By all accounts, Jeff Larson wasn’t the type to flirt with disaster. As the leader of Sowood Capital Management, a $3 billion Boston-based hedge fund, Larson was known as a prudent investor whose reputation had earned him a client roster of foundations and endowments, among them his former employer, Harvard Management Co., which topped the list with a $500 million initial investment. To fulfill his fiduciary responsibilities, Larson picked companies with strong balance sheets and highly collateralized senior debt, confident that their fundamentals would let him quickly unwind his positions should the markets decline. So sure was Larson of his strategy that he funded the majority of those positions with borrowed money, a method that had given him three consecutive years of 10 percent gains on average.
But in a matter of days last July, Sowood was sapped of more than half its assets, forcing Larson to sell off the remainder of his decimated portfolio to Chicago-based hedge fund Citadel Investments and return what he could — $1.4 billion — to his stunned investors.
“Jeff Larson was as honest as you can get,” affirms Hilary Till, co-founder and principal of Premia Capital Management, a Chicago-based proprietary investment and research firm. “That is why the collapse of Sowood was so startling.” Till says the sudden demise of Sowood had a canary-in-the-coal-mine urgency to it: Because of the fund’s relatively small size, Larson should have been able to unwind its positions at nondistressed levels.
“But that’s not what happened,” says Till, who knows Larson from her days as a quantitative analyst at Harvard Management in 1992 and 1993. “Right then, I knew there must be a wider, more systemic problem brewing.”
Indeed, the failure of Sowood was one of the first indicators of a major shift in the risk tolerance of the markets, as uncertainty over the U.S. housing market raised fears among investors 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 firm 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.
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 firms 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 that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it.”
Although a fortunate few may profit from the uncertainty, there are always more losers than winners, Zehner notes. Hedge funds’ ability to mask trading positions and to hide assets and capital that could serve as a buffer against market shocks can ultimately contribute to the instability. “When a hedge fund blows up, it renews fears among investors that things are happening that they don’t fully comprehend,” says Bruner. “Information asymmetry, in short, amplifies anxiety.”
An asymmetry of information was also partly to blame for the ripple effect between the subprime mortgage and the hedge fund markets, says the IMF’s Dodd. The inability of markets to immediately identify the nature and location of the huge subprime risk — again because of the inscrutable nature of big hedge funds — led inevitably to a sudden shift in risk assessment.
“Once overly optimistic about the risks of the subprime market, scared and confused investors suddenly panicked and overestimated risk, shunning even senior, investment-grade tranches,” Dodd explains.
This process, brutal and swift, caught even the best managers — Jeff Larson and Peloton Partners included — completely off-guard.
The future promises similar turmoil unless transparency in hedge fund pricing becomes the norm, says Craig Asche, executive director of the Chartered Alternative Investment Analyst Association, an Amherst, Massachusetts–based trade group. For instance, all the trouble with CDOs was exacerbated because there were no market prices to serve as benchmarks and no way to determine the value of the various risk tranches.
“The question is, ‘What is appropriate?’” Asche says. “How does someone mark to market something that at one point may have been trading on a fairly regular basis but is no longer?”
In situations where there are multiple bids and a large dispersion between the bids, Asche says managers need to be able to see the prices at which similar securities have traded. They also need to compare the bids against their models, using a variety of methods to make sure the prices make sense. Asche believes that market forces will require hedge funds to offer such detail sooner or later.
“If investors understand the process, they will be comfortable,” he explains. “The difficult part for fund managers will be trying to anticipate all the possible variations they may have to face down the road, rather than doing it on an ad hoc basis.”
TRANSPARENCY, HOWEVER, ISN’T ENOUGH. It’s imperative that hedge funds curb their leverage habit as well, some critics say. Like many hedge funds, Sowood relied heavily on borrowed money, at one point exceeding ten times available capital. (Typical hedge fund leverage in the purchase of high-yield tranches is about five times available capital.) Whatever liquidity Larson believed he had proved irrelevant.
The hedge funds that failed to survive the liquidity crisis had one thing in common. “Specifically, these hedge funds had relatively short financing or redemption terms compared to peers, particularly in strategies that involved illiquid or significantly levered assets,” says Callan Associates’ McKee.
Though Sowood’s holdings fell irrespective of quality — thus undermining the fund’s “beta neutral” strategy, which was meant to mirror the broader market — the losses were worse because of Larson’s heavy use of leverage, particularly when he was forced to sell securities bought on margin. By comparison, hedge funds with longer-term financing were in a stronger position to stay the course, notes McKee. “The ultimate measure for each and every fund,” he says, “is the long-term resolve of its investors and lenders.”
A case in point involves the respective outcomes of the highly leveraged Sowood versus the sufficiently risk-capitalized Citadel, which profited handsomely from Sowood’s demise. (Citadel picked up about $4 billion in Sowood securities at a 20 percent discount to face value; in 2007, Citadel, led by CEO Kenneth Griffin, chalked up gains in excess of 30 percent, compared with an industry average of 12 percent.)
