Hedge Fund Schadenfreude...

Louise Armitstead of the Torygraph:

Hedge fund legends hit by financial crisis: Soon the Griffins boasted a dining-room chandelier by glass artist Deborah Thomas, two installations by potter-sculptor Edmund de Waal (including a complete room of more than 600 porcelain vessels), and an architectural version of a Morandi painting.... Tisbury, a $2.7bn (£1.35bn) event-driven fund... Griffin... archetypal hedge fund manager: aggressive, arrogant and nearly always right.... The latest bite of the credit crunch has caught Griffin offguard... down 8 per cent in the first two months of the year.... Hamstrung by the lack of liquidity... new terms with his prime brokers, beg for patience from investors and offered his business for sale to bigger rivals, including GLG Partners....

Peloton Partners, the award-winning fund run by ex-Goldman Sachs star Ron Beller, imploded. Focus Capital, another EuroHedge fund of the year, wound up days later... Carlyle Capital Corporation.... John Meriwether, the man behind the collapse a decade ago of Long Term Capital Market... JWM Partners is struggling with losses of 28 per cent this month.... "This is just beginning. Somewhere been 40 and 100 hedge funds will liquidate shortly. It's a bloodbath and it will get worse."

Already investors are showing their fury. One said: "I thought volatility was what hedge funds lived for? Making money, or at least preserving cash, during volatile times is certainly what we pay them for. They have been poncing around during the good times and are now found wanting at the first sign of trouble. It's a debacle out there.".... Hedge funds have been blamed for all market woes from the implosion of Bear Stearns three weeks ago, the collapse of HBOS's share price days later and now the weaknesses of the entire Icelandic economy....

Just a few months ago these were the best brains in finance. Now they are being exposed as average fund managers at best, and potential market manipulators at worse. How many more pretenders are there out there and how much more chaos will their demise bring to the rest of the markets?... Scrambling to cope with the next stage of the credit crunch, bank bosses ordered their prime brokerage and repo departments to comb through their books again and slash risk exposure. Lending lines have been cut, just as the funds needed them most to cope with the volatility.... While hedge funds have traditionally used two or three times leverage in their funds, this figure has been multiplied to eight or nine times in many cases - and even more in some. One prime broker said: "Hedge funds have had it easy. Every man in a pink Cadillac has been able to raise money, start a fund and do really well. Frankly, those who have taken the biggest risks have come off best because markets have been so extraordinarily kind."...

The leverage that magnified gains in the rising markets has had the same impact on the way down. Weaker funds were the first victims.... Beller... often boasted that Peloton was sailing close to the wind. "I once asked Beller how he would cope if the market suddenly turned and he was forced to mark to market. He said he'd be in trouble but that would never happen." Focus Capital... EuroHedge industry award... returning more than 100 per cent in 2006. O'Brien and Bubb told investors that they had been the victims of the credit crunch and short selling.... Endeavour Capital, run by former Salomon Smith Barney fixed-income traders... 27 per cent of the value of the $3bn fund had been wiped out... 18 times leveraged.... Platinum Grove, the $5.5bn New York-based hedge fund set up by former Long Term Capital Management co-founder Myron Scholes, fell 7 per cent... London Diversified had lost between 4 per cent and 5 per cent... founders, led by David Gorton, famously took £55m in management fees... in 2004...

What's really going on? What's going on is that perhaps $6T of mortgages with a duration of a decade that had been priced at a 1% per year chance of default (with a 1/3 value haircut in the event of default) are now being priced at a 4% per year chance of default. That's a loss of $600B in market value--and if your share of that $600B is greater than your capital, or is thought to be greater than your capital and so impedes your operations, you are gone.

But truth be told it is a zero-sum game--not a real destruction of wealth. The real rates at which cash flows of constant risk are being discounted haven't changed much: there hasn't been a big redistribution of wealth between the present and the future. What has happened was that a bunch of people believed that the default risk was 1% when it was actually 2% and reported gains of $200B (of which they took 2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and that now a bunch of people believe that the default risk is 4% when it is actually still 2% (unless, of course, the assembled central banks of the world fail and unemployment heads rapidly upward). So in aggregate hedge fund partners have gained $20B, hedge fund investors have paid$20B to their money managers for the privilege of losing another $200B that they never had, and there are $400B of transitory paper losses that will turn into real losses for those overleveraged and caught by the credit crunch and so forced into fire sales, and into real gains for those with steel nerves and liquidity.

Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression. But then we would have much, much bigger things to worry about than $600B of missing paper mortgage value. 4 years x 3 percent excess unemployment x Okun's Law coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in lost real wages, salaries, and profits. That's the thing to worry about.

Comments

[a]

"That's the thing to worry about." Is it? I thought the real problem is that Americans are overconsuming by x trillion per year and every time it looks like they may finally be adjusting their overconsumption, economists scream "Recession!" and try to keep them spending, because otherwise the economy would go do down. More and more debt works, until it doesn't. It doesn't when suddenly everyone realizes at the same time that no one wants to lend any more money to the deadbeat in the neighborhood. It's true of hedge funds, and it's true of nations, even those with reserve curencies (Don't cry for me America).

Incidentally there are hedge funds failing which had nothing to do with mortgages. The linked article mentions one hedge fund (Focus) which invested in illiquid companies. So the analysis provided is, I'm afraid, off the mark and is not explaining what is "really going on".

[Benjamin]

As Warren Buffet says "You only find out who is swimming naked when the tide goes out."

[craig tindale]

To lose real wealth there had to be a gain in real wealth in the first place inflating housing by transmitting money to the consumer via the monetary transmission channel in order to bait the consumer via teaser rates into using the home equity atm because they were fooled by the wealth effect, Bernankian "cheap talk" inflation targeting, money financed tax cuts to transmit more money to the consumer to spend in Walmart, bogus enronesque cpi , unemployment and GDP government data, labor arbitrage via the smoke screen of free markets, instead of centrally planned production centrally planned consumption, socialism for investment banks, monetary measures instead of fiscal measures, delusional productivity

So how do we keep social insurance if we provide investment bank insurance, how do we keep it in any case if we measure worker output in consumption terms, should we tax speculation and the same as productive investment, how do lean toward budget surplus low tax productive investment, when monetary madness

Put Felix, Bernanke in a Barro and Weil it to the cliff and drop it it into the abyss

Pimp up Solow and run it on the endogenous freeway

Bring back a Volkerain Fed to stare down Washington

And grit your teeth cause yes this is a depression and everything thats been won could be lost.

Brad its a war stop wasting your time and intellect on the press

One of you guys is gotta come down from their ivory tower call and tell it how it is.

and you know whats at stake :)

[John Emerson]

"What has happened was that a bunch of people believed that the default risk was 1% when it was actually 2% and reported gains of $200B (of which they took 2-and-20 on the hedge fund slice, perhaps $20B, for themselves), and that now a bunch of people believe that the default risk is 4% when it is actually still 2% (unless, of course, the assembled central banks of the world fail and unemployment heads rapidly upward)."

I don't think that people in finance are capable of understanding how much the commoners hate them. And because we don't understand finance, by definition we don't know who exactly which financiers it's appropriate to hate.

We've just been trying to go about our lives at our own modest level, fully aware that we're at the mercy of the larger forces within a larger system we don't understand.

And we know that some of the people in charge of the larger system (Greenspan and the free-traders) have been jimmying the system for ideological purposes, and we know that a lot of the players in the system (the actual players) have been cashing in by playing fast and loose under rules they succeeded in rewriting and which no one really understands -- promising people the moon while prancing around bragging about their own profits.

And we know that a lot of the malefactors have succeeded in protecting their own wealth when the people dependent on them have lost theirs. (For an egregious, local, small-time example Google Andrew Wiederhorn, who was not a big player but did succeed in looting a union pension fund, and who us still doing very well for himself after his release from prison).

And some of us know that we have benefited at times from the games of finance. But for us, a gain and a loss of equal dollar amount are not of equal value. $40,000 a year is somewhat better than $30,000, but $20,000 is much, much worse. Diminishing marginal utility, etc.

