In light of the risk management problems that have occurred at Morgan Stanley, I thought it was interesting to run into this description of risk management at Morgan Stanley on the web. It was written by the firm's Chief Risk Officer, Tom Daula. It all sounds pretty reasonable to me. I guess I would give him an A for the planning and an F for the execution.
Given that things did not work out according to plan, it would be enlightening to know where these plans went astray.
Tuesday, December 25, 2007
In light of the risk management problems that have occurred at Morgan Stanley, I thought it was interesting to run into this description of risk management at Morgan Stanley on the web. It was written by the firm's Chief Risk Officer, Tom Daula. It all sounds pretty reasonable to me. I guess I would give him an A for the planning and an F for the execution.
Thursday, December 6, 2007
Sunday, December 2, 2007
Most crises are crystal clear after the fact, and the subprime crisis is no different. At least as far as it has affected the various banks and investment banks, the problem is that they had too much inventory in something that was risky and illiquid. How did they end up in that situation? Is it something that they should have recognized before they were hit with multi-billion dollars write downs?
I often replay these sorts of problems in my mind. Putting myself in the situation of the risk manager at one of these firms, here is one way I could have seen things playing out over the course of meetings with the trading desks.
Me: “Hey, guys, have you noticed that our CDO-related inventory has been growing. It wasn’t too long ago that we had just a few billion, and then it went up to $20 billion, and now nearly $40 billion. That seems worrisome to me.”
Them: “Maybe that’s because you aren’t sitting here on the desk watching these things all day long like we are. Look, you can’t make money in this business without ending up holding some inventory from time to time. At least if you can, be sure to let us know how. And in this case a lot of this inventory is rated AAA. You wouldn’t have a problem if we had a bunch of AAA corporate bonds, would you? I mean, that stuff is a better bet than our company is.”
Me: “You know, even if this stuff is AAA and you aren’t worried about defaults, spreads are really low right now. If they go up for some reason – and even up to somewhere in the range of their historically “normal” levels – we could see a multi-billion dollar write down on this inventory.”
Them: “Oh, right. Good catch. We’ll put something in place for a hedge against credit spreads widening.”
Me: “This stuff that you are saying is AAA. What if those ratings are off? I mean, it is not like the rating agencies have any experience with these sorts of structured products. They are basing the ratings on historical default probabilities and historical correlations. Don’t you think with all the changes we are seeing in the market – the very explosion in the issuance of CDOs, for one – that these correlations could be different than they have been in the past? And, for that matter, why should we be betting on what rating agencies have to say?”
Them: “Well, if you have a better way of assessing the risk of these things, let us know. Otherwise, do you mind if we get back to work. We’re trying to make money here.”
Me: “I’m sorry to bother you again. But, maybe we have been focusing on the wrong thing here. The issue for us is not so much if these are really AAA or not; our concern is not just with defaults being higher than we expected. The issue is whether these could trade substantially lower for any reason. And I think I have one scenario that could lead to much lower prices: The instruments in our inventory are not very liquid. That is, after all, the reason we have ended up holding these things in our inventory rather than pushing them out to a client. So what if someone suddenly is forced to liquidate, a hedge fund, say, that gets into trouble. The price in the market could plummet. And it wouldn’t take much of a price drop to hit us hard. When you have $40 billion of this stuff, a ten percent drop will lead to a mark to market loss that will wipe out all the profits you guys have made over the last few years.”
Them: “Good to see you are cranking out the scenarios. But if we worried about every little “what if” that you can cook up, we wouldn’t be doing anything. We are risk takers. That’s how we make money. So if you want us to stop making money – or if you have a better idea on how to do it without taking risk – then let us know. Otherwise, do you mind if we get back to work here?”
The point in this set of conversations is that the risk manager is always at a disadvantage when dealing with the trading desk.
First, the traders obviously know their market better than the risk manager can ever hope to. So if a concern gets elevated to the point of an us-versus-them debate with the traders on one side and the risk manager on the other, the traders will be able to run circles around most risk managers. So a firm either has to get the traders to share the same mindset as the risk manager, or the management of the firm has to handicap the risk manager if things come to blows.
Second, for each blowup that occurs, there will be ten cases where there was a legitimate concern but nothing happened. That is, if measured based on the realized outcome, the odds are the risk manager will be wrong more often than he is right. So there is the risk of looking like the boy who cried wolf.
Another point which is not expressed in the set of conversations above is that in most large firms the risk manager makes himself too busy to really focus on risk management. If he lets himself get sucked into making the role look weighty, he will end up spending his time running an organization, worrying about having adequate face time with senior management, and elbowing his way into all the right meetings. What he should be doing instead of all that is spend time trying to think outside of the box. There are possibly hundreds -- in some cases thousands -- of people in his organization, reams of risk reports to run through and meetings all day long. The risk manager can end up looking really, really busy while not actually doing his job.
