Leverage: A Nasty Eight Letter Word

So much of what the credit markets are wrangling with is leverage. Fixed income strategist arbitrage small percentage differences between what they can borrow v. what they can earn. I think that is called positive carry. For those of you who followed along in MAR/APR 2007 in the discussion of the the paper, Hedge Funds and Systemic Risk, you will remember that the riskiest strategy, indeed the one that caused most hedge fund failures was Fixed Income.

Why? The answer is simple. When you lever up, small changes in the underlying investment can equal big losses. I prepared a very simplistic example.

If you are levered 5:1, then your investment gets wiped out with a 16.67% loss. But that is YOUR money. If you lose more than that, then you have borrowed money that you have to pay back. I heard someone say that the Carlysle affiliate invested in GSE's was levered 32:1.

As people are de-leveraging, either by choice or necessity, it feeds a cycle within the entire market causing prices to go down further and pulling more into the vortex of money going down the drain. Leverage ratios are based on the market market value of an investment. The market value of many of these credit products (and I'm not even talking about derivatives) is plunging. Price goes down; leverage ratio blows up; margin calls are made. I'm sure that there are many margin calls that are not being made satisfactorily.

This example is very simplistic, and I'm sure that I'm not telling you anything that you do not already know. But seeing it on paper is sobering. It is these credit events that levels out dynamic hedge fund strategies and causes previously non-correlated outcomes to correlate.

I have to say that I'm becoming gravely concerned about my money market accounts, and I may look to move money into something a little safer than Fidelity's FDRXX which is what they require my retirement money when not fully invested to be placed. I know that I sound like Chicken Little, and I've expressed that concern before. I don't think that it is a misplaced concern.

Hedge Funds and Systemic Risk - Conclusion (III)

This is my final installment on this paper. I wanted to lift something out of The Hartford's 2006 10K:


"Limited partnerships increased by $363 or 84% during 2006. HIMCO believes investing in limited partnerships provides an opportunity to diversify its portfolio and earn above average returns over the long-term. However, significant price volatility can exist quarter to quarter. Prior to investing, HIMCO performs an extensive due diligence process which attempts to identify funds that have above average return potential and managers with proven track records for results, many of which utilize sophisticated risk management techniques. Due to capital requirements, HIMCO closely monitors the impact of these investments in relationship to the overall investment portfolio and the consolidated balance sheet. HIMCO does not expect investments in limited partnerships to exceed 3% of the fair value of Life’s investment portfolio excluding trading securities.

The following table summarizes Life’s limited partnerships as of December 31, 2006 and 2005.

Composition of Limited Partnerships
		2006								2005
		Amount				Percent				Amount				Percent
Hedge funds [1]		$	427				53.8	%		$	127				29.5	%
Private equity funds [2]			211				26.6	%			179				41.5	%
Mortgage and real estate funds [3]			46				5.8	%			6				1.4	%
Mezzanine debt funds [4]			110				13.8	%			119				27.6	%
Total		$	794				100.0	%		$	431				100.0	%

[1]		Hedge funds include investments in funds of funds as well as direct funds. The hedge funds of funds invest in approximately 40 to 90 different hedge funds within a variety of investment styles. Examples of hedge fund strategies include long/short equity or credit, event driven strategies and structured credit.
[2]		Private equity funds consist of investments in funds whose assets typically consist of a diversified pool of investments in small non-public businesses with high growth potential.
[3]		Mortgage and real estate funds consist of investments in funds whose assets consist of mortgage loans, participations in mortgage loans, mezzanine loans or other notes which may be below investment grade credit quality as well as equity real estate.

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The point of the paper is that it is particularly this inter-relatedness that poses risk. Rather than try to paraphrase the authors, I'm going to include their Current Outlook lifted directly from pages 81, 83)
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The Current Outlook

A definitive assessment of the systemic risks posed by hedge funds requires certain data that
is currently unavailable, and is unlikely to become available in the near future, i.e., counter-
party credit exposures, the net degree of leverage of hedge-fund managers and investors,
the gross amount of structured products involving hedge funds, etc. Therefore, we cannot
determine the magnitude of current systemic risk exposures with any degree of accuracy.
However, based on the analytics developed in this study, there are a few tentative inferences
that we can draw.

1. The hedge-fund industry has grown tremendously over the last few years, fueled by the
demand for higher returns in the face of stock-market declines and mounting pension-
fund liabilities. These massive fund inflows have had a material impact on hedge-fund
returns and risks in recent years, as evidenced by changes in correlations, reduced
performance, and increased illiquidity as measured by the weighted autocorrelation.

2. Mean and median liquidation probabilities for hedge funds have increased in 2004,
based on logit estimates that link several factors to the liquidation probability of a
given hedge fund, including past performance, assets under management, fund
ows, and age. In particular, our estimates imply that the average liquidation probability for funds in 2004 is over 11%, which is higher than the historical unconditional attrition
rate of 8.8%. A higher attrition rate is not surprising for a rapidly growing industry, but
it may foreshadow potential instabilities that can be triggered by seemingly innocuous
market events.

