Financial Times Warns of Impending Derivatives/Hedge Fund Meltdown

Financial Times commentator John Plender warns: … “[C]ollapsing standards will now stretch out the credit cycle while ensuring the delayed downturn will be more savage when the defaults finally happen. This subverts the argument that structured products uniformly enhance market efficiency. Credit is being mispriced, courtesy of credit rating agencies that are insensitive to market risk. Stand by for systemic consequences in due course.”

The consequences of credit's alchemical transformation, FT Alphaville, 5/22/07: High finance has never been more sophisticated. Bankers have never been more clever. Yet huge problems are emerging from the deterioration of lending standards – and at their heart lie the rise of structured financial products and the role of credit rating agencies, say FT commentators, beginning with John Plender in Tuesday’s Insight column. …

So what is the explanation for such apparently aberrant behaviour?

“At one level, it is simply that banks no longer have to worry about loan quality in securitised markets where the loans they originate are immediately sold. So the more pertinent question is, why do investors buy from the banks?”

“The answer, as Henry Maxey of the Ruffer fund management group argues in a forthcoming paper for the Centre for the Study of Financial Innovation, is that Wall Street has solved their most pressing problems with its invention of structured products.”

Take the hedge funds, says Plender, in which conventional investors such as pension funds invest increasingly via hedge fund of funds. “These intermediaries typically aim for positive returns of 1 per cent a month, net of fees, with low volatility. If the hedge funds they back fail to deliver on 3- to 6-month performance figures, they are culled.”

“The hedge funds need to make about 20 per cent gross a year, before a welter of fees, to provide that 1 per cent a month for their backers. Such a spectacular return can be gained either by market outperformance, which is beyond most fund managers, or by taking on leverage through borrowing, or trading in derivatives. For most, that means adopting leveraged strategies in illiquid assets,” he writes.

Structured credit products are tailor-made for this task, says Mr Plender. Collateralised debt and loan obligations (CDOs and CLOs) invest in poor-quality assets such as subprime mortgages or loans to super-leveraged buy-outs, and sell matching liabilities to investors (see Gillian Tett’s Market Insight column on the effect of collateralised debt).

“Yet the sale involves an alchemical transformation,” Plender writes. “The package is sliced and diced into high- and low-risk tranches, with usually up to 80 per cent being rated Triple-A or AA and the residue being very lowly rated or unrated.” For pension funds and managers of official reserves, the resulting high-grade paper is a boon at a time when Triple-A corporate borrowers have dwindled, he notes.

“For hedge funds the low-grade paper, which provides a cushion against default risk in the high-grade tranches, is likewise a boon, especially since, as Mr Maxey points out, it lends itself to arbitrage whereby hedge funds take long positions in the high-risk tranches and short positions in the low-risk tranches, which are relatively expensive. This ought to increase market efficiency since more investors can buy into a given pool of low-quality credit-enhanced assets.”

“The peculiarity of this trade is that profit is never arbitraged away in the benign phase of the credit cycle because positions are not constantly marked to market. Their illiquidity requires them to be marked to a model approved by credit rating agencies. But rating agencies, who are paid by those who they rate, do not adjust ratings to reflect deteriorating economics. They close stable doors after profligate horses have bolted.” (See the FT’s recent analysis of how the Big Three rating agencies are handling their job in the fast-growing and complex market for structured finance) …

See also Michael Panzner's Things Can Go Wrong , Financial Armageddon, 5/18/07

Comments

[Eric]

The safest thing to do is to put your money in the old maxwell house investment can under you bed. That way you know that its going to be there everyday.The Banks are making money on your money and paying you zip. Money is power, Denying that power to a bank is your right. By not driving to the bank to deposit your money will save you money in the gas prices of today. Saving money is making money.

Thank you.

[Hedge Fund Consultant . Richard Wilson]

Most sophisticated investors such as institutional consultants, pensions, endowments, foundations, and the ultrawealthy are INCREASING not decreasing their allocations to hedge funds.

- R

[Hedge Fund]

We are coming up on a year after this article was written now and hedge funds are outperfroming banks, most mutual funds and equity benchmarks but there are still doomsday predictors out there who are sure all 10,000 hedge funds are going to collapse and go away. I just can't swallow it, there are too many managers out there with diverse strategies for that to ever happen. Here are a couple articles I have written on this topic:

http://richard-wilson.blogspot.com/2007/10/fund-of-hedge-funds.html

http://richard-wilson.blogspot.com/2007/10/hedge-fund-managers-pedigree.html