On this score, I have suggested to a number of people at Citigroup (and the same points would hold true for Morgan Stanley and probably any number of other firms) that the real risk manager should not have people management and report generation responsibilities. He should be able to have the time and space to question and think. He should be able to use all the risk data as an input and demand other types of analysis he deems necessary, but then have the time to sit back and think. In this respect, his role would not look much different than any number of very successful portfolio managers. (I treat Citigroup in a chapter of my book entitled "Colossus" as an example of an overly complex, and thus crisis-prone organization).
Monday, November 5, 2007
Many people ask about the source for my cockroach analogy, which I go through on page 232ff in A Demon of Our Own Design. The source for this analogy is my paper with Joe Langsam in the Journal of Theoretical Biology. So I am linking to that paper here.
The argument in the paper is pretty readable if you read past the citations and the math, and it is relevant to how we construct financial markets and manage risk in those markets.
Thursday, October 25, 2007
It might seem now that it was in a different world, but it was in this one, and in fact it was in the United States. Traders watched their bank of broker screens as the 30-year Treasury dropped below 8% for the first time in their youthful memory. That was in the 1980s. I was working at Morgan Stanley at the time, and someone on the Treasury desk made a trade for his own account just so he could frame the ticket from that momentous event. Yes, interest rates can go above 8%. In fact, at the time an 8% rate seemed quite reasonable.
I mention this because over the past decade or so we have constructed a financial landscape where an 8% interest rate not only is hard for us to envision, but where it would be disastrous. The reason is the huge stock of adjustable rate mortgages. Looking at the dislocations that are coming about from the subprime problems and the related credit crunch, it is hard to fathom the effect on the housing market and the overall economy if all those remaining homeowners with various flavors of adjustable rate mortgages saw rates shoot up hundreds of basis points. I don’t know how to quantify the effect, but I would hope that there are researchers at the Fed who do. And I would bet that the implications are pretty scary. Maybe so scary that the Fed would not be able to push interest rates up very far for fear of triggering a populist revolt.
Of course, now all of the discussion is about possible Fed easing. So I am worrying about something that is not even on the radar screen. But can anyone envision a scenario where a substantial increase in interest rates would make sense from an economic standpoint, but where the Fed finds its hands tied because the costs to homeowners would be too great?
Friday, October 12, 2007
What a mess. With multi-billion dollar trading losses, we are starting to see heads roll. Citigroup is losing its long-time fixed income head Tom Maheras and several of his lieutenants. Merrill is continuing in its approach to managing human capital, bringing in new blood and losing experienced hands in the fixed income business. Oh, and they are putting someone into a Chief Risk Officer role. Talk about closing the barn door….
Other firms have fared very poorly but so far without executing any of the troops. Morgan Stanley layered a heart-stopping $390MM one-day loss in its prop trading desk on top of far bigger losses on leveraged loans and the like. This loss in Process Driven Trading was similar in timing to the losses at Goldman’s Global Alpha fund, AQR and other quant hedge funds. Which pretty much tells us that what this secretive group at Morgan Stanley was up to was a not-so-secretive strategy: They had a lot of capital riding on the same sort of momentum and value versus growth quant equity strategies as the rest of the gang.
What I don’t understand in all of this is that for all the mention in the press of the risk takers, there is not a single mention I have found of the people who are supposed to be overseeing the risk. If you are the Chief Risk Officer and everything blows up, don’t you bear some responsibility?
To get the idea of the CRO job, let me tell you a bit about myself. Although I am older and have a slight build, I am an Olympic athlete. My event is the shot put. I consider myself a top notch athlete in this event. I work out like the other competitors, follow a high protein diet, steer clear of performance enhancing drugs and train at the local track. The only trouble I have is when the Olympics roll around every four years, because it turns out that for an Olympic athlete, I am not very good. But then, that is only an occasional blip in my otherwise Olympic-worthy regimen.
In the CRO job 99% of the days there is nothing going wrong. The only test you get of how well you are doing – short of pouring out risk reports and looking ponderous and prudent in meetings – is what happens to the firm during times of market crisis. Every few years something calamitous happens in the market; if the firm gets blown away, that suggests you did not do a very good job.
What about the job of the risk taker? Well, a risk taker does, after all, take risk. He tries to do so intelligently, that is, he tries to put on positions that he hopes have a high return per unit of risk. But how much risk he takes and where he takes it has to be dictated by someone. You can’t just say “take risk, and good luck”.
The job of the risk manager at these firms is to convey the risk parameters to the risk takers, to define the boundaries. And that should involve more than simply running a value at risk calculation on the computer. If that is all you want, you don’t need a guy making a few million a year and employing a staff of hundreds. Before I would be so harsh on Tom Maheras and his compatriots, I would be calling to task the people who allowed that risk level to be taken in the first place.
Friday, October 5, 2007
I testified before the House Financial Services Committee on Tuesday in a hearing on "Systemic Risk: Examining Regulators Ability to Respond to Threats to the Financial System". In my written testimony I provided my views on specific questions they had posed in their invitation.
One of the points I made in my testimony was the idea of the government taking on a role as a liquidity provider of last resort. This is something I addressed in my September 10th post, "Bailouts for Profit", and it was also a central point brought up in the testimony of another member of the panel, Professor Steven Schwarcz of Duke University. I had considered this a radical idea, but it was a dominant focus from the members of the committee during the two hours of questions.
