Thursday, June 12, 2008

Deleveraging, Part II "You are the Hedge Fund Manager"

You, the $1 Billion Hedge Fund Portfolio Manager Imagine you are the hedge fund manager that invests $1 billion dollars of your clients' money in securities (“stocks, bonds, mortgage backed securities, etc.”) and it’s January 2007. This $1 billion is made up of one mortgage backed security called ABB-123 and its cost ("price you paid") is based upon a pool of mortgages that were given to a bunch of borrowers whose a) credit was suspect, b) produced no documentation to support their current and future earnings potential, etc., etc. You get the picture, ABB-123’s price is based upon payments from mortgages that have a very good chance of defaulting on the loan, but with this risk comes the promise of high returns. Your incentive to buy this high risk/high return potential security is because your high net worth clients demand high returns for your high fees. In fact, the only way these borrowers could pay the mortgage back is if the price of the house they bought rose faster than the mortgage’s value, and that there was an immediate buyer for this property at that higher price. That’s the key.

Your Portfolio Holdings OK, so your portfolio is $1 billion, and let’s make the price at which you bought ABB-123 was $500 million, or half the portfolio’s value at time zero. Finally, let’s say the rest of your portfolio is made up of 2 securities that are of high quality at the time. Let’s use Ebay and Alcoa as examples, and make each position in each stock worth $250 million. This is a simple portfolio, the names don't matter.

Fast forward to 2nd half of 2007 The market tanks in July on news that Bear Stearns' 2 hedge funds blowup, and stocks across the board fall rapidly with no stock spared. “De-leveraging" is to blame, and more specifically, you the hedge fund manager, along with all the other hedge fund managers holding the mortgage backed securities, are specifically blamed. Why?

The Rationale Home prices in Florida, California, etc. begin to fall as the supply of homes begins to outpace demand. Home prices thus begin to fall. On the micro level, the sub-prime borrower cannot make the minimum payment, and never really could. He bought the home for $500K, the loan is for $490K, with $10K of his own equity (cash) originally put up. The collateral is the house. If the plan worked, he quickly sells the house for $550K, pays back the $500K loan, and pockets the $50K (assuming no transaction costs). He hopes to earn a return of 400%, or $40K on his original $10K of equity. It’s the riskless profit, or free lunch, and Alan Greenspan was the chef. As a side note, you may ask, in addition to the fees the bank collects for a loan that they know will blowup, what was their incentive? During the heyday, banks who originated the risky loan didn't care, because with prices going up, if the borrower defaulted, the bank got the collateral which at the time, was considered high quality because they could sell the property in a can't lose market.

Let's Put Names to Faces... Now, what if the sub-prime borrower (Bob) sells the house for $450k, cause that’s all he can get in a declining housing market? Bob now brings a check to the closing. The buyer gives “Bob” $450k, but Bob still owes $490k to the bank. So now Bob must pay the bank $40k, losing his $10K in equity in the process. “Whoops, my bad.” As a side note, Bob’s return is -400%, that's leverage working in reverse, magnifying Bob's losses. The question now becomes, “how does the borrower raise the $40k he owes?” Maybe he sells his car, taps his savings, etc.

Zoom Out, Mr. Portfolio Manager, Let's Get Back to You Remember, you are running a high profile hedge fund that borrowed tons of “free money” and used this cash to buy massive amounts of sub-prime mortgage backed securities the investment banks created that promised high returns. In this example, ABB-123 security’s price begins to fall because the cash flows that make up this security will not be realized (i.e. the "Bob's of the world are letting you down.") You know the price of this security is falling, and you know you have to pay back the bank you borrowed at low rates to buy. So you try and sell ABB-123 as quickly as you can to minimize your losses. But now that Bear Stearns’ hedge funds blew up, everyone knows these mortgage-backed securities were bogus. So you try and sell ABB-123, but no one will buy it, even as you drop your price. So at some point, the value you can realize from ABB-123 is lower than the loan you have to pay back, so you have to raise cash, and the amount of cash you need to raise is inversely proportional to the hope you have of selling ABB-123 for anything. Worse still, your trading partners know this stuff is toxic and worthless, so you basically get pennies on the dollar for ABB-123. Oh, and the loan is still due. So what do you do?

Time to Raise Some Cash Well to de-leverage, or pay the loan back, and minimize your losses, you sell other high-quality securities to raise cash to cover the loss. If you liquidate your EBAY or AA shares to raise the cash, you put pressure on these shares. People know you need cash, so why not wait because they know they could get these shares for less? Or, what if you aren’t the only hedge fund out there with the same issue or the same strategy? No one will trade with each other because there’s no trust between buyer and seller for ABB-123, and so these markets “seize up.” As Bill Gross of Pimco stated, the fund manager trying to find a buyer for ABB-123 is like the person holding the card with the old lady on it in the card game “Old Maid" where everyone knows he's holding the card becuase the corner is "bent."

So once Bear Stearns’ hedge funds blew up in July, the race was on. Everyone knew these funds held lots of sub-prime based securities, but it was too late. In the second half of 2007, hedge fund managers raced to sell their good holdings to raise capital so they could pay back the loans ("de-lever") and minimize their losses. As more selling happened, prices fell, and everyone got caught in the down draft, i.e. your 401k. As a final note, guess who created all of these “mortgage-backed securities?” The investment banks, and that business of collecting fees is over.

Final note Lehman Brothers has been in the news a lot lately. Guess how levered LEHM is? The answer is ~30, based upon year end 2007 balance sheet figures. They basically have “loans” that amount to 30 times the amount of equity they have on their balance sheet. They are the homeowner that bought a house for $300K using $10K. Finally, their market cap is $13B (market value of equity).

Assets = $691B
Equity = $23 B (book value)
Liabilities = A –E = ~$670B
Leverage = $691 / 23 = 30x