At a recent conference titled “The Myths and Reality of Managing Liquidity Risk,” Bjorn Pettersen, a risk management expert with Chicago-based consulting firm CRA International, said during a presentation that it was obvious that better-financed funds like Citadel are on firmer ground than are certain others. “Any hedge fund that is highly leveraged and is really depending on the prime brokers for funding, unless it has some massive liquidity pool, is going to be in a world of trouble,” he said.
The problem with constantly borrowing to multiply returns is that managers require a continuous intake of investment capital, explains Donald Brownstein, CEO and founder of Stamford, Connecticut–based hedge fund firm Structured Portfolio Management. “And if the tide starts going out, the risk premia will go up, spreads will widen, and the dimension of leverage you’ve chosen will determine how exposed you are to that widening.”
The bigger danger, Brownstein says, is that returns generated exclusively with leverage tend to promote even greater use of leverage. “That’s because your spreads are going to tighten and you’re making more money, so therefore you have to invest more money, which tightens the spreads even further,” he says. “All this money is actually causing volatility to drop, and since it looks like the risk has been reduced, why not take more of it? So you do it again and again and again, until one day — snap! — the rubber band finally breaks.”
The calls for less reliance on leverage and for more transparency are joined by demands for greater government oversight — a clamor that has grown as the hedge fund risks have become more widely publicized. In London an industry-backed governance code championed by Sir Andrew Large, a former deputy governor of the Bank of England, is aiming for hedge funds voluntarily to disclose more information — such as what strategies are used to withstand sudden market jolts — in hopes of fending off more-stringent governmental regulation. But the U.K.’s Financial Services Authority is arguing that tougher rules are required, and the agency plans a review of a cross-section of hedge funds “to assess formally their market abuse systems and controls.”
The IMF’s Dodd agrees that the industry should consider applying universal limits on leverage and on complex derivatives to determine if such oversight could help prevent market catastrophes. Policymakers should also consider establishing reporting requirements for hedge funds, he adds, as well as extending measures obliging dealers to act as market makers to prevent the rush to cash out that started last summer’s meltdown.
But although regulation may solve some problems, it has the potential to create others, says MIT’s Lo. “If we were simply talking about preventing fraud or limiting leverage, regulatory changes may be effective,” he explains. “However, hedge funds now provide an extraordinary amount of liquidity to the global financial system, and because they’re unregulated, they can withdraw that liquidity without notice.”
This may be benign if it occurs rarely and randomly, but Lo — who founded hedge fund firm AlphaSimplex Group in 1999 and sold it last year, though he remains chairman and chief scientific officer — says a simultaneous withdrawal of liquidity across an entire sector of hedge funds could have disastrous consequences for the financial system. Government crackdowns, he adds, may only make things worse: “If we attempt to impose regulatory requirements on their provision of liquidity, we risk driving them offshore to jurisdictions with less stringent regulations.”
Instead, Lo advocates establishing what he calls a capital markets safety board, a group that would be made up of accountants, lawyers and financial professionals. By monitoring systemic risk, studying financial blowups and developing guidelines for improving methodology and modeling, such a group could offer a more direct way to deal with the systemic risks of the hedge fund industry, he argues.
Nor, he says, should a tightening of lending standards be out of the question. Critics like William Gross, chairman of Newport, California–based bond giant Pacific Investment Management Co., have railed perennially against what they call Wall Street’s shadow banking system and its arcane menu of securitized-debt products, which were good enough to pass muster with rating agencies despite the ambiguous value of the underlying assets.
The CAIAA’s Asche says he can only agree.
“These lenders got a bit too complacent with what was at the time a very comfortable liquidity environment,” he asserts. “They did make a lot of transactions that didn’t make much sense from a fundamentals standpoint, and the assumptions on which they were based were much too optimistic. When the pendulum swings, it tends to swing too far in one direction.”
Because it is profitable to lend — and equally profitable, if not more so, to borrow — Darden’s Bruner predicts a return to liquidity normalcy before long. He avoids, however, putting a specific time frame on the change and says it will be accompanied by greater attention to risk management and more transparency between lenders and hedge funds.
The bottom line, Asche notes, will be a smaller appetite for complexly structured products. “Anyone who has a fiduciary responsibility as an institutional investor has to err on the side of caution,” he says.
But it is hardly as if hedge funds are suffering from across-the-board flights of capital, and not all institutional investors agree with Asche. Michael Travaglini, executive director of Massachusetts’ Pension Reserves Investment Management Board, says he isn’t giving up on alternatives investing just yet. Despite losing $30 million in the Sowood collapse, the Massachusetts fund ended 2007 up 11.9 percent, well above its annual target of 8.25 percent.
“I know people don’t like to hear this, but you can have a situation like Sowood, and there aren’t always real lessons to be learned,” says Travaglini. “Obviously, if Jeff Larson knew what was going to happen in advance, he would have acted much differently. But that’s the intrinsic challenge of investing: We don’t always know what’s going to happen tomorrow.”
Lo thinks that even if much-needed changes are made, market globalization all but ensures more shocks like last summer’s. “We’ll never be able to eliminate such risks entirely,” he says. “But we can certainly improve the way we handle them by educating the public.”
Additional reporting by Staff Writer Imogen Rose-Smith.
