Static Measures for a Dynamic Environment

It is with a touch of disappointment that we read S&P's announcement yesterday that they're downgrading certain leveraged super senior (LSS) notes based on a change to their model.

What's particularly disappointing is that they're applying a (new) static measure for volatility -- a variable which we all know is certainly not static -- to long-term transactions. We call this a model "plug." Essentially, each time volatility changes, S&P could legitimately recalibrate its model and either upgrade or downgrade tranches (typically downgrade) on the basis of this change. From their release...

Today's rating actions reflect a recalibration of the model we use to rate these transactions. Specifically, we have increased the volatility parameter we use when simulating spread paths.

In future, we will use CDO Evaluator v4.1 and a volatility parameter of 60% to model all LSS transactions that have spread triggers. Before this recalibration we used a volatility parameter between 35% and 40%.

Given the rating agencies typically hide behind the mantra that their ratings are long-term "opinions" (expected loss or default probability measures, as the case may be) it's odd that they would adapt their model to incorporate short term "plugs." Each time volatility changes going forward, can we expect a reciprocal adjustment to be made to rating levels?

The ratings are being given based on a static volatility measure, and updated at S&P's whim to recognize the inherent flaw with the model... and that's not to mention the elephant in the room, the static correlation assumptions for all environments.

Let's look at this from another viewpoint: when trading stock options using Black-Scholes, one could legitimately argue that you're trading volatility. The price is out there in the market - it's a given. The Black-Scholes formula allows you to solve for volatility, and you could then buy or sell the option based on your assessment of the current and future volatility of the stock's price. Thus volatility is assumed to change over time, and if it were assumed to be constant (such as S&P is assuming), options wouldn't trade. Black Scholes suffers from having a static volatility measure (sigma), but if you're going to have a model where price is not known (from the market) and volatility is a huge unknown, it can't suffice to apply a static measure which then gets updated with time, at the agency's discretion, potentially adversely affecting your supposedly long-term ratings.

What do we recommend?
If rating consistency is important (which we believe it is, especially when pension funds and other endowment funds are substantial investors and when institutions place regulatory capital -- and hedge funds post margin -- against assets based on their ratings), then it's suboptimal to apply static, long-term measurements for both correlation and volatility, as these are key inputs to the model. We're not suggesting it's easy to model each variable as path-dependent, or time-dependent, but if you can't accurately estimate the key parameters in your model the only solution is to stop rating the instrument until you feel you can accurately estimate those variables.

Summary
Volatility, like correlation, is best understood as a measure that's dependent on time. Having said that, if S&P legitimately believes that the new (60%) measure is forever good, we would like to see them admit that the original measure was flawed (and show us how and why they reached the incorrect level), and reimburse all note issuers who paid and continue to pay for these flawed ratings. Ah, the responsibilities that come with collecting fees for your assumptions and modeling capabilities!

Reclassifying from Available-For-Sale to Hold-To-Maturity

Back in September Asset-Backed Alert put out an article describing how various banks (Zions Bancorp, National Penn and others) have rearranged their CDO holdings, reclassifying certain CDOs, previously held as available-for-sale (AFS), into hold-to-maturity (HTM) accounts.

Some background musings relating to yesterday's Financial Times article about IASB, and possibly FASB's adoption of dual AFS and HTM measurements:

This reclassification allows banks to avoid FASB 157-esqe "fair value" accounting, and employ an "amortized cost" (think, "intrinsic") analysis rather than marking to (a rather volatile) market.

The International Accounting Standards Board (IASB) and FASB have been in heavy communication about fair value accounting for a while now, with the hope of maintaining cross-Atlantic consistency. Thus far, FASB has been the stronger proponent of fair value measurement, with IASB allowing for greater leniency and maneuverability.

Some more recent examples:
- Citigroup plans to reclassify approximately $80bn of assets (likely to dampen the effect of further writedowns at year-end)
- IAS 39 reclassifications: see Deutsche Bank's and Unicredit's Q3 2008 earnings conference calls of Oct. 30 and Nov. 11, respectively

These principles present various challenges, including the ability to recognize and appreciate the likelihood of an asset's impairment, and whether it's other-than-temporarily-impaired (OTTI) as a result of market conditions.

But let's consider the crucial item here: irrespective of whether they're impaired assets, why not take the writedown today, even if its not a fundamental, permanent writedown? The sooner the banking system licks its wounds and returns to profitability, the better, and from a macro-perspective the sooner we can shrug the burden of losses the sooner we can return to a functioning, profitable financial market.