Sunday, September 23, 2007
[This is a modified version of an article I wrote that appeared in the September issue of Institutional Investor].
With the collapse of the U.S. subprime market and the aftershocks that have been felt in credit and equity markets, there has been a lot of talk about fat tails, 20 standard deviation moves and 100-year event. We seem to hear such descriptions fairly frequently, which suggests that maybe all the talk isn’t really about 100-year events after all. Maybe it is more a reflection of investors’ market views than it is of market reality.
No market veteran should be surprised to see periods when securities prices move violently. The recent rise in credit spreads is nothing compared to what happened in 1998 leading up to and following the collapse of hedge fund Long-Term Capital Management or, for that matter, during the junk bond crisis earlier that decade, when spreads quadrupled.
What catches many investors off guard and leads them to make the “100 year” sort of comment is not the behavior of individual markets, but the concurrent big and unexpected moves among markets. It’s the surprising linkages that suddenly appear between markets that should not have much to do with one other and the failed linkages between those that should march in tandem. That is, investors are not as dumbfounded when volatility skyrockets as when correlations go awry. This may be because investors depend on correlation for hedging and diversifying. And nothing hurts more than to think you are well hedged and then to discover you are not hedged at all.
Surprising Market Linkages
Correlations between markets, however, can shift wildly and in unanticipated ways — and usually at the worst possible time, when there is a crisis with volatility that is out of hand. To see this, think back on some of the unexpected correlations that have haunted us in earlier market crises:
- The 1987 stock market crash. During the crash, Wall Street junk bond trading desks that had been using Treasury bonds as a hedge were surprised to find that their junk bonds tanked while Treasuries strengthened. They had the double whammy of losing on the junk bond inventory and on the hedge as well. The reason for this is easy to see in retrospect: Investors started to look at junk bonds more as stock-like risk than as interest rate vehicles while Treasuries became a safe haven during the flight to quality and so were bid up.
- The 1997 Asian crisis. The financial crisis that started in July 1997 with the collapse of the Thai baht sank equity markets across Asia and ended up enveloping Brazil as well. Emerging-markets fund managers who thought they had diversified portfolios — and might have inched up their risk accordingly — found themselves losing on all fronts. The reason was not that these markets had suddenly become economically linked with Brazil, but rather that the banks that were in the middle of the crisis, and that were being forced to reduce leverage, could not do so effectively in the illiquid Asian markets, so they sold off other assets, including sizable holdings in Brazil.
- The fall of Long-Term Capital Management in 1998. When the LTCM crisis hit, volatility shot up everywhere, as would be expected. Everywhere, that is, but Germany. There, the implied volatility dropped to near historical lows. Not coincidentally, it was in Germany that LTCM and others had sizable long volatility bets; as they closed out of those positions, the derivatives they held dropped in price, and the implied volatility thus dropped as well. Chalk one up for the adage that markets move to inflict the most pain.
And now we get to the crazy markets of August 2007. Stresses in a minor part of the mortgage market — so minor that Federal Reserve Board chairman Ben Bernanke testified before Congress in March that the impact of the problem had been “moderate” — break out not only to affect other mortgages but also to widen credit spreads worldwide. And from there, subprime somehow links to the equity markets. Stock market volatility doubles, the major indexes tumble by 10 percent and, most improbable of all, a host of quantitative equity hedge funds — which use computer models to try scrupulously to be market neutral — are hit by a “100 year” event.
When we see this sort of thing happening, our not very helpful reaction is to shake our heads as if we are looking over a fender bender and point the finger at statistical anomalies like fat tails, 100-year events, black swans, or whatever. This doesn’t add much to the discourse or to our ultimate understanding. It is just more sophisticated ways of saying we just lost a lot of money and were caught by surprise. Instead of simply stating the obvious, that big and unanticipated events occur, we need to try to understand the source of these surprising events. I believe that the unexpected shifts in correlation are caused by the same elements I point to in my book as the major cause of market crises: complexity and tight coupling.
Complexity means that an event can propagate in nonlinear and unanticipated ways. An example of a complex system from the realm of engineering is the operation of a nuclear power plant, where a minor event like a clogged pressure-release valve (as occurred at Three Mile Island) or a shift in the combination of steam production and fuel temperature (as at Chernobyl) can cascade into a meltdown.
For financial markets, complexity is spelled d-e-r-i-v-a-t-i-v-e-s. Many derivatives have nonlinear payoffs, so that a small move in the market might lead to a small move in the price of the derivative in one instance and to a much larger move in the price in another. Many derivatives also lead to unexpected and sometimes unnatural linkages between instruments and markets. Thanks to collateralized debt obligations, this is what is at the root of the first leg of the contagion we observed from the subprime market. Subprimes were included in various CDOs, as were other types of mortgages and corporate bonds. Like a kid who brings his cold to a birthday party, the sickly subprime mortgages mingled with these other instruments.
