Yesterday, the House Oversight and Government Reform Committee hauled in a gaggle of hedge fund managers to grill them about, among other things, why they should receive such favorable tax treatment. If I were a congressman, the question I’d have liked to have asked this crowd is, “Why is it so often the case that when hedge funds fail, they don’t merely fail, they implode, like dying stars?” This failure mode seems especially inappropriate for an investment class that’s often touted as a way to make money in both good times and bad.
I can’t possibly discuss all the causes of hedge fund failure here, because the reasons are often complex. As the New York Times’ Joe Nocera reported today, MIT professor Andrew Lo also spoke to the House Committee and recommended that the financial industry needs an entity analogous to the National Transportation Safety Board. This would be a board responsible for surveying the wreckage of failed financial institutions (including hedge funds) and for reporting on why they failed and what should be done to prevent similar failures in the future.
Still, it seems to me that a number of large hedge fund collapses have had something in common: lots of borrowed money.
There have been some spectacular hedge fund failures in recent years, including two Bear Stearns funds and Amaranth Advisors. If you have a long memory, you’ll recall the granddaddy of all hedge fund failures that took place about ten years ago, when Long-Term Capital Management, a hedge fund anchored by Nobel Prize-winning economists Myron Scholes and Robert Merton, lost over four billion dollars in a couple of months and had to be bailed out by a consortium of investment banks.
The acquisition of Bear Stearns by J.P. Morgan Chase in March of this year narrowly averted Bear’s bankruptcy. The proximate bankruptcy risk was due to the large number of complicated credit swaps and other liabilities held by Bear Stearns, but Bear had also lost the confidence of its creditors through the failure of two of its hedge Funds. Although they had great-sounding names – High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Strategies Enhanced Leverage Fund – the funds lost about $1.6 billion of their investors’ money. Their losses prompted Merrill Lynch to seize $800 million in mortgage securities that had been held as collateral for the funds. At one point in July of 2007, investors in the worst-hit fund were trying to sell their positions for 11 cents on the dollar. The funds had invested heavily in subprime mortgage securities that went south; in addition, the “Leverage Fund,” like Long-Term Capital Management before it, made excessive use of borrowed money.
In order to talk about why hedge funds are able to lose such prodigious amounts of money, I should introduce two terms that may be unfamiliar to some readers: leverage and liquidity. Leverage is just borrowed money. When you buy a house by putting 20% down and borrowing the rest, you’re using leverage.
Liquidity is the ability to convert an asset into cash without greatly affecting the market price. This is a simplified definition; people who know much more about liquidity than I debate about what it is. What’s important to understand is that when the market for a security is not liquid, nasty things can happen. Either it becomes impossible to sell the security because no one wants to buy it, or it can only be sold at a fire-sale price.
The Role of Leverage in Hedge Fund Losses
I must acknowledge that not all hedge funds use leverage; some don’t use it at all. The average amount of leverage among hedge funds is estimated to be about 2.5x: for every dollar of investors’ equity, the average fund is also investing $2.50 of borrowed money. However, many hedge funds use higher leverage, and it can even be an order of magnitude higher. By some estimates, prior to its collapse Long-Term Capital Management was using at least 25x leverage. I recently attended a seminar in which the speaker, a professor at the Wharton Business School, asserted that LTCM’s leverage was probably as high as 70x.
Suppose a hedge fund manager comes up with an investment strategy that he believes has a vanishingly small risk of loss plus a high probability of generating a six-month gain of 3.5%. On the face of it, this is not a huge amount of gain, but it’s pretty good. However, the manager knows that he can increase the magnitude of the gain by using leverage. Let’s suppose, as was the case not so long ago, that the manager is able to borrow money at short-term annualized interest rates of 4%. He decides to use a fair amount of leverage, borrowing nine dollars for every dollar of invested capital.
If his investment scheme succeeds, here’s what his return would be in six months:
If for some reason the manager had to pay back his borrowed funds at this point, he’d have $1.17 for each dollar of invested capital: the 3.5% return has been transmogrified into a 17% return through the use of leverage.
What would happen if, contrary to the manager’s expectation, the investment actually lost 5%? In an unhedged portfolio, a 5% loss is not great, but it’s hardly a disaster. But in a leveraged scenario, losses, like gains, are amplified:
|Net value||$ 9.32|
Now if the loans are called in, what remains is 32 cents of each dollar originally invested, for a loss of 68%. A miscalculation of the potential for loss suddenly has much greater consequences when leverage is involved. A somewhat larger investment loss – 8.2% – would wipe out all of the fund’s capital. Any loss greater than 8.2% would leave the fund with a negative net worth.
The Role of Liquidity
Hedge funds are expected to avoid large losses; part of what makes them attractive is the putative ability to make money even in a down market. Thus, if an investment strategy sours, a hedge fund is usually under pressure to act quickly to cap its losses. In order to sell a security quickly at a reasonable price, liquidity is essential.
In practice, it’s not unheard of for multiple hedge funds to use similar investment strategies simultaneously. If an investment strategy fails, there are sometimes multiple hedge funds all trying to sell their holdings at the same time. When there are lots of sellers and few buyers, the market for a security can seize up as liquidity disappears. In order to sell an illiquid security, the seller may have to settle for a drastically reduced price. In such a situation, losses can mount rapidly, especially if a fund has a sizable amount of money invested in similar or related strategies. Add some leverage to the situation, and disaster can ensue.
Fees on Fees
Recently Business Week made an interesting observation about a category of hedge funds known as “funds of funds” (FoF). These are hedge funds which contain holdings of several other hedge funds. In a seminar on alternative investments, I heard a hedge fund expert jokingly refer to the “FoF” acronym for these funds as “fees on fees,” because investors in these funds pay two layers of fees – one to the underlying hedge funds, and another to the manager of the fund of funds.
The Business Week article notes that although funds of funds were thought to be safer than individual hedge funds (because they are not concentrated in any single fund), they’ve been underperforming individual hedge funds. It turns out that about half of the funds of funds have been using leverage, and the hedge funds they bought with borrowed money were also leveraged – at an average level of $6 of debt for every $1 of capital. They were actually offering leverage on top of leverage, so that a downturn in one or two underlying funds could cause a more severe downward spiral in a fund of funds.
Hedge fund managers are supposed to be among the smartest people in the investment world. It’s hard to understand why such smart people have been able to lose so much money so quickly. My opinion is that they had too much faith in their investment models; they really believed that they were taking very little risk. Levering up their investments felt “safe” to them.
The widespread use of leverage can spread default risk throughout the financial system: Hedge Fund A collapses, causing Fund of Funds B to fail, causing that fund’s lenders to fail, and so on. If something like the NTSB does get put into place to analyze hedge fund failures, we can only hope that one outcome of its work is the establishment of reasonable limits on the amount of leverage that an investment entity is permitted to use.