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What role did Hedge Funds play in the credit crisis?

July 3, 2011 2 comments

I have been asked numerous times questions along the lines of “What was the role of hedge funds in precipitating the credit crisis?”

The short and simple answer is: They are NOT responsible for the credit crunch. (If anything, Hedge Funds as unregulated investment vehicles probably help keep the markets in check).

Below is the long answer I posted on a discussion forum which attracted recommendations and interests; as such, I am reposting here.

If you have to draw the line somewhere, like with all market cycles, then post-dot-com crash or 9-11 in 2001 would be a good arbitrary starting point. The key points to remember are:

1) Greenspan kept interest rates for far too low after 9-11 and the dot-com crash – fuelling a credit bubble.

2) This cheap credit meant a housing bubble, as low rates = low mortgage = let’s all buy a house! Happy days!

3) As house prices went up, banks ran out of people to loan money to, they went to subprime or Alt-A (alternative to A-paper).

4) From subprime/Alt-A, greed led us to NINJA loans. No income, no jobs and no asset. These people can’t even prove their income but they can get a mortgage. Happy days!

5) House prices were going up, banks kept lending at record low rates, paying themselves huge bonuses. Everyone was doing it. Can’t beat ’em join ’em mentality. Risk was perceived to be low as everyone believed this housing boom was going to continue. Therefore, banks can easily repossess and sell the houses on, fuelling predatory lending.

6) The loans were packaged up, sliced up and sold on worldwide (e.g. European/Japanese pension funds/institutions).

7) ‘Experts’ argue that never in the US history has there been a NATIONWIDE simultaneous fall in the housing market. (Blackswan event, God I hate that word.) This led to the belief that securitized mortgages are relatively ‘safe’.

8) Pension funds can only buy triple A or AAA rated investments. Investment banks got around that problem by mixing up subprime loans with top rated ones. Paid good money to Moodys and S&P to rate them triple A. The rationale was that not everyone is going to default at the same time (see no. 7). The CDOs (Collateralized Debt Obligations) spread the risk around…

9) Hedge funds act like vultures. They are like the market vigilante. Some of the top guys like Michael Burry, John Paulson, Andrew Lahde (my favorite because he knew when to call it quits) begin to explore ways to short housing.

10) This proved to be almost impossible. They could short firms like NATIONWIDE or homebuilders but naked short selling = their losses can be unlimited and the market can remain irrational then we can remain solvent. (Some managers who correctly foresaw the crash lost money because they bet too early and the market still kept going up.)

11) So smart guys like Paulson found a way to bet against housing by buying Credit Default Swaps (CDS). It is sort of like an insurance policy in case the loan goes bad. His line of reasoning is that, when the shit hits the fan, everyone will be scrambling to buy insurance because their loans will be worthless.

12) As Nouriel Roubini puts it: “It is weird that these CDSs (insurance policy) can be traded around freely. For example if you own a house, only YOU can buy fire insurance for it. But in the case of this credit crunch, I or anyone can buy insurance for your house insuring it multiple times, and then sell it on later, essentially betting on your house burning down.”

13) On a sideshow, Goldman Sachs got hauled up to Congress to explain the fact that they helped Paulson & co pick the worst tranches to bet against. GS later turned around and bet against housing themselves.

14) Those that did not bet against housing were geared and long – and as it turns out they were also ‘long and wrong’. Banks were highly leveraged: 30:1 for Lehman 42:1 in Bear Stearns’ case. It was a case of the sausage makers keeping all the sausages on their books despite knowing what went into them.

15) It was only a matter of time when homeowners started defaulting. It became a snowball effect. When half your neighbourhood is being foreclosed, the value of your home plummets. You bought your house for 500k, now it is worth 300k. You hand in the keys and walk away. So more defaults again!

16) Now all the banks are scrambling to buy CDS. House is on fire! CDS shot through the roof. Guess who is holding it? The hedge funds who correctly bet on them like Paulson.