The result can be unexpected higher correlation. Investors that have to reduce their derivatives exposure or hedge their exposure by taking positions in the underlying bonds will look at them as part of a CDO. It doesn’t matter if one of the underlying bonds is issued by a AA-rated energy company and another by a BB financial; the bonds in a given package will move in lockstep. And although subprime happens to be the culprit this time around, any one of the markets involved in the CDO packaging could have started things off.
Tight coupling is a term I have borrowed from systems engineering. A tightly coupled process progresses from one stage to the next with no opportunity to intervene. If things are moving out of control, you can’t pull an emergency lever and stop the process while a committee convenes to analyze the situation. Examples of tightly coupled processes include a space shuttle launch, a nuclear power plant moving toward criticality and even something as prosaic as bread baking.
In financial markets tight coupling comes from the feedback between mechanistic trading, price changes and subsequent trading based on the price changes. The mechanistic trading can result from a computer-based program or contractual requirements to reduce leverage when things turn bad.
In the ’87 crash tight coupling arose from the computer-based trading of those running portfolio insurance programs. On Monday, October 19, in response to a nearly 10 percent drop in the U.S. market the previous week, these programs triggered a flood of trades to sell futures to increase the hedge. As those trades hit the market, prices dropped, feeding back to the computers, which ordered yet more rounds of trading.
More commonly, tight coupling comes from leverage. When things start to go badly for a highly leveraged fund and its collateral drops to the point that it no longer has enough assets to meet margin calls, its manager has to start selling assets. This drops prices, so the collateral declines further, forcing yet more sales. The resulting downward cycle is exactly what we saw with the demise of LTCM.
And it gets worse. Just like complexity, the tight coupling born of leverage can lead to surprising linkages between markets. High leverage in one market can end up devastating another, unrelated, perfectly healthy market. This happens when a market under stress becomes illiquid and fund managers must look to other markets: If you can’t sell what you want to sell, you sell what you can. This puts pressure on markets that have nothing to do with the original problem, other than that they happened to be home to securities held by a fund in trouble. Now other highly leveraged funds with similar exposure in these markets are forced to sell, and the cycle continues. This may be how the subprime mess expanded beyond mortgages and credit markets to end up stressing quantitative equity hedge funds, funds that had nothing to do with subprime mortgages.
All of this means that investors cannot put too much stock in correlations. If you depend on diversification or hedges to keep risks under control, then when it matters most it may not work.
Monday, September 10, 2007
When a market is under stress, prices come untethered from value, driven instead by the liquidity demand of those who have to get out – for example, funds that are leveraged and have the banks breathing down their necks – and those who simply cannot face the mounting losses and find it prudent to cut and run. But if the breakdown is coming from the liquidity needs of the leveraged fund, cut-and-run may not be the right strategy; profits can come to those who are willing to provide the other side of the trade for those who must liquidate.
This is a role we have seen Citadel take in the past couple of years, once with Amaranth and once with Sowood. They provided liquidity to the market when it was needed, and in providing this service they scooped up the assets that were going begging for pennies on the dollar. Good for them. I think this can be a great business for a fund to be in.
No one seems to begrudge Citadel, no one is chastising them for providing a bailout. The reason, of course, is that while they did bail out the markets – that is, while they helped stem a problem from getting worse or propagating out further to affect other firms – they are the ones who put up the capital, took the risk, and ultimately will earn the profits from their action. And Sowood and Amaranth are still out of business.
The point is that there are two types of bailouts. There are bailouts that keep the offending fund on it feet and in business. Arguably these sorts of bailouts create a moral hazard problem. But there is another sort of bailout that does not stand in the way of failure, but that still reduces the collateral damage. What I have described above are bailouts of the latter type. And the government should start to think of financial bailouts in these terms.
To be specific, what if the government maintained a pool of capital on the ready to buy up assets of firms that are failing, much as Citadel did for Amaranth and Sowood? Of course, if a private entity is willing to step up to the plate, all the better. But as a last resort, what if the government took on the role that Citadel did in these instances. There would be no moral hazard problems, since the firm still fails. But the collateral damage would be contained; the market would be kept from going into crisis, the dominos would be kept from falling. And the taxpayer would have good odds of pocketing some profits.
We have seen other cases that were ripe for this type of bailout. Take the Bear Stearns hedge funds; in their case a bailout of sorts occurred through the banks, which in an exercise of price suppression (as opposed to the usual function of the market, which is price discovery) agreed not to push their collateral into the market. Or take LTCM, where the Fed in effect used the banks as a surrogate for performing the second type of bailout.
Thursday, August 23, 2007
Lower volatility can mean higher risk. Here is how I think we get to this paradoxical result.
With the growth of hedge funds over the past few years, more and more capital has been scavenging for alpha opportunities. When anything moves a little out of line, there is plenty of money ready to pounce on it. That is, there is more liquidity. And this is great for the liquidity demanders – for example a pension fund that has to invest a recent inflow – because they don’t have to move prices very far to elicit the other side of the trade. And that means lower price volatility.