I have heard economists speak of the plebian overvaluation of losses and undervaluation of gains as an irrationality (or even worse, as a kind of ungrateful selfishness.) But this just shows us that economics is a defective and biased science which only sees large collective entities, and not actual individual human units (or even large actual groups of individual human units.)

A lot of us just want to stay in the game of life at a modest level. We really don't need to "get ahead". If riverboat-gambler economists succeed in jimmying the common system to the advantage of themselves and their gambler friends, and to the disadvantage of the rest of us, resentment ensues and we look for our torches and pitchforks.

And granted, nothing very bad has happened yet. While Armistead seems sublimely unaware of the possibility that anything really bad might happen, Brad's last sentence seems to admit that possibility.

We all know that we'll be the last to know.

[christofay]

Poor Ben Bernanke spending like a drunken Republican drifted into his crisis. The first year he had to establish some domination after A Greenspan's record setting tenure. The second year there was no reason to get excited until it was holy heck what happened to summer vacation.

The banks are being saved cause if they went down it would be like stopping traffic on the Mississippi, shutting down the electricity grid, or the sun coming up tomorrow. "Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression. But then we would have much, much bigger things to worry about than $600B of missing paper mortgage value." Between the FHLB and the Fed they have bought enough stuff to be well on the way to $600B. The missing $600B or the bearers of it go without.

Some worthy from Poughkeepsie wanted to convene a committee to save the people but perhaps can only aid the innovative financial system. She blew the politics of establishing this super structure by showing her hand too early, she wanted to include two guys from the WWF, one to wrestle inflation and one insolvency.

"February California median home prices declined $20,550 to $409,240. Median prices are now down $67,140 in two months and a stunning $179,730 since August. Prices are down 32% from June’s high, and are now even 13% below the level from three years ago. Granted, these median prices are impacted by the dearth of sales at the upper-end. Yet it’s clear that the California market is in the midst of an historic crash. The Credit standing of Golden State households, businesses, and various governmental agencies now deteriorates virtually by the day. I would argue the explosion over the past three years in “private-label” mortgages, Wall Street balance sheets, hedge fund assets, and California home prices were all part of the same Bubble. This Bubble inflated largely outside the banking system and outside GSE finance – and will now prove stubbornly unaffected by policy maneuvers. "

http://www.prudentbear.com/index.php/CreditBubbleBulletinHome

I'm failing to feel the positivity. The Prudent Bear site often featured a quote from craggy Charlie Munger, "eight thousand hedge funds were started last year, there aren't that many smart people on Wall St."

[christofay]

I have one name for you, Pallson.

[christofay]

Really, only Marvin Gaye asks "What's going on?"

Really, "Hedgestock"?

"There were talks and meetings like any normal business conference, except the grounds were decked out as if it were a 1960s music festival, with the additions of a polo field, laser clay pigeon shooting range, hot-air balloon station and remote-controlled duck racing, while 4,000 delegates were dressed as hippies and danced to a live performance by rock giants The Who."

The next paragraph goes vertical with the satire including Prince, Bill Clinton, Madonna, We are the World, and Liz Hurley.

"Every man in a pink Cadilac"

"Ain't it hard out there for a pimp."

[Neal]

(quote)
....Unless, of course, Ben Bernanke and company fail to contain the crisis, and we wind up in a severe depression. But then we would have much, much bigger things to worry about than $600B of missing paper mortgage value. 4 years x 3 percent excess unemployment x Okun's Law coefficient of 2 x $13T economy means a $3.1T cumulative Okun gap in lost real wages, salaries, and profits. That's the thing to worry about.

(end quote)

Well, given that the US has gotten used to a trillion dollars a year pumped in through MEW from real estate inflation, and there was all of that new housing construction on top of that with all of it's jobs and spending and taxes,etc, etc it seems to me that Okuns gap is here now--every year. That is the crisis for most people. It is made worse by the reckless financial innovations of the financial sector which is collapsing like the house of cards it was.

