The fall-out from Lehman Brothers

I ended my last article on hedge fund counterparty risk, which was prepared shortly before the Lehman collapse, with the following words:

“Ultimately, the hedge funds cannot get away from the risks systemic to the financial system. The failure of a PB (prime broker) will have catastrophic knock on effects starting a chain of collateral liquidation. This risk is very well understood by both global central banks and regulators.”

Clearly this may not have been the case!

Prior to the Lehman collapse, hedge funds had enjoyed relatively favorable performance. After the collapse generating alpha from largely dysfunctional markets became more of a challenge .

 Returns prior to Lehman Brothers

2007 was the year the financial crisis started, yet a diversified hedge fund portfolio would have returned 10 to 14%. This was better than most underlying asset classes. More significantly, such a portfolio would have avoided the large losses suffered by the banking industry trading their own proprietary capital. For many strategies the proprietary desks are arguably their closest competitor. We believe that the hedge fund model, where a portfolio manager’s interests are aligned as a significant investor and owner of the business, provides for more measured risk taking. Bank prop traders are often more aggressive in exercising the so called “trader’s option” which has an asymmetrical risk reward profile.

The first 8 months of 2008 were difficult conditions for hedge funds with most diversified portfolios down by a few percent. However, given the large falls in equity markets this was far from disastrous

The Lehman Impact

The failure of Lehman Brothers impacted funds in many ways both directly and indirectly but, mostly indirectly.  A summary is given below:

Counterparty losses - A collapse in the finance industry is always very value destructive and recoveries for unsecured shareholders tend to be poor. The component businesses tend to be complex involving several entities and the time to finalize any recoveries may be over 5 or 10 years. Hedge funds will typically have unsecured claims for re-hypothecated assets and balances due under ISDAs. Our research indicates that 44% of funds have some exposure, of which 30% is less that 1%. For 3% of managers it is significant at more than 5%. As Lehman Brothers had been perceived as the weakest of the broker dealers after Bear Stearns was rescued, many hedge funds had taken steps to mitigate their credit exposure.

Effects of lost hedges - As all OTC trades with Lehman effectively defaulted, many funds were left with un-hedged positions. The environment made the two options available costly; to sell the un-hedged long or find a replacement hedge.

Market related losses - Although equity markets had already discounted much bad news, they had not discounted the loss of confidence that ensured across the entire financial sector. We estimate that many of the equity related funds were only running 20 to 30% of the maximum risk, though moves of the magnitude we have seen since September provide little room for protection. There was also significant negative alpha part due to large unwinds from the banks themselves as well as fundamental long managers substantially contributing to the fast disappearing liquidity in small and mid cap stocks.

Effects of Lehman’s liquidation on the market - Any long Lehman proprietary assets or hedge fund assets which have been re-hypothecated are likely to have been used as collateral against Lehman’s own borrowings. These will have been liquidated upon Lehman’s default. Conversely, any assets lent to Lehman to support short positions will be bought back and the collateral against it liquidated. The execution of these processes is highly value destructive As a result many assets hedge funds were long were sold down and many where they were short, bought up. This effect widened the spread on many arbitrage trades hurting many relative value strategies.

Effect on broker dealers - It was clearly hoped that after letting Lehman collapse and Merrill Lynch being taken over, that the problems would cease. However, it quickly become apparent that this was a end of the broker dealers as a business model. The market saw that broker dealers were viewed as less important by the authorities and may not be rescued and determined that broker dealers should not be afforded the same access to funding. Within days Goldman Sachs and Morgan Stanley were forced to announce their intention to become banks. To qualify they had to reduce their own leverage. As two of the largest prime brokers, this had spill-over effects and led to a restriction in their ability to lend to hedge funds .  We have heard of increased prime broking fees and increased margins and haircuts.

Effect on collateralized lending - One of the reasons that hedge funds were able to borrow at tight spreads was that the prime brokers were able to on-lend that inventory (i.e. re-hypothecate) to other institutions to finance their prime brokerage business. In a similar way the broker dealer and investment banks had used the same market to finance their proprietary trading operations. This market tended to be short term and the margins on the collateral made it appear close to riskless. Even as the unsecured credit spreads for many of these institutions widened in the first half of the year, this market continued to function. However, this came to a stop with the collapse of Lehman. The concerns over broker dealers had a knock on effect on other financial institutions. The effect of this market not working could have been very serious for the broker dealer and investment banks with high levels of leverage. Although the hedge funds generally had much lower leverage, these same institutions were their prime brokers and sources of funds, and their appetite to lend has been seriously diminished.

The seriousness of this has caused  the central banks to widen the types of collateral they would accept to fill the void. Effectively, the central banks had become “prime brokers of last resort”. We now hear regularly from funds about how prime brokers are reluctant to extend any credit against assets they cannot pass through to the central banks. Even where they can find banks prepared to lend, the funding spread reflects the lender real cost of unsecured funding. This has made the holding of many illiquid assets costly.