The lower volatility in turn leads to higher leverage. One reason is that many funds base their leverage on value at risk, and they calculate value at risk using historical volatility. So when there is lower volatility they can lever more and still stay within their VaR limits. A second reason is that as more capital flows into the market and as leverage increases, there is more money chasing opportunities. Alpha from the opportunities is thus dampened, so a hedge fund now has to leverage up more in order to try to generate its target returns. And so the cycle goes – more leverage leads to more liquidity and lower volatility and narrower opportunities, which then leads to still higher leverage. This cycle is not much different than the classical credit cycle – which it is a part of this time around – where financial institutions make credit successively easier and easier because of competitive pressure and an environment that has, up to that point, been clear sailing.
This then gets to the higher risk. Because the real risk in the markets is not the day-to-day volatility, it is the risk of a crisis. And as I argue in A Demon of Our Own Design, high leverage is one root cause of crisis.
Bernanke has said the hedge funds “provide a good deal of liquidity in the markets and help the markets work more efficiently.” And that should be good, right? Well, it depends on how they are getting that liquidity. If it is through leverage, there may be a cloud inside that silver lining.
This relationship between liquidity, volatility versus risk is hard to observe, because there is nothing in the day-to-day markets to suggest anything is wrong. In fact, with volatility low, everything looks just great. We don’t know that leverage has increased, because nobody has those numbers. We don’t know how much liquidity will be forthcoming if there is a market stress, nor do we know how many of those who are the liquidity providers in the normal, quiet market times will move to the sidelines, or turn into liquidity demanders themselves. On the surface, the water may be smooth as glass, but we cannot fathom what is happening in the depths.
Friday, August 17, 2007
I was asked to write a column for Time Magazine on what is causing the subprime mortgages to have so broad an impact. Since you can see it there via the link, I am not also putting it here. But comments here are welcome. (To make a comment, click on the title so that the post appears on its own page).
Thursday, August 16, 2007
One part of the solution to the quant hedge fund problem is to use a strategy no one else is using. (The other part, in case you are wondering, is not to lever so much). Of course, it is hard to know if you are really differentiated from what other quant shops are doing – it is not like everyone gets together and presents papers at hedge fund symposiums. But, in any case, I think this is hard to accomplish.
The reason I think this is for the same reason the quant funds ended up with very similar strategies in the first place: they use the scientific method.
The key to the success of the scientific method is the reproducibility of results. If you do the same experiment I do, you will reach the same conclusion. More than that, if you and I start with the same hypothesis and apply the same data, you will discover what I discover. That is why we see so many races for the prize in the pure sciences. Even with the spectacular discovery by Watson and Crick, there were others nipping at their heels.
With the quant funds, we have well-trained professionals applying the scientific method to capture anomalies in the market. Most are trained at the same handful of institutions, they have read the same academic literature, and they are applying the same statistical tests, using the same analytical tools, to the same sets of data. So it is no surprise they come up with similar models.
That is not to say you can’t be successful doing this sort of thing. Think of Jim Simmons and Renaissance. Granted his longer-term fund has been in the same boat as Goldman and others, but his high frequency fund has made money with uncanny consistency for years. But he has a number of things working for him. First of all, he has huge scale; there are about two hundred top-notch scientists in his firm. He also has had years to amass a proprietary knowledge base, so he does not need to rely as heavily on the existing academic research. So it is reasonable to think he could stay ahead of the curve – others might get to where he has been, but by then he is another step ahead.
Saturday, August 11, 2007
There are a host of very large and well-managed quantitative equity funds that are up against the ropes, all seeing big losses at the same time. And these are market neutral funds that spend a lot of time and resources monitoring risk and systematic exposure. They try to avoid taking market bets. They also try to avoid large exposure to other systematic factors like interest rates or credit spreads. Yet they are all getting hammered. Why is this happening?
If I were to venture a guess – and it can only be a guess, because I do not know the internal workings of these funds – I would look at three culprits.
First, quantitative funds are highly levered. The modus operandi for quant funds is to find small price anomalies and turn them into meaningful returns by applying a lot of leverage, so they end up with many times the leverage of most fundamentally-driven equity hedge funds. As I point out in my book, leverage is the raw material for just about every market crisis. When a fund is highly levered and things start to go bad, it might get a call from its prime broker informing it that its collateral has dropped to the point that it no longer have enough assets to meet the required haircuts. If that happens, the fund – and others who are in the same boat – will be forced to start selling assets to reduce exposure. The selling drops prices, so the collateral declines further, forcing yet more sales. And so goes the downward cycle.
Second, they have strategies in common. This should not be surprising, given that many of these funds share a common lineage: Goldman’s Global Alpha Fund and AQR; Tyke and DE Shaw. The bread and butter strategies for many of these larger quant funds are momentum and stock valuation, with some factor-based allocation strategies sprinkled in. There aren’t a whole lot of different ways to measure momentum, so what one firm considers a high momentum stock is likely to have been similarly tagged by other firms in the game. The same is true with stock valuation and factor strategies. Valuation is modeled using factors like free cash flow, earnings quality and analysts’ earnings estimates. While there may be nuances in how you do this, you can only twist these sorts of data around so much. So at the end of the day each of these funds will be long and short similar sorts of stocks – if not the exact same stocks.