17) AIG (yup, US taxpayers money bailed them out) wrote most of the CDS and sold it dirt cheap. In traders’ lingo – you have AIG making money paying huge bonuses selling insurance policy for houses built from flammable material next to a pyrotechnic factory located on an earthquake fault line. It was a case of ‘picking up nickels and dimes in front of a steamroller/freight train’.

18) No problem – when AIG was about to go down, we have TOO BIG TO FAIL. Lehman was Goldman Sachs’ number one competitor but they were allowed to fail. If AIG went down, Goldman Sachs was on the hook. But no problem, the then Secretary Hank Paulson was former CEO of Goldman Sachs (conflict of interest?). Hank played a key role in bailing out AIG. AIG straight away paid back Goldman.  Make of this what you will. “It is Government Sachs mate. GS is a branch of the US government.” (That was what a friend said to me.)

19) When the market tanked, a lot of institutions started pulling funds from hedge funds. Some of which were geared/leveraged. They then had to unload their positions in a thin market, causing a death spiral. The liquidity problem killed them.

20) So do hedge funds have a role in causing the crash? Answer = NO!  They were as much a casualty as a profiteer.

So what caused the credit crunch? Well, no simple answer. I tried to keep it to 20 sentences. I guess it is a case of pluralistic ignorance, greed, hubris and regulation (or the lack of it)?

“If I had known I was going to fall down, I would have sat down” old Polish proverb.

 

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The Four Most Dangerous Words in Investing

June 26, 2011 Leave a comment

First published on BBeyond Magazine blog – an ultra niche publisher that caters exclusively for the global UNHW market and community: http://bbpublications.org/BBblogs/the-four-most-dangerous-words-in-investing/

“The four most dangerous words in investing are ‘This time it’s different.’”

– Sir John Templeton (29 November 1912 – 8 July 2008)

In 2005, the late Sir John Templeton penned a memo, which wasn’t discovered until after his passing in 2008.  It was eerily pithy, almost ‘prophetic’  as the first two words were bolded in its original text and begins as follows:

Financial Chaos – probably in many nations in the next five years. The word chaos is chosen to express likelihood of reduced profit margin at the same time as acceleration in cost of living.”

Sir John had already correctly predicted the Dot-com crash and his predictions of a housing bubble (that will eventually burst) and subsequent stock market fall all came to pass. However, those with views similar to Sir John back in 2005 would generally have found their concerns of the housing market pooh-poohed by the proponents of securitization as the US housing market has ‘never experienced’ a simultaneous nationwide fall.

Time and again, investors have always used the words “this time it’s different” or many of its variants to justify our actions when we rush headlong into a bubble. Caught up in the euphoria of a bull run, we post-rationalize our thoughts and seek out ‘evidence’ to support our hypotheses. Much like when we suddenly decide to purchase a car of certain make and color, we tend to notice it a lot more often on the road. As our paper wealth increases, we use that as justification, or worse, as ‘proof’, that our earlier convictions were indeed ‘correct’. Perhaps it is cognitive dissonance – not too dissimilar to a smoker who is perfectly cognizant of the health risks yet continues to feed his habit by inhaling from the cancer stick. Psychologists have shown that we have a tendency to underestimate the risk of an activity when we ourselves are engaged in it. We also have a penchant to indulge in intellectual materialism where we treat our ideas like possessions. We find it difficult to admit we were ‘wrong’ in light of new contradictory information and as a result, we hang on to our ideas for far too long. Perhaps this could be a reason why economic bubbles continue to persist despite ever more efficient markets.

Hindsight is a beautiful thing or, as I always say, “hindsight vision is always 20/20”. From the tulips mania in 1600s and the South Sea bubble in 1720, to the Housing bubble in the 2000s – it was never a bubble in foresight, only in hindsight. To quote the ‘greatest stock operator’ that ever lived:

“There is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again.” – Jesse Livermore

The whole premise of efficient markets lies in the fact that overvalued stocks should theoretically attract short sellers to bring it back in line. Arbitrageurs should keep the markets in check. However, as Yogi Berra once said “in theory there is no difference between practice and theory, in practice there is” and as we now accept, the markets are not always rational. In fact, I would go as far as to argue that rationality itself is an arbitrary concept.

