The rise & the fall of LTCM

The rise -

Hedge funds became (in)famous in 1992 with George Soros’s Quantum Funds. At that time, UK was a part of the European Union, because of which it was following the highly conservative monetary policy of the German Central Bank - Deutsche Bundesbank. The British economy was suffering from a recession despite of which, it had to keep its interest rates high, making the pound sterling very strong. Because of this conflict faced by UK, it was widely believed that the country would soon let the pound go. This is where Quantum Funds stepped in. George Soros borrowed 15 billion pounds and short sold the currency intensifying the pressure on the pound and what would have happened over 4-5 months, was made to happen immediately. UK pulled out of the EU, lowered its interest rates and let the sterling fall (it depreciated by 15%). Soros made a quick profit of 2 billion pounds. For a common man, he became a villain overnight, who twisted the market conditions to make a quick profit. However it must be noted that Quantum Funds did not lead to UK pulling out the EU. It just hastened the whole process.

& the fall -

In August 97, Russia devalued ruble and defaulted on Sovereign debt. There was an Increase in spreads between emerging-market and Western government bond. Though few believe that LTCM never owned any russian debt & that they simply owned spread products, which cracked out in the wake of Russian default. But it was their excess leverage & use of derevative products that saw rapid decline in their investments. Finally Federal Reserve of New York bailed out LTCM with $3.65 billion purchase of of 90% of its equity.

Effects of the Collapse of LTCM: Banks and security firms are demanding more information from highly leveraged clients and Increased credit terms:- Increase collateralization; Increase diligence in credit analysis of counterparties.

Most Hedge Funds are leveraged, but how much?

Most Hedge Funds don't disclose how much they are leveraged, but most investment banks currently are somewhere between 8:1 and 12:1 levered. Bear Stearns was at about 10:1 when it blew up. There are some hedge funds operating at about 20X leverage but that may applies exclusively to Forex trading and arbitrage since they have the smallest moves to make a profits. But Hedge Funds have notorious history - the famous LTCM fund which blew up had 35:1 leverage and they nearly destroyed the US bond markets single handedly. They had an equity of $4.7 billion, leverage of $125 billion and dereatives position of $1.25 trillion!!

The appropriate amount of leverage to use is one of the hardest things to find out since it depends on the market, the volatility, the economic environment, the liquidity, the spreads in the market, and a whole host of other issues. Generally it is believed that most funds and traders operate at more than 15X leverage.

Side Pockets

The term "side pocket" refers to a portion of the hedge fund that is segregated from the remainder of the assets for certain illiquid investments. These illiquid investments are hard to value, as much of the investments are class 3 assets, which do not even have a comparable assets class that are priced by market forces. Hedge Funds uses their own internal models to value them (which can be biased)! The profits and losses derived from a side pocket investment are allocated solely to those investors that are in the fund at the time such investment is made. The capital related to such investment is not available for withdrawal until such investments are realized or otherwise become marketable securities. Typically about 10 to 15 percent of a fund may be reserved for side-pocket allocation, although there have been instances of larger side-pocket pools.

On the larger scale, there is potential for excessive leverage. For example- a subsidiary of Hedge Fund (say in a business of distressed lending) may keep on transferring its riskier positions into side pockets to free up and raise more capital from its parent Hedge Fund for fresh investments. This is called leverage. Though organizations are more responsible today & keep a check on their leverage strategy, but one can never know when LCTM part-2 happens!!!

Excessive concentration of positions, the dependence of valuations upon complex proprietary models, and high leverage are some issues that raises concerns over side-pockets. Hedge funds propogate that side pockets are necessary to bundle & classify a similar type of investments because different investors have a different investment horizon & objectives. Whatever be the objective, the system should be made more transparent to the market & investors. This way the fund managers are more responsible & these issues will be addressed batter.

On a different note, I personally feel that Hedge funds should more concentrate on improving the performance of their investments than being busy with transferring & bundling investments into side pockets. There are numerous compliance, transfer rules, auditors & back office stuff that just keep the organization busy, forgetting the main objective - returns! Thats the difference between a Leveraged Buyout & a Hedge Fund - Once the Leveraged Buyout firms buys a company, they work closely with them on its turnaround strategy, unlike Hedge Funds that investes & sleep!

Independent Portfolio Valuation of Hedge Funds & PE Assets on a Rise....

Independent Portfolio Valuation: The Independent Portfolio valuation service is a relatively new business area where companies have their illiquid assets valued by some third-party evaluator. This was born from the need of financial institutions to have transparency in their asset valuations as well as a slew of regulatory moves of which FAS 157 has been the latest. Also owing to the present doldrums in the market, independent valuations serve to reassure institutional investors as well.

Growth Drivers:
· Regulatory Changes Driving Demand (FAS 157): Demand for independent portfolio valuation services continues to be positively affected by increased regulatory scrutiny of corporations, a shift toward fair value accounting principles, increased awareness of and sensitivity to conflicts of interest and the globalization of corporations. In the US, Financial Standards Accounting Board (FASB) Statements Nos. 141 and 142, 123(R), 157, and 159 are a few examples of statements that require valuation expertise. Effective November 15, 2007, FASB mandates that assets be measured at "fair value", described as "the price that would be received if those assets are sold today". Here the companies need to determine the fair value of their hard-to-value securities (level 3 assets), which do not even have a market trading comparable. Valuing such investment has always been difficult, and with the introduction of FAS 157, these level 3 assets have to be valued at today’s prices. This requires specialized valuation advisory services, so that the valuations numbers get the clearance from auditors.