Finally, in aggregate these quant funds may be operating beyond the capacity of the markets. Well, right now that is pretty much true by definition, since it seems they can’t get out of each other’s way while they try to liquidate. But even during less crisis-prone times, the money employed by these strategies might be more than the market can absorb. One indicator of a capacity problem is the performance of these funds over the last few years. They have not been doing very well, which suggest there might be too much money chasing the opportunities. And it might be that their alpha has been dropping even as they have been increasing their leverage. If so, then the market opportunities are drying up even more than the performance would suggest. Hedge funds have to measure capacity – how much money they can effectively put in a strategy – by looking at the total capital being applied to the strategy they are pursuing, not just what they are putting to work in their fund. You need to take all of the quant funds employing the momentum-cum-valuation strategies and multiply their capital by the leverage they employ, and only then start asking the capacity question.
The quant fund crisis is as close as it gets to a pure example of the point in my book that it is liquidity and market dynamics, not economics, that spawns market crises. These are funds that invest substantially in talent and systems, and focus on keeping clear of anything systematic. Yet they are embroiled in a liquidity crisis. If it can happen to them, it can happen to anyone.
Monday, August 6, 2007
Credit derivatives may be altering market dynamics in a way that makes these derivatives and the bonds that underlie them riskier than we think. In particular, bonds may become more correlated than in the past because credit derivatives, rather than fundamentals and default probabilities, are driving their prices. Higher correlation may become most marked during a credit-based event. Investors who have to reduce their derivatives exposure or who have to hedge their exposure by taking positions in the underlying bonds will look at the bonds as part of a CBO package, and the bonds in that package will move in lockstep.
Rating agencies do not consider this new dynamic, so the ratings underestimate risk. If a set of A-rated bonds are put in a portfolio, the principle of diversification leads that portfolio to be less risky than the individual bonds. And the lower the correlation between the bonds, the lower the risk. Historically, bonds are not very correlated when it comes to default, so a rating agency that relies on historical data might come to the conclusion that the portfolio of bonds has low enough risk to merit an AAA rating. But if there is a credit derivative-based crisis, those bonds will become more correlated for no reason other than that they are bound into the same derivative instruments.
Things might only get worse when the rating agencies come around to marking these instruments correctly, because they will likely do so at the least opportune time. I don’t think they will wake up and start to revise ratings based on abstract arguments concerning market dynamics and the effect derivatives might play on the linkages between bonds. Instead, they will wake up when the market finally manifests the level of risk these instruments really contain; that is, when a crisis hits and the higher correlation becomes evident. So at the worst possible time, ratings may be revised and push many of these derivatives over the edge – either the A-rated or the investment-grade threshold. Many investors with ratings restrictions on their portfolios will be forced to liquidate these positions. The result will be a crisis laid upon another crisis.
Friday, July 20, 2007
Credit risk is hard to estimate. The negative events in credit markets, though significant when they occur, are infrequent. The market can chug along for years at a time without a major blowup, and each month the coupon payments roll in, risk grows: more capital pours into the market, leverage ratchets up and increasingly complex credit derivatives are added into the fray.
Because recent history does not provide a guide for the risk, to gain perspective on what can go wrong with credit markets let’s look back nearly two decades to the junk bond crisis. The components of that crisis – increasing leverage, a market shock, forced liquidation and an evaporating investor base – could all see a replay today.
Junk bonds were the mainstay of the LBO and hostile takeover strategies of the 1980s. These strategies started out as good ideas that were selectively applied in the most promising of situations. But over time more and more questionable deals chased after the prospect of huge returns, and judgement was replaced with avarice. Dealmakers continued working full throttle even as the universe of leveragable companies declined. They maintained deal volume by lowering the credit quality threshold of LBO candidates. The failed buyout of UAL in 1989 is one example of this; airlines are cyclical and until that time had not been considered good candidates for a highly levered capital structure. Leverage in the LBOs also increased over the course of the 1980s. Cashflow multiples increased from the 5x range in 1985 to the 10x range in 1988. This turned out to be fatal for many companies; by 1989 defaults started to increase.
On the other side of the issuers were the junk bond investors. High yield bonds wormed their way into the Savings and Loan industry. A number of Savings and Loans, many with the coaching of Drexel salesmen, found that government guarantees could essentially convert their risky bonds into government insured deposits; the S&L investors could capture the spread between the bond returns and the risk free return provided to the depositors. The government responded with the Financial Institutions Reform, Recovery and Enforcement Act in 1989, which barred S&L’s from further purchases of high yield bonds and required them to liquidate their high yield bond portfolios over the course of five years. Seeing the writing on the wall, S&L's had already begun to reduce their holdings; in early 1989 S&L junk bond holdings dropped by 8%, compared to an increase in holdings in the previous quarter of 10%.
Investors reacted quickly to the rise in defaults and the liquidations coming from the S&Ls. In July 1989 high yield bond returns turned negative. Over the third quarter of 1989 the N.A.V. of high yield mutual funds declined by as much as 10 percent. For investors who did not understand the risk of high yield bonds, the negative returns were a rude wake up call. The implications of erosion of principal – coupled with media reports of the defaults looming in the high yield market -- led to a wave of selling.
