate and Mortgages at 11:47 pm by David Merkel

More on speculation, while avoiding subprime which is still over-reported.

1. How much risk do hedge funds pose to the financial system? My view is that the most severe risks of the financial system are being taken on by hedge funds. If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system. The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
2. There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced. I want to get a copy of Richard Bookstaber’s new book that makes this point. Let’s face it. Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential. Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
3. Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy. Inefficiencies are finite. Now Renaissance Institutional is feeling the pain. My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy. Asset growth is self-reinforcing to performance, until you pass the limit.
4. I have seen the statistic criticized, but it is still true that we are at a high for short interest. When short interest gets too high, it is difficult but not impossible for prices to fall a great deal. The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome. Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
5. I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment. It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds. That said, Sowood benefits from the liquidity of Citadel.
6. Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds. This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
7. Should you be worried if you have an interest in the equity of CDOs? (Your defined benefit pension plan, should you have one, may own some of those…) At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt? If so, you have reason to worry. Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
8. There have been a lot of bits and bytes spilled over mark-to-model. I want to raise a slightly different issue: mark-to-models. There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves. This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties. For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
9. If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities. Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
10. If you need still more proof, consider this article. The problem for hedge fund managers gets worse when illiquid assets are financed by debt. At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.

That’s all in this series. I’ll take up other issues tomorrow, DV. Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix. In this cycle, might simplicity will come into vogue again? Could balanced funds become the new orthodoxy? I’m not holding my breath.