Monday, November 3, 2008

Illiquidity: Self-perpetuating Phenomenon

This relates to our earlier piece Jack of All Trades which talks about why multi-strategy hedge funds are amongst the worst performing hedge funds, in this down-cycle. With the help of some UBS research we read a while ago, we've put together a chart describing the downward spirals we're seeing at high-yield companies and -- more particularly -- hedge funds.

It is downward spirals such as these that bring down leveraged hedge funds like LTCM, and highly-levered companies like Lehman and Bear Stearns, and which keep the SEC and insurance Superintendent Eric Dinallo busy chasing down any market participants who spread false rumors that may initiate or perpetuate such a cycle.

(Click on it to enlarge the graph)

On the corporate side, the difficult market conditions manifest themselves in a re-pricing of credit risk across the board. Corporate debt and equity suffer with the onset of illiquidity. (The more illiquid the asset, the higher its illiquidity "premium" to the discount margin, the lower its price.) The general widening of credit spreads translate into a higher cost of funding for the company, which, coupled with the limited access to funding (debt/equity), may encourage rating-agency downgrades, as the corporation's default probability is increased. Downgrades, then, further decrease the value of the company's debt/equity, increase the cost of funding, and so the vicious cycle perpetually fulfills itself.

For leveraged funds, the self-perpetuating tendencies are more acute; with price deterioration, leveraged funds are typically forced to post additional variation margin (often one-for-one, as the collateral backing their funding is worth less). Obtaining additional cash to post as margin may require the highly levered fund to sell assets ("forced sale").

(As an aside, when forced-sales are occuring en masse in the market, they cause the value of these assets to decrease, as investors can wait for opportune moments to buy assets, at a discount, from forced sellers.)

Once you're a forced seller, you become an increasingly likely default possibility, and so your lender will likely raise haircuts, which causes further forced selling (deleveraging), price deterioration, margin calls, &c.

1 comment:


Nobody ever questions the value of these hedge funds even when they have an enormous impact on the financial markets.