When things seemed like they couldn’t get any worse, they did. The insurance industry followed the S&Ls out the junk bond door.
In 1991 the California Insurance Commission seized Executive Life. In reaction to this seizure, insurance companies that had not participated in the high yield bond market lobbied for stricter constraints on high yield bond holdings. Insurance companies that did have junk bond exposure started to sell off their junk bond portfolios; they were loath to stand out from their competitors in their holdings of high yield bonds, many of whom were now trumpeting their minimal holdings of junk bonds as a competitive marketing point.
By this point there were not many people ready to take the other side of the trade. A broad range of investors spurned the market because it was considered imprudent. Everyone seemed to want to get rid of junk bonds, and the more prices dropped, the more they wanted to get rid of them. The low prices provided a confirmation that high yield bonds were an imprudent asset class. Rather than having the expected effect of increasing demand for the bonds, the price declines made the bonds look even worse than they actually were. Regulatory pressure and senior management concerns – not to mention losses on existing bond positions – stymied any traders who might have seen the emerging debacle as a great buying opportunity.
The result was a market laid to waste. Bond spreads widened four-fold and prices plummeted. The price drop was all the more dramatic because bonds, even non-investment grade bonds, are supposed to have much lower price volatility than stocks. By the time the dust settled, the impact on the market was equivalent to the US stock market dropping seventy percent.
Monday, July 16, 2007
The Blackstone IPO has focused attention on the fact that hedge funds and private equity funds have their fees taxed at the 15 percent capital gains rate rather than the 35 percent ordinary income rate. The ensuing debate has asked if these funds should receive favorable tax treatment. Wherever you come out in this debate – and I am too removed from the world of tax legislation to venture a yea or nay view – a starting point for answering this question in the affirmative is to establish that these funds are somehow different from other businesses. If they aren’t any different, then it is hard to argue they should be taxed differently.
Hedge funds are businesses in which managers are responsible for assessing a set of possible investments and allocating the firm’s capital to the best investments within that set. They are then rewarded according to the results of their decisions. That does not sound a whole lot different than what manager do in any other business. Granted fund managers are compensated for their results in a more formulaic manner than are those in most other businesses, but ultimately they are being compensated based on how well they manage the assets under their control, just as any other business manager is – or at least should be – compensated.
So if there really is a difference, it comes not from what they do, but how they do it. In particular, it must be based on the nature of the capital they use or the types of investments they make.
The typical hedge fund gets its capital from private investors. But then, so do a lot of other businesses – namely all those that are private. And for the larger hedge funds and private equity firms – the ones like Blackstone and KKR that are at the center of the tax controversy – the capital sources look a lot like any other public companies. They are tapping into the public equity market for capital, just like all the other public companies. And almost all of these funds have substantial leverage, so the majority of their investments are done using short-term debt. Some large hedge funds also issue longer-term debt, just as a host of other businesses.
So there is not much distinction between these and other businesses in terms of the sources of their funds. How about how they use those funds?
Well, there are a lot of different types of hedge funds, so it is hard to come up with a one-size-fits-all answer. As I argue in my book, A Demon of Our Own Design, hedge funds – and I would include private equity firms within the “hedge fund” moniker – are so varied in their strategies and the markets they follow that it is hard to consider them as a well-defined entity. But for present purposes, let’s look at two types of funds, those that do short-term trading, and those that do longer-term investments and private equity.
The funds that do short-term trading – those that do statistical arbitrage or high frequency trading – are providing a market making role. They are providing liquidity to the marketplace. In this function, they are not really different from the main business of the broker-dealer community. The managers at private equity firms and any number of the “deep value” hedge funds that do longer-term investing apply the same sort of analysis and premise for returns as the managers making acquisitions at Google, deciding to go through with a merger at Alcan, or growing a division at GE. They think a business is undervalued, or can be improved with better management or with a refocus of strategic direction, or can be combined with other assets to generate synergistic value.
There are many other aspects to this debate about the correct tax treatment for these funds. But it seems to me that a good starting point for allowing differential tax treatment is to demonstrate that these funds are different from other types of businesses. After that, of course, comes an argument about whether the difference is one that justifies a difference in taxation. But putting first things first, I would like to hear the opposing case to what I have presented here, that the hedge funds and private equity funds are spending their time and capital doing the same sort of thing that any number of other business are doing, and getting compensated in a similar way.
Tuesday, July 10, 2007
Reports of outsized hedge fund manager remuneration have been making the rounds. It started with a tally in Alpha Magazine that has been bouncing through the media like a pinball, “This year's list of 25 top-earning hedge fund managers make, on average, an altogether astonishing $570 million”.
But don’t believe the numbers.
It is easy to do the math to estimate a hedge fund’s revenue: If a $10 billion fund with the typical 2-and-20 structure has a great year, generating gross returns of 25%, it will generate $700MM of revenue – $200MM from the management fee and $500MM from the incentive fee. But to get the profits you have to subtract out the costs, and people seem to be forgetting this part of the equation.
Costs have gone up markedly over the past ten years. In the “old days”, the 1990’s, the manager did the trading and had a relatively modest support staff. Now large hedge funds are run with substantial infrastructure and with a stable of portfolio managers who get a cut of the action.