[curmudgeonly troll]

Well, the Torygraph also says that Al Gore is poised to take the Democratic nomination.

http://www.telegraph.co.uk/news/main.jhtml?xml=/news/2008/03/30/wuspols130.xml

The hedge fund growth has much in common with the dot-com bubble. In '99 every HBS grad wanted to start a dot-com, the last couple of years they gravitated to hedge funds. And in each case, why not? if you make it you're set for life, if not it's someone else's money. But also like the dot-com bubble, enduring technological and structural changes are afoot. A couple of smart guys can compete with large investment firms, just as a couple of smart guys in a garage can sink Microsoft and Yahoo. It's now 2000, and the late and foolish are starting to get their comeuppance.

The banks and mortgage companies, enabled by Wall Street, created the crisis with widespread foolish and fraudulent practices. (see for instance http://digg.com/business_finance/Dear_Citigroup_Customer )

Hedge funds, by and large, take risks other people don't want, at the right price, and cushion volatility. (although some are momentum players or may engage in nefarious practices.) It's a stretch to link them to the mortgage crackup, other than that they're both boosted by changes in technology and deregulation.

[Bruce Wilder]

I have been doing some back-of-the-envelope arithmetic, and I think you are off a bit, in your premise.

I think the mortage paper loss is better estimated at $1200 billion ($1.2 trillion) or twice your guesstimate. I don't think I am being unnecessarily pessimistic or factoring in any positive feedback from the inevitable recession. It is a weighted distribution, with a lot of more recent mortgages written on houses with no equity cushion. The weight of fraudulent loans and faulty securities is skewed in a way that brings a bit more of the $6 trillion decline in house values down upon mortgages and mortgage-backed securities of recent vintage.

[Bruce Webb]

Wilder what index are you using? Because everyone else seems to be using Case-Shiller which to me seems horribly flawed by being overweighted to bubble markets as well as some less than transparent weighting within the model.

If you go down the list of top twenty cities or Metropolitan Statistical Areas and then compare that to C-S you end up with some huge omissions, and ones that tend to have been more stable housing markets. C-S includes three markets in California yet only one in Texas. Case Shiller covers two markets in Florida but none in Pennsylvania. If you examine the map (page 2) you see a very odd phenomenon:
http://www2.standardandpoors.com/spf/pdf/index/SP_CS_Home_Price_Indices_Factsheet.pdf
Apparently there are no property concentrations on the Mississippi south of Minneapolis, no body lives in the Missouri River Basin or for that matter the Ohio River Basin, upstate New York and the upper Plains are both howling wildernesses. But by God you got Las Vegas (no 36 MSA or was) even though C-S misses Philadelphia (no 4) DC (no 7) and Houston (no 8).

Or if you are drawing from some other source to get that $6 trillion figure please give me a link. Because just about every number I see cited ends up one way or another falling back on C-S. Which to me seems to be the classic case of GIGO.

Because near as I can see people are measuring declines in house values based on a skewed model

[anonymous]

I think Bernanke has done a pretty good job and has been very responsive and in-tune to daily changes in the economy and market.

Okun's law is an interesting reference. I am not super familiar with it. How does "overemployment" figure into Okun's law? (that is where we have an excessive proportion of people that make poor decisions put in charge of people who would make better decisions - allocate resources or run jobs & organizations more effectively].

[anonymous]

One more: schadenfreude may not be a great emotion for long-term health.

[anonymous]

http://www.finalternatives.com/node/1416

Recap of total liabilities at a sample of large, fin svc organizations as of most recent balance sheet available at yahoo finance today

Bear Stearns - $384 billion
Lehman - $669 billion
Merrill - $988 billion
Morgan Stanley - $1,014 billion
Goldman Sachs - $1,077 billion
Citigroup - $2,074 billion

Summary: around $6 trillion plus in total liabilities for these 6 organizations alone (average of $1+ trillion per orgz) (you might check my numbers)

[Maurice Lanselle]

"$6T of mortgages with a duration of a decade "

-- the average duration of 30-year mortgages would be 50% longer, fifteen years, and
-- with the "increases in property value" and ensuing selling price increases in the recent past, those due in 25-29 years probably outway those due in the next few by a whole lot.