TARP has provided the banks with the liquidity to stomach the loss now, but it looks like CEOs (and perhaps FASB and IASB) are allowing the short-sightedness to continue and, with it, prolonging the pain.

Opal CDO/Structured Products Summit

We came down to sunny southern California for the Opal Financial Group Summit which ended yesterday and thought we'd relay some of what was spoken about.

To be fair, despite the lush greens of the Dana Point resort town, the attendees were rather bleak about what the future holds, in terms of the resurrection of the structured finance market in general, the calling of the "bottom," expected future recovery rates, and the foreseeable issuance (or lack thereof) of new issues to the market in general and particularly relating to residential and bank loans.

Across the board, panelists expressed their views that 2009 would be a very tough year. Wide-spread pessimism as to the leveraged loan recovery rate future relative to other historically difficult times, with Four Corners' Michael McAdams being the notable exception, expecting 1st lien recoveries above the 50s to low 60s region, particularly for good managers who are able to hold on to the loan for a while post default.

On the economic side of things, from the panels and from discussions we had with market participants, almost nobody was confident in the government's effectuation of the Troubled Assets Relief Program (TARP) and almost everyone was opposed to the automakers' bailout. There was less talk about the covered bond market alternative to securitization than we would have expected ... perhaps alternative lending forms and mechanisms are in developmental stages behind the scenes to repaint the unfairly blemished face of the securitization industry. We'll share our views on the covered bond market shortly.

To end on a positive note, traders were seeing increasing trading levels over the last month, and expect this to continue through year-end at last, as (often newly-funded) opportunistic and distressed funds have begun to put their capital to work.

Is this a (permanent or temporary/false) bottoming with technicals matching fundamentals, or simply an end-of-year rebalancing and maneuvering of balance sheet assets and liabilities for fiscal year-end accounting and audit purposes?

Deleveraging by Leveraged Funds-of-funds

The calling of Allianz’s EUR300 million Phenix CFO -- purportedly the first to be liquidated -- augurs poorly for the hedge fund industry, adding a further redemption burden to their tally of existing difficulties: staving off general investor fear and redemption requests; reserving against price markdowns and margin/haircut postings; deleveraging in a difficult market; establishing new and maintaining current sources of funding; combating higher funding costs; complying with increased accounting and regulatory demands; mitigating against rating agency downgrades; ...

And now a new source of redemption requests - by CFOs

CFOs -- collateralized fund obligations -- are essentially leveraged bets against the performance of a (oftentimes managed) portfolio of hedge funds. As is the case with CDOs, investors in CFOs go "long" the performance of a set of receivables (usually from debt). For CBOs, these receivables are the coupons of bonds (hence the "B" in CBO). For CLOs, loans. For ABS CDOs, the underlying are ABS (really, RMBS) tranches. For CFOs, the return of the funds, with the underlying typically comprising direct purchases in hedge funds or referenced exposures via total return swaps.

CFOs differ from typical CDOs in a few ways (e.g., similar to market-value CDOs, overcollateralization tests measure market value coverage - as opposed to par/principal coverage; there's no real notion of interest coverage ratios; existence of minimum net worth tests with various curing and/or liquidation procedures, such as the issuance of additional preference shares).

In the case of Phenix CFO, according to Bloomberg, more than 75 of the 80 hedge funds invested in by the structure have either liquidated or limited (or completely suspended) client withdrawals from their funds. With this in mind, Phenix's bondholders voted to liquidate the deal.

This notification, which came out on Friday, ends a tough month for hedge funds and banks in general, as can be seen from the graph below (click on it to enlarge).


UPDATE - February 2, 2009: Fitch Ratings Announcement

To address short-term volatility in CFO performance as well as reporting delays from underlying hedge fund investments, Fitch's [newly updated] analysis applies a 10% haircut upfront to the most recent reported portfolio NAV. The 10% haircut was derived using the worst monthly return decline reported by Fitch-rated CFOs.

...

Hedge fund returns, as represented by several multi-strategy indices, declined approximately 20 to 25% in 2H 2008. As well, Fitch has observed reductions to hedge fund CFO liquidity (including gating, restructuring, side pockets) in a range of approximately 5% to 40% of net asset value(NAV) in fourth-quarter 2008.

Interestingly, this final paragraph bring us back to our October '08 piece (Jack of All Trades?), highlighting the underperformance of multi-strategy hedge funds.

UPDATE - March 26, 2009: Moody's downgrades all tranches issued by SVG Diamond Private Equity II. SVG is a CDO somewhat similar to CFOs, but is backed by returns to shares of (principally) private equity (PE) funds, as opposed to a diversified pool of hedge funds.