For example, one hedge fund on the Alpha Magazine list has 800 employees and over 90 portfolio managers. Each of these managers gets half of the incentive fee their trading brings in. Add to these costs the partnership shares of all those in senior management, and the revenue gets whittled down further. And, of course, besides these big ticket expenses for talent and staff, there are the cost of office space, communications and data feeds. Once you make adjustments, you can see that the reported numbers, based on revenue, are way too high.
Truth is, you can’t actually adjust for costs even if you want to, because estimating the largest costs – the incentive fees to the portfolio managers – requires information that is not available to anyone outside the fund. The problem is netting: if some of the managers do well and pull in a total of $5 billion while the rest generate losses of $2.5 billion, the fund will have gross returns of $2.5 billion, but there will be nothing left over after the portfolio managers who are in the black take their fifty percent split. Because of netting, a fund can be up for the year and still be operating at a loss. But to get a handle on the netting you have to know the revenue and payout structure for each of the portfolio managers. And that’s top secret.
So even if you know the cost structure, you cannot take revenue and get any sense of the net income going to the guy whose name is on the door. The estimates are likely to be inflated, or just plain wrong.
Sunday, July 8, 2007
It looks like we have dodged another bullet – Amaranth Advisors blew up last year with little if any collateral damage and now the failure of the Bear Stearns funds has likewise passed with barely a ripple. For the optimists, these are indications that somehow we have learned the lessons of LTCM, and the world is a safer place. So we can lever to the hilt, with the occasional failure leaving all but that fund’s investors – who, I guess, are viewed as getting what they deserve – intact. I am more of a pessimist by nature; that is probably why I have felt at home doing risk management. And if you look at these failures with that lens, the picture is not as rosy.
From the pessimists’ viewpoint, the concern is simple: When failures like these end up being contained, it emboldens us to take on more risk, even though the fact that they were contained indicates little if anything about the prospects for future market crises. After all, no one is arguing that every hedge fund failure will cascade into a systemic crisis.
As an analogy for my concern, consider one of the examples in my book: the Discovery Space Shuttle disaster. When the Space Shuttle was designed, I doubt the specifications called for foam debris hitting the shuttle during launch. But, of course, it happened. And each time it happened without any adverse consequences, it was viewed as less and less of a problem, until it got to the point that it became part of the accepted launch process. The more successful launches there were with the foam debris raining down, the harder it was for the engineers – the risk managers of the system – to argue their case that this was a design flaw of critical proportions.
The same will occur as we have hedge fund failures that do not lead to broader market crises. But it is even worse than the analogy suggests, because with the market, the lack of apparent risk will not just lead us to maintain the status quo, it will lead to taking increased leverage and allow for further complexity, making the crisis, if it does occur, that much worse.
My first answer is that I can’t really say. The problem with liquidity-driven market crises is that they depend not so much on the inherent volatility of a market as they do on the degree of leverage of those who are in the market that is under stress and what else they own. So it is difficult to trace the path and determine the ultimate impact of a liquidity event without knowing who owns what.
This point is best illustrated with the LTCM crisis. LTCM was an ultimate victim of the Russian default even though they had no exposure in Russia. The problem was that many of those who did have exposure in Russia during the default also held instruments similar to those that LTCM held.
But, that said, if someone pushes the point, (and it does happen), my focus for potential crisis is in the same arena where nine out of ten people are focused: mortgages and credit markets. I will discuss the credit markets another time, but given the recent events with subprime mortgages and the troubles at Bear Stearns, this market is worth a few thoughts now.
The mortgage market has the two characteristics I voice concern about in my book. Many mortgages instruments are complex, and many people in the mortgage market are levered. The leverage that is the greatest concern is not that of the hedge funds that trade in these instruments, but the leverage of the homeowners. Many homeowners push the envelope – in some cases misrepresenting their financial situation in the process.
Suppose interest rates climb a few percentage points, triggering increases in the monthly payments for those holding adjustable rate mortgages and some of the other exotic types of mortgages. And suppose that in the process the economy slows down, so that homeowners do not see the increase in their income that they anticipated when they took on the mortgage. We will see an increase in defaults and forced sales.
Most people want to have one primary home, but few want to have two, so prices might have to drop a lot to entice the buyers, especially if the prospects for speculative gains appear diminished. And a decline in housing prices can have a secondary effect for the market, because many baby boomers are using their home’s appreciation as a store of wealth for retirement. If they cannot pull in the cash they had anticipated from their home, their next stop will be their equity investments. If this happens, the result of a mortgage-driven liquidity crisis will be to depress the stock market. Think again of LTCM – if you have to generate cash and you can’t sell what you want to sell, you sell what you can sell.
What will be unusual about a mortgage-based liquidity crisis is that it will progress in slow motion when compared to the usual liquidity crisis. It could play out over the course of years; I would say it will occur in “demographic time”. This will not only be because of the time it takes for housing transactions and mortgage foreclosures, but because part of the equation really is demographic – the behavior of the baby boomers moving toward retirement.