Thursday, August 2, 2007

Speculating with Derivatives in the Mortgage Markets

News reports tell us that a third Bear Stearns hedge fund that invested in mortgage-backed securities has suffered serious losses and stopped honoring investor requests for withdrawals. A number of hedge funds are reported to have suffered losses in the mortgage markets. Among those affected are funds operated by hedge fund veterans Paul Tudor Jones and Bruce Kovner, who were tangling with market volatility when many of today's newer hedge fund operators were dabbling in acne remedies. European banks have reported sizable losses, as have Australian hedge funds. Mortgage brokers and mortgage companies have suffered heavily, and bankruptcy lawyers are sharpening their pencils. The financial press hints at many more losses yet to be reported.

The cascading losses from the subprime mortgage mess reveal a flaw in the rationale commonly provided for derivatives. Derivatives are said to be socially beneficial because they diffuse risk and place it in the hands of those that want to carry that particular risk. The impact of losses is spread out and market volatility is damped. It all sounds good.

But if losses are diffused, then how could all these big players in the financial markets have been clobbered as badly as they were? Or, in a few cases, forced to file for bankruptcy?

Derivatives have sometimes been used as hedges, and many of the earliest derivative contracts were conceived as hedging mechanisms. Why didn't the hedge funds hedge their mortgage market exposures? There are so-called credit derivatives contracts that are like an insurance policy against a CDO default. A hedge fund or other investor that had held CDO credit derivatives when the yogurt hit the fan would have been out of pocket the cost of the credit derivatives. But that beats paying midnight retainers to bankruptcy lawyers.

The apparent answer is simple, if disturbing. Derivatives contracts, although in many cases originally developed as hedging or risk shifting mechanisms, are now frequently used to speculate. Investors can start off with a neutral trading position and invest in a derivatives contract that gives them exposure they hope will be profitable. In other words, they seek out risk. This is the opposite of hedging.

Hedge fund operators appear to have used CDOs holding subprime mortgages largely for speculative purposes. Although these investments are risky, they'd probably have been priced at attractively low levels that would allow for big potential returns.

The fact that derivatives contracts can be leveraged also would have played a critical role. In a world flush with cash (until perhaps recently), it would have been easy for the hedge fund kings to line up credit from investment banks to buy derivative contracts sold by the investment banks that were offering credit. (Furniture stores do the same thing--sell you their sofas and love seats on the installment plan; but sofas and love seats usually don't turn around and bite your butt into bankruptcy.) With the availability of easy credit, hedge funds could leverage up their derivatives speculations, and go in for a dollar instead of a dime.

Using credit-financed derivatives to speculate takes us to the back hills of Virginia, into hollows and ravines where moonshine is still made by truck driving men who don't talk a lot, and who transport it to Washington by the light of the Big Dipper to be sold to select bars where you can get a taste of white lightening if you know what to ask for and how. Leveraged speculation in derivatives is 180 proof stuff, and so potent you might not even taste it. You'd just get a burn in your mouth.

Although hedge fund operators are aggressive, why would they take such large risks? In part, the answer probably involves things like ambition, testosterone, hubris and an affinity for adrenalin rushes. Some soldiers like the thrill of combat, even though the consequences can be extremely prejudicial.

But a crucial part of the answer is competition. Hedge funds compete with, of all things, index funds. The hedge fund industry has grown exponentially in the last ten years. As experienced investors know, the more money that crowds into the field, the fewer good investment opportunities there are. Thirty years ago, the Peter Lynchs of the world could drive around their home towns, see which fast food joints were drawing big crowds, and figure out what companies to invest in. Investing has become a lot harder than that. Hedge fund operators who just read 10-Ks and annual reports will have a tough time surpassing the S&P 500. In that case, why would their clients pay them 2% of assets and 20% of returns? The Vanguards and Fidelitys of the world are much less expensive and a whole lot less risky.

So the hedge fund guys need to use leverage and invest in alphabet soup esoterica like CDOs, CLOs, etc. in order to have a shot at beating the indexes. And hedging their exposure would only reduce the potential for them to beat the indexes. If you hedge, you necessarily start to lose money roughly around the same time you start to make money. You can try to play the game of investing in arbitrages a la Long Term Capital Management, in the hope of probably making small amounts of money at the risk of possibly losing large amounts. But that, too, requires leverage if the returns are going to give you bragging rights.

So, it would appear that the hedge funds and other mortgage market players must have made unidirectional hope-these-CDO-things-work-out bets. Maybe they had some hedges, and maybe they had other investments that were unrelated (or, "not correlated" in the parlance of risk management junkies) to the mortgage backed investments they had. These holdings would have provided some degree of protection or diversification. But, net net, if you don't take some above average risks, you won't get above average returns. So these folks eventually had to place their chips on either red or black.

Some hedge fund investors may have thought that the hedge fund operators had special insights or could do especially diligent research. And it would not be surprising if some hedge fund guys may have encouraged such beliefs. But, with a large, mature market such as mortgage backed securities, is it really likely that a 36-year old newly minted hedge fund operator, founder of the 2,500th hedge fund to be created in the last ten years, would truly have an informational advantage over the rest of the herd?

So, where does this leave us? First, if we didn't figure it out after the 1998 Long Term Capital Management bailout, let's figure it out now: the derivatives market is as capable of reckless irrationality as any other market, whether it be dot com stocks, real estate or tulip bulbs. The old chestnut that derivatives disperse risk and damp volatility has gone the way of the American Chestnut. Say it now and say it loud: derivatives are speculative instruments.

Second, even though the tamales in the debt and derivatives markets are getting red hot, no one knows who's going to end up holding them. These markets are substantially unregulated; there's no disclosure or reporting. The yogurt has hit the fan, but none of the Fed, SEC, Treasury, CFTC or any other governmental body knows where it will land.

The lack of transparency is not lost on investors. As we noted at the beginning of this blog, investors in a third Bear Stearns fund were sending in so many withdrawal requests that Bear Stearns ceased to allow withdrawals. That's akin to an old-fashioned run on a bank, where the bank simply tells the depositors to go home. Closing the doors doesn't reduce investor anxiety. If anything, it may heighten it. But we're no longer in the 1930's and Jimmy Stewart isn't with us any more to calm things down.

As a practical matter, we can only wait and see how things turn out. If they turn out badly, perhaps we can hope that the Fed's likely interest rate cuts give us a real-life Miracle on 34th Street. But some things happen only in the movies.

Record News: let's get away from this Barry Bonds stuff for a moment. The kazoo record seems safe.

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