Unequal Hedge Fund Disclosure - How "Fair Value" May Become Unfair

The Problem

All hedge fund disclosures are equal, but some investors apparently have more equal transparency than others.

Perhaps, for a tough sale, a hedge fund manager may be inclined to show certain procedural documents to a certain investor, while the less inquisitive investor may not be privy to the same information. That's just a guess, but whatever the case may be, let's call this situation "Preferential Treatment."

For example, fund-of-funds ABC knows that hedge fund HF would exit strategy STR if situation XYZ occurs. Suppose fund-of-funds DEF doesn't isn't privy to this exit strategy.

An Accident Waiting to Happen

From a fair value perspective, should ABC's investment in HF be accounted for equally with DEF's investment?

I would argue they're not equal, even though the HF's NAV is obviously the same for both funds-of-funds. ABC clearly has optionality that DEF lacks. Knowledge of HF's procedures gives ABC the option to either invest more or redeem, as it may see fit, whereas DEF is unaware of any changes. For the financial engineers out there, you all know that options cost money. ABC is long an additional option in this example, and so ABC's investment in HF should be greater than or equal to that of DEF.

Similarly, as an investor, knowing about your hedge fund's side pockets or ability to ring-fence part of its portfolio is crucial knowledge, as it affects your "redeemability."

Whereas the imposition of gates is highly publicized, the usage of side pockets is not well publicized: GLG Partners, and to an extent JB Global Rates Hedge Fund, being notable exceptions (see, for example Side Pockets - Keeping Hedge Fund Capital in Their Pockets).

A Litigation Disaster

Here's how this all went wrong for some firms (including Bear Stearns), according to certain excerpts from the SEC's: "Lessons Learned from Significant Examination Findings and Recent Enforcement Actions."

TRANSCRIPT

November 13, 2008

SECURITIES AND EXCHANGE COMMISSION

DELMAGE: ... we've seen situations where firms have failed to consistently apply these redemption policies.

Again, this is primarily in private funds. As everyone's well aware, firms have opposed gates. They've curtailed other abilities for people to extract liquidity from their underlying investments.

And again it comes out to disclosure. The [SEC] staff is gonna be looking at what's in the private offering documents, what's in the marketing materials, what's been in the ADV regarding the process for handling redemptions.

Timing, you know -- when certain times, certain dates, how much notice people need to give before they want their -- get their redemption proceeds -- and I guess, as part of that, one thing we will be looking at is to make sure there is no preferential treatment. Obviously, one of our concerns is, you know, maybe in days leading up to the announcement of the gate being imposed -- certainly the insiders of the investment advisor or maybe larger investors who have
a sizable stake in -- in the underlying funds -- are allowed to get their money out on different terms than other investors before the gates have been imposed.

And we've actually been seeing that in a number of examinations where, in this situation, the firm didn't impose the gate but they created a side pocket for a pretty sizable portion of the portfolio and had informed investors, and I believe they actually had sent out notice and people agreed to it, that they would be able only to redeem from the liquid portion of their investments up to a certain percentage.

And what we actually had seen -- looking at journals, e-mails again -- we had seen, you know, certain investors being able to redeem 100 percent of their investment. We had seen -- or saw situations where redemption requires had been backdated to certain investors.

Again, in certain situations, certain funds, depending on their asset class, have suffered some liquidity problems. There were other funds that didn't have that same problem and it appeared that the more liquid fund was funding the illiquid fund's redemption request; again, not disclosed to investors, nowhere in the offering documents.

... I think the lesson to be learned is, obviously, when the [SEC] staff sees a fund -- has imposed gates or somehow curtailed liquidity -- we are going to be looking at the disclosure documents. We're gonna be looking at how redemption requests have been handled, especially the period leading up to the announcement of that event.

... obviously, you have a fiduciary duty -- giving people preferential treatment, you know -- engaging in practices, you know -- backdating and other things, obviously, does not meet that test.

CHRETIEN-DAR: Just to emphasize Bill's point about preferential redemption not only is that a problem, in terms of your fiduciary obligation to your clients, but your insider [trading] procedures probably should be affected by this type of activity. There were -- in private litigation -- we saw that there were shareholders in the reserve fund made claims of inside information, in that some investors got out before the money markets fund broke the buck.

So there were a lot of private claims about insider training. The commission brought an action against the two portfolio managers of the Bear Stern hedge funds that invested in subprime-related securities.

