Minsky Moment: Hundreds of Hedge Funds Hang in Balance

Nouriel Roubini calls it a "Minsky Moment". I'll not argue. Here's Roubini:

[Are We at The Peak of a Minsky Credit Cycle? Nouriel Roubini] … The Minsky idea of loosening of credit/lending standards among mortgage lenders – and the phenomenon of supervisors/regulators falling asleep at the wheel while the reckless credit bubble occurs – is also now evident in the recent mortgage credit cycle. A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. The toxic waste aftermath of this bust includes more than fifty subprime lenders gone out of business this years, soaring rates of delinquency, default and foreclosure on subprime, near prime and non-conventional mortgages, and the biggest housing recession in the last few decades with now home prices falling for the first time – year over year – since the Great Depression of the 1930s.

While the process of releveraging started in the household sector – that is the most financially stretched sector of the US economy – the releveraging more recently spread to the corporate and financial system: in the financial system the rise of hedge funds, private equity and speculative prop desks led to a sharp rise in the financial system leverage. In the corporate sector given the cheapness - until recently - of credit we observed a massive process of switch from equity to debt that took the form of leveraged buyouts, share buybacks and privatization of formerly public companies. This releveraging fed that equity/asset bubble: as expectations of more LBOs occurred equity valuation of many firms went higher and higher. The excesses took recently the form of premia of 40-50% or higher on the stock price of firms that were a leveraged takeover target. Specifically, CLO demand for corporate debt helped fuel the private equity sponsored LBO wave over the past few years, and thus contributed to the recent bull market in equities. Notice also that the amount of issuance of low grade corporate bonds (below investment grade "junk bonds") had been rapidly rising in the last few years.

While pure "Ponzi" borrowers were not as common in the corporate system, there is wide evidence of “speculative borrowers” who relied and still rely on continued refinancing of their debts. Ed Altman, a colleague of mine at Stern, is recognized as the leading world academic expert on corporate defaults and distress. He has argued that we have observed in the last few years record low default rates for corporations in the U.S. and other advanced economies (1.4% for the G7 countries this year). The historical average default rate for US corporations is 3% per year; and given current economic and corporate fundamentals the default rate should be – in his view - 2.5%. But last year such corporate default rates were only 0.6%, one fifth of what they should be given fundamentals. He also noted that recovery rates - given default - have been high relative to historical standards.

These low default rates are driven in part by solid corporate profitability and improved balance sheets. In Altman's view, [PDF] however, they have also been crucially driven - among other factors - by the unprecedented growth in liquidity from non traditional lenders, such as hedge fund and private equity. Until recently, their demand for corporate bonds kept risk spreads low, reduced the cost of debt financing for corporations and reduced the rate of defaults. Earlier this year Altman argued that this year "hot money" from non traditional lenders could move to other uses for a number of reasons, including a repricing of risk. If that were to occur, he argued that the historical patterns of default rates - based on firms' fundamentals - would reassert itself. I.e. we are not in a new brave world of permanently low default rates. He said: "If we observe disappointing returns to highly leveraged and rescue financing packages, some of the hedge funds may find it difficult to cover their own loan requirements as well as the likely fund withdrawals. And broker-dealers who are not only providing the leverage to the hedge funds but whom are also investing in similar strategy deals will recede from these activities." The same could be said of the consequences of the unraveling of some leveraged buyouts. Altman suggested that triggers of the repricing of credit risk could also be "disappointing returns to highly leveraged and rescue financing packages". So he argued that the unraveling of the low spreads in the corporate bond market could occur even in the absence of changes in US and/or global liquidity conditions.

Thus, until recently the Minsky "speculative borrowers" in the corporate sectors included corporations that could service their debt only by refinancing such debt payments at very low interest rates and financially favorable conditions. While "Ponzi borrowers" were those firms that, under normal liquidity conditions, would have been forced into distress and debt default (either of the Chapter 7 liquidation form or Chapter 11 debt restructuring form) but were instead able to obtain out-of-court rescue and refinancing packages because of the most easy credit and liquidity conditions in bubbly markets.

The Minsky phenomenon of loosening credit and lending standards during a credit bubble included both the corporate borrowers and financial institutions. First, there are clear parallels between the mortgage market and the leveraged loan markets. These include corporate borrowers’ high leverage ratios, declining credit standards ("cov-lite"loans instead of subprime), PIK (or payment-in-kind) deals (variants of negative amortization), insufficient monitoring by lenders due to the "originate and distribute" model (loans repackaged into CLOs instead of CDOs), banks' retained exposure (bridge loans as opposed to CDO equity tranche). In the financial system, margin requirement for hedge funds and other leveraged speculators became lower and lower as the competition for prime brokerage services for hedge funds among lenders became fierce.