This loss of a source of easy finance has been one of the most significant factors in creating the current deleveraging cycle. While broker dealers and investment banks are the most directly affected, hedge funds also feel the squeeze, though most are already much further advanced in the deleveraging cycle.

Effects on the OTC markets - The reluctance of banks to lend to each other has been extended to a reluctance to except assignment or novation of an OTC contract from one bank to another. Therefore, it is difficult for a fund to buy a derivative from one bank and sell it through another. We hear funds complain the banks are exploiting this situation to give less favorable pricing on exits. The choice of running both the long and short to maturity is costly in funding the margin.

Effects of regulatory response - The short selling ban on many financial sector equities and in certain case across whole markets, was introduced in a number of countries to take pressure off the financial sector and not jeopardize their fund raising efforts. This had an immediate impact on many strategies undertaken by hedge funds. There is little indication that the short selling bans were of any long term benefit to share prices. In fact, the bans may have caused more capital to be withdrawn from the market.

Effects of government response - In the case of TARP (Troubled Asset Relief Program) the use of the program changed with time. Initially it was to buy troubled assets mainly in the mortgage sector, but then moved to take stakes in financial institutions. This switch had a very detrimental affect on the pricing of CMBS.

A Perfect Storm

The combination of these effects has been “a perfect storm” for hedge funds. Diversified portfolios could now be down around 20% in 2008 which will be the worst year on record.  At first the pain was mainly due to the long biased strategies but gradually moved to hurt the strategies that used the most leverage, which often was relative value.

A good example of the perfect storm is convertible bond arbitrage. During the collateral liquidation of the Lehman lenders, the bonds were sold down at indiscriminate prices and the short stock bought up. The short sale ban then caused the asset prices to further cheapen as it reduced the ability to hedge especially the financial sector issues.  The prime brokers have also been very reluctant to continue to finance them. The CBs cannot be used as collateral at central banks and the appetite for financing less liquid assets is low. The banks also have large proprietary books which they have been selling down in a move to deleverage. The CDS market has also not traded in line with the cash bonds so credit hedges have not worked well.

Redemptions

In the first half of 2008 the industry started to see some redemptions coming from fund of funds, especially those for retail clients. Institutions had been small net investors. However, the industry is now facing a period of significant redemptions. The timing of the Lehman collapse in September proved unfortunate and accelerated redemptions for that critical 90 day notice period for many funds with end of year redemptions at the quarter end. The scale of redemptions has forced many funds to take actions to restrict liquidity.

Initially fund of funds seems to be the main source of redemptions. Some of the issues they face are compounded by a number of factors:

• Some have a mismatch between the liquidity they offer their investors and the liquidity that they get from the funds they invest in. In times of uncertainty they need to build a larger cash buffer to pre-empt future redemptions.
• They are finding that the difference between theoretical redemption terms and the effective redemption terms a manager can impose can be significant, increasing this mismatch even further.
• Some products are more exposed to the retail sector.
• Some products had been sold as a “libor plus” or bond alternative, which makes 2008 returns hard to justify.
• Some products have some level of leverage applied, especially for some of the perceived low risk relative value strategies that started to unravel in September and October.
• Some investors had further leverage on their holdings.
• Some products were offered to investors in Euro, though the underlying funds were in dollars. Due to the large move in foreign exchange they were forced to reduce the investment in underlying fund rapidly to cover the currency loss on the hedge.

While institutions have been more stable, they have been far from immune. Some of the more sophisticated endowments and foundations have significant alternative portfolios including private equity. The cash flow profile of private equity has changed significantly from the original assumptions. They are now finding cash calls exceeding returns of capital, causing net investments to grow. This effectively forces investors to find liquidity from other products or take unfavorable prices in the private equity secondary markets.

All institutional investors will have some asset allocation policy and given the recent poor performance of equity markets it is likely that the current equity allocation is below policy. This may led to some further redemption pressure on hedge funds to balance portfolios. However, pension funds in general are not heavily invested in hedge funds and many had been looking to increase this component.

Many hoped that the worst of the problem would be over by 2008 year end redemption window. It now appears that this process may continue to be significant for at least another quarter. The Madoff scandal will not have helped the case, just prior to another key redemption notice period.

Conclusion

Up to August 2008, we could have argued that hedge funds had done a relatively good job of navigating the crisis. They were in a process of controlled de-leveraging and side-stepped the worst of the losses. The Lehman collapse brought the whole world into panicked de-leveraging and many of the knock-on effects were very destructive to hedge fund strategies. Hedge funds are probably now well-advanced in this deleveraging cycle, though some have taken restrictive liquidity measures to protect the long term value of their fund. The redemption cycle has exposed some of the excesses and frauds within the industry. We may have passed the worst, but the cycle is not over. However, a period of excess return should be waiting at the other side.