Companies in the financial services space such as investment banks, hedge funds, private equity funds, etc., will be the most affected as they hold significant amount of Level 3 assets. FAS 157, coupled with the credit turmoil, should have a positive impact on the demand for the independent evaluations. With the introduction of FAS 157, PE and hedge funds can provide comfort to their investors, auditors, and fund managers by seeking independent estimates of the fair values for Level 3 assets.

· Alternative Assets: Alternative asset classes (like investments in arts) continue to flourish as many hedge funds are setting up specialized funds focusing on the same. These asset classes are difficult to value sometimes as they contain illiquid assets; which has led to firms and investors requesting independent valuation on their portfolio.

· Sarbanes-Oxley - Limiting Auditors on providing certain non-audit services: Provisions of the Sarbanes-Oxley Act of 2002 limit an accounting firm’s ability to provide certain non-audit services (including valuation or appraisal services, fairness opinions) to its audit clients. These restrictions, together with the perceived conflicts of interest when auditors provide valuation services to their audit clients, provide independent portfolio valuation firms with a competitive advantage over public accounting firms. This has led to evolution of new financial service class called “Portfolio Valuation Firms”.

Volatility is bad for Hedge Funds !!

Increased allocation to equity long-short strategy during extreme volatile markets is precisely the worst thing to do. Thats where some hedge-funds have made mistake.

Much of the problem this year has come from extreme price movements in different markets. The S&P 500 has moved by 1 percent or more on about half of all trading days this year, according S&P. The last time the percentage hovered at that level was in 1938. Commodities prices have also moved wildly. This year, crude oil has fallen below $90 a barrel twice and jumped to a high of $110 a barrel. U.S. dollar has lost 4.13 percent this year against a trade-weighted basket of currencies tracked !!!

No hedge is perfect. In periods of unusual volatility, hedges are more likely to fail. They are much more likely to outperform in a low-volatility bear market than in a high-volatility messy market. Much of their "black-box" complex algorithamic models start to behave abnormally during volatile markets as they are unable to forecast anything clearly & bad trades happens... I have heard - at times of extreme volatility, some Hedge Funds does wise thing - put algors to rest :)

If Hedge Funds are investing in a relative-value play, then volatility works against them. It's only the noise traders who really make money from volatility, and they're actually a minority in the hedge-fund world. Anyhow, if a Fund hasen't blown up yet, money will keep pouring !!

Recent LBO deal trends

• Average size of LBOs has fallen to under $1 billion from $2.1 billion in 2007.
• Average equity contribution in leveraged buyouts has increased from 33% in 2006-2007 to 42% in 1Q08, which is near levels seen in 2001-2003.
• Difference (in terms of EBITDA multiple) between what sellers willing to sell for and what lenders are willing to finance has increased.
• Leverage/Coverage metrics have improved.
• Average Debt/EBITDA multiple in large corporate LBO loans has decreased from 6.2x in 2007 to 5.1x in 1Q08.
• Average interest coverage ratio in large corporate LBO loans has increased only slightly (due to wider spreads) to 2.2x in 1Q08 from 2.1x in 2007.
• Structures of loans have become more stringent due to significant increase in the use of LIBOR floors, Financial tests, Restricted payments language and no covenant lite loans.

CDOs greed spells financial crisis

The story is familiar- Bear Stearns and many others.... here is a perfect example of CDOs mess....

IKB Deutsche Industriebank AG, a German bank, was bailed-out for €3.5 billion. This is because IKB’s subsidiary- Rhineland Funding Capital is in a financial crisis. The reason is that Rhineland was holding €14 billion debts, most of them are Collateralized debt obligation (CDO).

CDO is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also..... these CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept teh ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!

Coming back...... Rhineland issued commercial papers to get the required money to buy CDO's. Since commercial papers have lower interest rate than CDO, Rhineland earns the differences and became a very profitable vehicle of IKB.

So this is how the cash flows: US investors bought commercial papers from Rhineland, which had very good credits. And Rhineland is paying them at a rate of LIBOR. Rhineland then used the money to buy CDO’s from other US issuers. These debts have higher risk and pay higher interest rate to Rhineland and many are back by MBS’s. So, Rhineland earns profits.

Last few years, the US banks provided more mortgage to homeowners with weak credits (e.g. some even allow the homeowners to have zero down payment) during low interest rates years of 2006. These are called sub-prime mortgages. However, the abilities of these homeowners to pay the mortgage are generally weak. As a result, when there is a slight economic downturn or increase in interest rate, these homeowners have to give up their houses to the bank. But since the housing price has been dropping, even banks are not able to get back the entire mortgage through house auctions. So, banks won’t be able to pay the MBS they have issued! And since some CDO’s have MBS as backing, these CDO’s will be default too.

As a results, CDO’s market price drops. Rhineland also has to pay back the money to their commercial paper holders as it is of shorter terms. But Rhineland cannot do so because the price of the CDO’s it’s holding is dropping. And they cannot issue more commercial paper neither because now everyone believe that Rhineland is holding risky CDO’s backed by sub-prime mortgage. So, Rhineland is in financial crisis.

Since parent has to back its subsidiary, IKB is in financial crisis too. Similarly, many other hedge funds and investment banks in the world have engaged in the CDO’s or MBS’s involving sub-prime mortgages. And similar was Bear Stearns story - fallout of Bear's hedge funds that actively traded CDOs!!!

Today, the world is blaming complex CDO products for the financial woes of the 2007 credit crunch. Credit rating agencies failed to value these products using their risk and recovery models. Some institutions buying CDOs even lacked the understanding to monitor credit performance and estimate its expected cash flows. As many CDO products are held on a mark to market basis, the steep fall in the credit markets and declining liquidity in CDOs led to substantial write-downs in 2007-08.