And redemptions were also a big issue in that case, not only in terms of the commission's allegations regarding the representations on the status of redemptions, which was important to investors to know about, but on the criminal side there were allegations that the portfolio manager pulled out of the fund as he was reassuring investors about the fund.

So not only is it, you know, what you tell your investors, in terms of the status of redemptions, but also what you were doing with your own stake in those funds. Bear, apparently, had a policy at the time that portfolio managers in the funds that they mentioned should have a personal stake.

1 in 5 Americans 60+ Days Delinquent

J.P.Morgan came out with their September 2008 Home Price Update. The report shows the national average 60+ delinquency rate at a whopping 17.24%. Florida leads the numbers with 28.76% of borrowers 60+ delinquent (Michigan is next in line with 24.55%).

We graphed the state-by-state distribution of these delinquencies:

(Click on the graph to enlarge)

An Investor's Guide to Hedge Fund Leverage (Part 1)

Leverage (more specifically deleveraging) difficulties have caused more than their fair share of pain of late in the hedge fund world.

We're going to explore the concept of leverage by way of an example for now; let's suppose:

1. we're in a simple world (let's call it Wonderland) in which the price of a bond or a loan remains constant at $100 per $100 of par;
2. managers can only buy (go long) assets, and no naked shorting is allowed;
3. AA bonds carry coupons of LIBOR + 90 basis points (i.e., L + 0.9%); and
4. A bonds carry coupons of LIBOR + 125 bps (i.e., L + 1.25%).

Imagine these bonds are fairly illiquid and so the manager's strategy is to buy them and hold them to maturity. Assuming zero defaults, the manager who buys AA bonds will earn L + 90 bps on his/her investment, while the manager who took on more risk with single A bonds will earn L + 125bps.

Let's put aside our feelings about whether LIBOR + 1% or so is a "good" return. One thing we know for certain: unless LIBOR goes crazy and hits the 29% mark, your hedge fund is never going to earn 30% annually by simply buying and holding bonds, even if there are never any defaults. We're not going to invest in a hedge fund that targets L + 1%; to compensate for the limited upside potential of bonds/loans, relative to equity, fixed-income hedge fund managers need a little more zip. To "hit" the big numbers (assuming no shorting for now), they need leverage.

Leverage can be "achieved" in various forms, such as total return swaps and repurchase agreements ("repos"); for now let's examine the essence of the mechanism.

Suppose hedge fund HARRY has $10mm of capital and wishes to buy a $10mm position in that AA bond paying L + 90 bps. HARRY could buy it, after which HARRY is fully invested and yielding L+ 0.90%.

Alternatively HARRY enters an agreement with bank that wants to sell HARRY the bond. The agreement says that bank will LEND HARRY $10mm to buy the bond, subject to the following conditions:

1. HARRY must post the purchased bond to the bank as collateral for the loan;
2. HARRY must pay bank LIBOR + 10 bps on the loan, as long as it's outstanding; and
3. HARRY must post 5% haircut against the AA-rated collateral (to mitigate the bank's risk that the collateral defaults or depreciates in value).

Summary: HARRY's collects L+90 on this bond, pays L+10 to the bank, and has to put down $500K capital (5%) as haircut. Thus, he captures L+ 90- (L+10) = 80 bps on this transaction (of size $10mm). Since he's posting 5% haircut, he can logistically (we're still in Wonderland) perform this operation 20 times (20 x $500K = $10mm = HARRY's total capital). In so doing, he's making:

20 x 80bps x $10mm = a handy 16% return p.a. on capital

Some market terminology for you:

• HARRY is 20 times levered;
• HARRY manages $10mm capital, but has $ 200mm of assets under management (AUM);
• The bank's lending rate to the hedge fund is often termed the "Pricing Rate"; and
• The "haircut" described may also be referred to as initial margin, but bear with me here - we haven't yet breached the topic of "variation margin."

The better the collateral quality, the lower the haircut. Using a 1% haircut in the above example, would allow HARRY to lever up 100 times in Wonderland. Municipal bonds -- historically typically AAA rated and often insured -- are an example of collateral that could be highly leveraged on the back of this strong credit quality.

Now let's have a look at some actual (slightly historical) numbers, while remaining for a while in Wonderland...

(Click on the table to enlarge it)

This concludes Part 1. Part 2 will follow shortly, and will discuss, among other things:

• deleveraging, and its effects
• variation margin - and what happens with 2008 numbers
• leverage facilities: diversification, termination
• and possibly, the cases of Bear Stearns Asset Management (and Merrill Lynch), and the municipal arbitrage deleveraging nightmare

The Bankruptcy Burden

We're not economists, and certainly not of the Chris Flanagan/Mark Zandi ilk, but thought we'd give it a bash for a change and share with you all some of our thoughts on the October bankruptcy filings, which were up a troubling 13% from September for the US as a whole.

