Friday, July 20, 2007

Credit Risk – Lessons from the Junk Bond Crisis

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

Tax Treatment of Hedge Funds and Private Equity Funds

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

Hedge Fund Billionaires

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

Dodging Bullets

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.

What sorts of crises am I worried about now?

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.