If you recalculate with $2T at a duration of five years and $4T (or more) at twenty years, do you arrive at the same conclusion?

[Robert Jennings]

I think that Brad's analysis of hedge funds is good, but I think his estimate of default probabilities fails to recognize how much the US household has also been increasing their leverage, sorta like hedge funds . The last time I looked at the Fed's Z1 I calculated that aggregate indebtedness (all sectors)was at something like 320% of GDP, up from something like 170% in the mid '70s. I think indebtedness (leverage) not only changes the severity of financial outcomes when things go badly but also the likelihood. I'm speculating that one of Bens' problems is how you deleverage an over-leveraged economy with falling prices.

[anon]

"I'm speculating that one of Bens' problems is how you deleverage an over-leveraged economy with falling prices."

And how you get creditors who may gain in a deflationary environment (real estate anyways) to spend to offset the reduction in spending from debtors who may have less to spend in a deflationary environment.

[Hedgefundguy]

I think Brad has only part of the picture.

"What's really going on? What's going on is that perhaps $6T of mortgages ... are now being priced at a 4% per year chance of default."

This unraveling applies to much more than just the US mortgage market, and it's bigger than even the credit market.

For example, the story he links to starts with the troubles of Gerard Griffin. Gerard is a risk arb guy - he bets on the chance of mergers going through (and other special situations). Credit spread widening has meant many mergers won't necessarily go through at the original terms and severely dampened prospects for future deals. Internal political gambits can backfire at a time when investors are generally antsy.

Paul Matthews at Endeavour in London... He's been around virtually since the inception of bond arb. But the fund got too big too early in a relative value trade that ought to have been very liquid. After the Bear news the box spread gapped through his stop and there was just no one to take the other side. Normally banks will make prices for reasonable size, but marketmakers have zero appetite for risk in an environment where there are doubts even about the solvency of many institutions.

Carlyle Capital got stung on their very-levered holdings of agency paper. In theory the government backing is only implicit (in other words they certainly could default). But as a market participant I can say that the blowout in agency spreads vs Treasuries owed more to forced liquidations and a flight to liquidity than a genuine repricing of prospective defaults. Ginnie Mae debt (which unlike Freddie and Fannie, is fully govt backed) also widened out to extreme levels vs UST (200 bps over)

Stat arb/quant funds blew up last summer and have had a difficult time this year because it turned out most funds had similar strategies long and short and we were going through a period of aggressive deleveraging.

So this is more than just a repricing of default risk. From 2003-2007 we experienced a period of very low volatility, synchronised markets when every asset went up (the lower quality the better) and that saw unprecedented flows into the hedge fund industry. The more leverage you use the better the returns and end-investors always tend to chase returns.

Now we are seeing an unwinding of this whole cycle. Implied volatility will continue to rise for the next five years and any business model depending on much leverage is likely to be severely tested. The pendulum is swinging back to investors who don't need much leverage to generate acceptable returns.

Brad ought to try bringing out his inner Austrian again. There has been an incredible destruction of real wealth. The false rally in credit markets drove capital away from higher-valued uses (capex in resources and infrastructure) toward lower-valued uses (bubble-era residential and commercial construction ... not just the US - in Spain, Ireland, E Europe too). Now there is some scrapping of incomplete projects, plenty of completed projects that should never have been built and we still have to spend a couple of trillion dollars on mining, agriculture and infrastructure.

It's an interesting observation that just like in the 20s when the Austrians were the only ones to catch on to the magnitude of the crisis, the same has been true this time round. Frank Shostak and Gerard Minack made you money getting you long Eurodollar calls and fed fund futures last summer... I'm not sure the Chicago-school guys did quite so well.

[Dave]

Looking at that Okun gap calculation, I just have to remark it'd be a real shame to have a 3T USD problem in financial markets (which, in principle, are positive sum games) come at a time when the country's already engaged with another few T USD problem in military adventures (which, in principle, are never better than negative sum games).