(Click on the graph to enlarge)

While an increase is understandable -- if not expected -- the rate of increase (i.e., the convexity) is disturbing.

As is typical, the lion's share (+- 95%) of these are non-commercial and heavily concentrated (99%) among chapters 7 and 13 of the bankruptcy code, although the distribution differs vastly from state to state (see table below).

We know October was a tough month for fixed-income, and by extension for banks and hedge funds, but the pain here remains non-commercial (think residential homeowners with little equity in their houses, in areas exhibiting strong home price depreciation).

(Click on the table to enlarge it)

We found this to be largely consistent with Economy.com's Dismal Scientist's analysis of recessionary vs. at risk states from last month (the top 5 are all in red, and the bottom 5 -- aside from Mississippi -- are all in orange, for now.)

We'll keep you posted on changes as the commercial real estate difficulties start to take their toll on corporate sustainability.

Back to the (Hedge Fund) Future

So the hedge funds are struggling.

Name the fund, pick the strategy; it's struggling. It doesn't matter if you're an academic playing the curve (Myron Scholes' Platinum Grove) or a contrarian macro-fund manager (Peter Thiel's Clarium).

Don't get me wrong here - I'm not suggesting all hedge funds are equal. Indeed some are more equal than others. The access to funding and execution resources may be material differences (although these funds often tend to be more highly leveraged on the back of their support system, and in this deleveraging nightmare are subsequently underperforming their peers despite the availability of this backing - see for example Highbridge Capital, Goldman's Global Alpha, UBS's Dillon Read, and various Citigroup hedge funds).

And despite all the blah blah about 2 & 20 fees being problematic, let's face it - it's not the fees causing 20%, 50% or 80% losses. And it's not regulation either: almost by definition, hedge funds are not having to mark-to-market (MtM) their illiquid/hard-to-value securities. (I'm not strictly correct here, particularly for Och-Ziff, Blackstone and Fortress, which are publicly traded.)

So what is it?

If you're a hedge fund, you're net long; if you're trading OTC securities, you're subjected to comparatively massive bid-offer spreads; and if you're levered, you're dependant on the banks for financing.

What does this all mean?

As a hedge fund you've got capital and you're being paid to put that capital to work. Even if you're long/short equity, you're typically net long at least the same amount as your capital, unless you're holding substantial portions in cash. As an investor in a hedge fund, you don't want your manager charging you hedge fund fees to invest in cash. You can do that yourself. For free.

In a down-cycle, the equity hedge fund manager would have to be a pretty impressive stock picker and seller just to cut even. It's tough to be consistently correct, especially in a fear-driven, volatile market.

But it's the fixed-income hedge funds that have to deal with large bid-offer spreads on OTC-traded securities to cover the market's illiquidity premium/discount and the intermediary's (bank's/broker's) risk that it can't off-load the security and may become subjected to downside MtM pricing risk. You have to be pretty good just to come out even.

And then there's that little issue of leverage. With hedge funds going under all over the place, the banks are understandably being ultra careful about who they lend to (not to mention spending extraordinary amounts of time reverse-engineering the value of their clients' portfolios, to get a better idea of any pending client defaults). If you're looking like defaulting, your haircuts are going to go out of the roof and/or they may draw their line completely. So your hedge fund's default probability -- or more accurately your leverage providers' perceptions of your default probability -- adds an additional burden to the deleveraging nightmare (see our piece Illiquidity: Self-perpetuating Phenomenon). But a blog on this will have to wait for another day...

Where to from here?

We can't pretend to have all the answers; let's call these guesses for now:

Similar to the increased regulatory demands Goldman and Morgan now face as bank holding companies (subject to the Fed), hedge funds are suffering from increased scrutiny and, with it, criticism of their investments and operations - not to mention decreasing investor confidence and redemptions skittishness.

(Even New York City Mayor Michael Bloomberg endorsed the U.S. Treasury's recent recommendation of a new "market stability regulator," that would be able to step in when markets got out of control, having oversight over firms that generally escape regulation, like hedge funds and private equity firms.)

In the absence of "free reign" we envision the natural progression (particularly among the larger hedge funds) towards advisory or asset-management-esqe businesses (think PIMCO, Blackrock): the move away from bank dependency to the unleveraged world of asset management seems an appealing option; alternatively, the move into the advisory space is quite cheap and relatively swift a process, especially as they already have the expertise in-house.

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.