Keynes once remarked that “The markets can remain irrational longer than you can remain solvent.”  Even the best investors have painfully discovered that being early and right is the same as being wrong.

Michael Burry of Scion Capital faced an investor revolt when he bet too early on the recent subprime mortgage crisis.  The housing bubble continued to inflate before his predictions came true and the investors that stuck with him made a tidy profit.  Scion ultimately returned almost 500% (net of fees and expenses) from November 2000 until June 2008 whilst the S&P returned just over 2% over the same period.

Even the likes of George Soros, his once right-hand man Stanley Druckenmiller of the Quantum Fund and Julian Roberston were not spared from the ‘irrationality’ of the markets. Titans of the industry and legends in their own right, each man has paid dearly for being ‘right too early’ at one point or another in their careers. If being right too early equals being wrong, does being ‘wrong’ too early equal being ‘right’? Is it homogeneous and symmetrical? (More on this later.)

Julian Roberston’s Tiger Fund paid the ‘ultimate price’. Robertson correctly called the tech bubble in the late ’90s but had to unwind the legendary fund in March 2000  ̶  just before the NASDAQ tanked. Since there was no hope of bucking the trend as momentum traders continued to ride the wave, hedge funds mostly jumped on for the ride. Only the bravest or perhaps the foolhardiest would even dare consider trading against this mania.

Perhaps the bravest of all was Julian Robertson, who suffered heavy losses when everyone else surfing the wave was making extraordinary profits. Faced with a flood of redemption requests from investors as the bubble drove the price of tech stocks to dizzying heights, Robertson, who famously refused to partake in the Internet craze, just couldn’t hang on long enough. He had repeatedly warned the ‘day of reckoning would come’ when Internet companies that had never turned a profit continue to skyrocket against a backdrop of collapsing stocks elsewhere.

In March 2000, Robertson decided he had had enough of waiting and closed down the battered Tiger Fund. At around the same time, the NASDAQ crested to mark the beginning of the end for the tech bubble. But for Robertson and his Tiger Fund, the end just could not have come soon enough. The ‘day of reckoning’ did come on 13 March 2000 when the sell off began, but for Robertson it was too late. The market had remained irrational longer than he could stay solvent. Over the next 20 months, the NASDAQ fell from 5038 to a bottom of 1114. At its peak, Tiger had well over $20 billion in assets under management and Robertson was second to none when it came to stock picking.

Back in 1867 John Stuart Mills noted “Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive work”. The same lesson could still be applied to the Stock Market Crash of 2000-2002, which wiped off $5 trillion in the market value of companies.

Perhaps it is no wonder that Sir Isaac Newton famously said “I can calculate the motions of heavenly bodies, but not the madness of people” when the genius himself got caught up in the South Sea bubble and reportedly lost £20,000 (equivalent to £3 million today).

Earlier, I argued that rationality itself is an arbitrary concept and posed the question “If being right too early equals being wrong, does being ‘wrong’ too early equal being ‘right’?” Think about it: if everyone in the world suddenly became ‘irrational’, would that not make you the irrational one (at least from a medical standpoint)? If rationality is defined by consensus, then by implication rationality is a moving target. Hence, when the market is acting ‘irrationally exuberant’, do you try to remain ‘rational’ and short the market (like Robertson did)? Or do you act ‘rationally’ by jumping on for the ride to profit from it (like Druckenmiller eventually did)?

George Soros famously said “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong”. I would venture as far as saying when it comes to the markets, there is no such thing as ‘wrong’ or ‘right’. There are strategies that are profitable, and strategies that blow you up. That’s it.

Fortunately, in finance, economists have another term called ‘profit-maximizing’, which is often used interchangeably with ‘rational expectations’. However, as investors we may not always have the luxury or liberty to consider etymological and philosophical questions when our portfolio is haemorrhaging money. If it walks like a duck, quacks like a duck and looks like a duck, for all intents and purposes, it is a duck!

 

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