3. The banking sector is exposed to hedge-fund risks, especially smaller institutions, but
the largest banks are also exposed through proprietary trading activities, credit arrangements and structured products, and prime brokerage services.

4. The risks facing hedge funds are nonlinear and more complex than those facing traditional asset classes. Because of the dynamic nature of hedge-fund investment strategies, and the impact of fund inflows on leverage and performance, hedge-fund risk models require more sophisticated analytics, and more sophisticated users.

5. The sum of our regime-switching models' high-volatility or low-mean state probabilities is one proxy for the aggregate level of distress in the hedge-fund sector. Recent measurements suggest that we may be entering a challenging period. This, coupled with the recent uptrend in the weighted autocorrelation , and the increased mean and median liquidation probabilities for hedge funds in 2004 from our logit model implies that systemic risk is increasing.

We hasten to qualify our tentative conclusions by emphasizing the speculative nature of
these inferences, and hope that our analysis spurs additional research and data collection to
refine both the analytics and the empirical measurement of systemic risk in the hedge-fund
industry. As with all risk management challenges, we should hope for the best, and prepare
for the worst.
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I hope that my objective of creating awareness without insanity has been met. Keep your eyes and ears open for exposures, particularly if you have a DNA quirk that has you nosing around 10-K's of financial institutions. Keep in mind the example of HIG.

Thank you for reading this and your comments (both public and private) on the material. Because I wrote (regurgitated) this information, it forced me to wrestle with concepts that were both foreign and complex. Nevertheless, I understand the risk--so if we ever have a meltdown, you can say, "Yes, I've read about those auto-correlations and this event is not a surprise to me."

Hedge Funds and Systemic Risk - HF Profile (II)

In installment II of our look at Hedge Funds and Systemic Risk, (remember, that none of this is my own work, but rather that of the referenced paper). All page numbers refer to the numbered pages. If you are looking at the PDF doc, the PDF page will be higher than the numbered page.

I wanted to provide a bit of a backdrop of hedge funds (HF's). You may not be a qualified investor and may never will be, so HF's funds may never be in your investment horizon. Nevertheless, they are in the same financial arena as you competing for returns. And the whole point of my writing about this is that if they screw up, it can cost you money.

Let's reflect a moment on the basic tenets of the paper.

• HF's have proliferated;
• They have a high attrition rates;
• Risk profiles (due to leverage and investment styles) are unavailable;
• Operations are not transparent; and
  
• Non-correlated dynamic strategies can correlate into phase locking during periods of market stress.

(I hope not annoyingly, but I'm purposefully repeating some of the core concepts of the paper to solidify them and make them relevant to the current installment without your having to keep going back.)


In their paper, the authors started with a population of 4,781 funds using information from 02/1977 - 08/2004 using the TASS data base. This database does NOT include all hedge funds, but rather is the data base that included all of the information they needed. As these guys appear to be professionals, we can trust that they designed their study to minimize underlying bias in the data. In fact, they go to some pains to explain that, but I'll not do it here.

They parsed this population into HF's that were Live as of 08/04, and those that were in the Graveyard as of 08/04. That split was 2920 and 1861, respectively. Due to the data vagaries, one cannot equate that with a failure rate. See attrition rates below. The authors had to go through and design there study in a way that required them to tweak these numbers so that there was appropriate homogeneity in terms of reported returns etc in the study population. Accordingly, the Live list was reduced and the Graveyard was increased.

Here is a graphic (p. 17) of the final study population by investment style. I would urge you to look at the Appendix A of (p. 84) the paper to read about these styles.





The authors note: "it is apparent from these figures that the representation of
investment styles is not evenly distributed, but is concentrated among
four categories: Long/Short Equity (1,415), Fund of Funds (952),
Managed Futures (511), and Event Driven (384). Together, these four
categories account for 71.9% of the funds in the Combined database."

There's another graphic that is telling. Below (Figure 1) are two pie charts--one showing the composition of the Live Funds and Graveyard funds. Click to make larger or refer to the original study on p. 19.

The authors note "databases are roughly comparable, with the exception of two categories: Funds of Funds (24% in the Live and 15% in the Graveyard database), and Managed Futures (7% in the Live and 18% in the Graveyard database). This reflects the current trend in the industry towards funds of funds, and the somewhat slower growth of managed futures funds."

I'm going to gloss over the section that talks about the correlation matrices. There are three points that are worth noting:

1. In general hedge fund index is not well correlated to the S&P 500 (p. 19)
2. Correlations among/between investment styles can vary widely (p. 23)
   
3. Events such as LTCM can increase correlation--in 1998 10 out of 13 syle-category indexes yielded negative returns. (p. 24)
   

Remember that non-correlation moving to correlation is a key part of systemic risk. To show just how pervasive and lingering affect an event such as LTCM can have on correlations, I'm going to include the author's table (CTML) here (oval and highlighting are my own):



The authors report some excellent detailed data regarding HF's using the TASS database. To give you a sense of the increase in HF's over the period, I want to share the authors' table with you. Three things to keep in mind while reviewing this table:

1. these are additions, only.
2. 2004 is reflective of the study cut off, so I would not use that
3. Funds exiting the database were not tracked.
   