Housing bubble, mortgage bubble, credit bubble, debt bubble and asset prices (equities, housing, prices of corporate debt and other risky loans) rising well below what could be justified by the economic and credit fundamentals. It certainly looked like a typical Minsky Credit Cycle. The first crack in this cycle was the bust of housing and of subprime mortgages in the US. The second crack was the spread of the subprime carnage to near prime and prime mortgages and to subprime credit cards and auto loans. The third crack is the most recent repricing of risk in a variety of credit markets and the beginning of a credit crunch in the LBO and corporate credit markets.

For spice let's also air this prediction from Roger Ehrenberg at Information Arbitrage that hundreds of Hedge Funds may soon be 'toast':

[Sowood, So Long. And Not Short Enough. Roger Ehrenberg] … Sowood [is] simply the next in the parade of likely credit hedge fund blow-ups. Exactly how many funds will be laid low by the current credit markets ugliness? I'd hazard a guess that the final count will be in the low hundreds. …

… Sowood was a Day 1 $2 billion launch by Harvard Management rock-star Jeff Larsen. This is not some greenhorn tossing around huge institutional dollars without having any inkling of what they should be doing. This was JEFF LARSEN. Of the super-successful Harvard Endowment? Right - you know the one. Don't you think Mr. Larsen knew better than to place so many concentrated and statistically-related bets such that, if all hell broke loose, he'd drop 50% of his NAV in a month? I'd think so. But then, I'd be wrong.

I guess if it can happen to LTCM and its brain trust it can happen to anyone. But didn't Mr. Larsen learn from LTCM? Or, more recently, Amaranth? What is driving these types of behaviors? Unhappy with a few years of mediocre returns and trying to shoot the lights out? I'd bet a lot of money that Sowood's true NAV didn't drop 50% in a month - it actually dropped a lot less. Why? Because it really began dropping well before last month, it is simply that positions weren't marked to true liquidation value but marked-to-model. I will almost guarantee you that this high-profile blow-up will cause many to revisit this issue - and fast. This kind of practice causes artificial stability in both position values and fund NAV, and generally provides a false picture of risk as well as possibly resulting in excess manager compensation. Autocorrelation - the smoothing of returns - is a big no-no, and if there is some basis in fact that banks aren't causing gradual mark-downs in counterparty collateral because it would hurt their own proprietary positions, we've got a big, big problem. And this is what I'm afraid we may have. …

Comments

[bailey]

Clearly, the markets STRONGLY believe BB can & will come to the rescue. Let's assume he'll try, are his efforts likely to work?

[Dave Iverson]

As I see it, Bernanke faces a double bind and likely public damnaton no matter what course he chooses, no matter what action (or inaction) he takes. From a post earlier this spring:

"If the Fed tries to keep the economy 'pumped' by lowering interest rates in the wake of the subprime meltdown, speculative fever may continue to escalate, albeit not necessarily in the housing market. If the Fed raises rates, or maybe even if they don't lower them, Bernanke will be blamed for inducing recession— the recession Paul Kasriel recently warned as 'imminent'." http://forestpolicy.typepad.com/economics/2007/03/bernankes_doubl.html

Paul Kasriel once said "Alan Greenspan is the luckiest Fed Chairman in the post-WWII period." http://forestpolicy.typepad.com/economics/2005/08/in_greenspans_w.html

Bernanke may end up being the unluckiest. Or maybe not. Maybe we will be singing praises to him within a few years. What do I know? What do any of us know?

What we do know: It is going to be interesting indeed going forward!
But the ancient Chinese knew that too, in the form of this curse/blessing: "May you live in interesting times!"

[LoraPreet]

Great site very informative two thumbs up!

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http://www.earwod.com

[Hedge Fund Consultant - Richard Wilson]

So much for BB coming to the rescue.

- Richard

[Dave Iverson]

I dunno, Richard.

BB, along with other central bankers, may indeed be coming to the rescue in some slightly nontraditional ways. See, e.g. Paul Krugman's Dec 14 video -- at this post: http://forestpolicy.typepad.com/economics/2007/12/catching-up-on.html

Or maybe BB will become AG's "goat", catching all (or most) of the flak from the mess that Greenspan started, after reigniting the flames of wanton speculative excess. I'm betting more on the former than the latter. We will know better in 2-5 years. At that point in time we can review points and prognosications. 'Till then we wait, and worry.

PS.. I edited your comment slightly, deleting the URL for your blog. When I went to your site, I couldn't just go back to mine. Readers can still find your site hyperlinked under your name in your message--that opens in a new window. Someday soon, maybe, I'll open up my comments section to allow html tags. Then I can allow folks to advertise their sites directly and can make sure that when they do their sites open in a separate window. Happy Holidays..