Attrition Rates:

It's important to note that the database used (TASS) by the authors does not included all hedge funds--but rather it is a database that contained all of the information that they needed for their study. The point in considering failure rates is that a hedge fund failure could be one of those "events" like LTCM. In fact, as I wrote this and as I considered the blow up in sub-prime mortgage I wondered if that would pose problems for fixed income arbitrage hedge funds. I asked this of R. Nusbaum on his website.

Here's a screen capture of the ANNUAL average attrition rates in the TASS database:


The authors then go on to build a logit model to estimate liquidations based on the mix of investment styles. This analysis is beyond my ability to convey, but the takeaway is that their estimate is over 11% for the 2004 data base which is 25% higher than the average of 8.8% (p. 63). Here's some information from p 15 cited in their literature review.



I hope that you found this installment interesting. In this installment, I hope that I conveyed:

• The number of hedge funds and the predominant types of investment styles
  
• The increase of hedge funds since inception
• The attrition rates, and how those attrition rates can be affected by events (LTCM and tech bubble), as well as fund performance to include both funds and volatility.
  
• How events can affect the correlation of non-correlative styles (though admittedly, I gave just a small slice and did not produce any of the wonderful tables and work that the authors did. If you are statistically inclined, I hope that you will review their work.)
  

Hedge Funds and Systemic Risk - Introduction (I)

In an earlier post, I indicated that I had read the paper referenced below, and I wanted to summarize for you some of the more salient points. I write this post requesting your forgiveness in advance that I'm such a poor conduit for expressing some of the issues in this paper. Despite my inadequacy in purveying the learned information--I'm going to liken this effort to not being able to play the concerto but able to hum (off-key, of course), the tune--I'm nevertheless going to try.

As an individual investor, I find the complexity of the financial markets overwhelming at times. But Albert Einstein found simplicity and elegance in his economic rendering of the theory of relativity to e=mc(2). By that example (and clearly understanding that I'm no Albert Einstein, but rather one who appreciates simplicity), I will see complexity, then, as an obstacle that must be cut through to find the essence--the kernel--that is fully within the grasp of us mere mortals. We'll let the statistical and economic gods wrestle with and collegially debate the more arcane aspects of this learned paper. And, on a strictly selfish basis, I will extract those aspects that I found interesting and worth considering.

But why be interested at all in this paper and its theories and findings? Why should you be interested, wasting your valuable time reading this post? In a word, RISK. Risk v. reward is a time honored means of measuring whether an endeavor will prove fruitful or not. I feel inadequately informed on risk; and maybe you are well-informed. If you are not, then some of these considerations may amplify your awareness of risk. If we do not have a basic understanding of the risks--what those risks are and whether or not the risk profile of the market is rising or falling--then how will we make prudent choices with respect to allocating/protecting our resources?

This paper and my distillation of it is only a slice of overall risk--but I think that it covers one of the greatest risks--an exogenous event that creates a rather serious problem in the markets. Trust me, you will not be able to get out of the market if such an event happens. I couldn't even get current data through Fidelity during the February 28 Shanghai Express that had all the exits blocked.

In the interest of not losing you (or myself) in this exposition, I'm going to break it up into manageable segments. I will create a label for the post "HF and Systemic Risk" so that you can see the series). I'd like to also add that everything expressed herein is 100% attributable to the paper. However, I will have a couple of peanut gallery observations, and I will clearly label them as my own through bracket offsets [.....].

Finally, I would deeply appreciate some feedback as to if you find this exposition of this article helpful at all. Granted, there is a piece of me that is writing to force (and reinforce) my personal distillation of the material, but I would be lying if I stated didn't care if YOU were interested. I'm not looking for any blind encouragement, but rather a sincere judgment on your part as to whether or not this is a good use of your time. You may e-mail me (see profile) or place a comment in the comments section.

First, let me introduce the paper and the authors as well as the abstract. Emphasis added. The link on the header is to the paper.
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Systemic Risk and Hedge Funds
Nicholas Chany, Mila Getmanskyz,
Shane M. Haasx, and Andrew W. Loyy
This Draft: August 1, 2005

Abstract

Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions|typically banks|that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.
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[The latter part of the paper is beyond my experience and education; but it is an outline of how the authors attempt to build a model to measure hedge fund risk. I'd like to provide you with a broad view of what the author's were looking at and some of the characteristics of hedge funds. Remember, that they are attempting to measure systemic risk. To do so, they detail the

• number of hedge funds
• characteristics of these hedge funds to include (1) the dynamic investment strategies, (2) opacity; (3) attrition rates/longevity (or lack of it);
  
• interdependency of financial institutions with hedge funds (from both an investor and creditor stand point);
• correlations/non-correlations the dynamic investment strategies and how outside events can cause these strategies to suddenly correlate resulting in phase locking.
• reliance on linear risk models that do not effectively quantify non-linear risk

The failure of Long-Term Capital Management is a tangible example of how the system can seize up in phase locking. With the proliferation of hedge funds combined with their mortality rate increases the amount of risks to the system in the event of failures.

I'll spend the next installment providing some color regarding the hedge fund profile.]