Dear Members,
Welcome to the
June 2010 edition of
our newsletter.
We have many new members, and several interesting
questions. Most of them are pretty young. Just for them, today
we will remember an interesting paper:
"Hedge Funds, Leverage, and the Lessons of Long-Term
Capital Management". Report of The President’s Working Group on
Financial Markets, April 1999
HEDGE FUNDS
A. General Description
The term
“hedge fund” is commonly used to describe a variety of
different types of investment vehicles that share some similar
characteristics.
Although it is not statutorily defined, the term
encompasses any pooled investment vehicle that is privately
organized, administered by professional investment managers, and
not widely available to the public.
The primary investors in hedge funds are
wealthy individuals and institutional investors.
In addition,
hedge fund managers frequently have a stake in the
funds they manage.
Entities classified as hedge funds are commonly organized as limited partnerships or limited
liability companies, and in many cases are domiciled outside the
United States.
Hedge funds are not a recent invention, as the
founding of the first hedge fund is conventionally
dated to 1949.
A
1968 survey by the Securities and Exchange Commission (“SEC”)
identified
140 funds operating at that time.
During the last two decades, however, the hedge fund
industry has grown substantially.
Although it is difficult to estimate precisely the
size of the industry, a number of estimates indicate that as of
mid-1998 there were between 2,500 and 3,500 hedge funds managing
between $200 billion and $300 billion in capital, with
approximately $800 billion to $1 trillion in total assets.
Collectively,
hedge funds remain relatively small when compared to
other sectors of the U.S. financial markets.
At the end of 1998, for instance, commercial banks had
$4.1 trillion in total assets; mutual funds had assets of
approximately $5 trillion; private pension funds had $4.3
trillion; state and local retirement funds had $2.3 trillion;
and insurance companies had assets of $3.7 trillion.
With $200 - $300 billion spread among
approximately 3,000 hedge funds, most hedge funds are relatively
small, with the vast majority controlling less than $100 million
in invested capital.
In fact,
according to commodity pool operator (“CPO”) filings
with the CFTC, there are perhaps only a few dozen hedge funds
today that have a capital base larger than $1 billion, and only
a small handful that exceed $5 billion.
The very largest hedge funds have less than $12
billion in investor capital, although some “families” of funds
have greater stakes.
Although individually and as an industry, hedge funds
represent a relatively small segment of the market, their impact
is greatly magnified by their highly active trading strategies
and by the leverage obtained through their use of repurchase
agreements and derivative contracts.
Apart from size,
hedge funds differ in other important ways from
alternative types of investment vehicles.
Hedge funds are
able to sell securities short and to buy securities on
leverage.
While this activity is not unique to hedge funds,
hedge funds
often use leverage aggressively.
Hedge funds also charge advisory fees based on
performance, and they tend to pursue short-term investment
strategies.
In general, active market participants such as
hedge funds
can provide benefits to financial markets by enhancing
liquidity and efficiency.
Additionally, they can play a role in financial innovation and the reallocation of
financial risk.
However, some hedge funds, like other large highly
leveraged financial institutions, also have the potential to
disrupt the functioning of financial markets.
Indeed, some observers have asserted that
hedge funds are responsible for large and sometimes
disruptive market movements in vulnerable economies.
According to several comprehensive analyses of the
issue, however, hedge funds do not appear to have played a
significant role in precipitating the financial market crises of
the past few years.
Further study of this issue will be undertaken by the
Financial Stability Forum, recently established by the
G-7.
There is
no single market strategy or approach pursued by hedge
funds as a group.
Rather, hedge funds exhibit a wide variety of
investment styles, some of which use highly quantitative
techniques while others employ more subjective factors.
Researchers and other industry observers therefore
often classify hedge funds according to the main investment
strategy
practiced by the funds’ management.
Global-macro funds, for instance, take positions based
on their forecasts of global macroeconomic developments, while
event-driven funds invest in specific securities related to such
events as bankruptcies, reorganizations, and mergers.
A relatively small set of
market-neutral hedge funds employ relative-value
strategies seeking to profit by taking
offsetting positions
in two assets whose price relationships are expected to move in
a direction favorable to these offsetting positions.
Hedge funds are also
diverse in their use of different types of financial
instruments.
Many hedge funds trade equity or fixed income
securities, taking either long or short positions, or sometimes
both simultaneously.
A large number of funds also
use exchange-traded futures contracts or
over-the-counter (“OTC”) derivatives, to hedge their portfolios, to exploit market
inefficiencies, or to take outright positions. Still others are
active participants in foreign exchange markets.
In general, hedge funds are more active users of
derivatives and of short positions than are mutual funds or many
other classes of asset managers. In this respect, the trading
activities of hedge funds are similar to those undertaken by the
proprietary trading areas of large commercial and investment
banks.
Hedge funds that conform to certain requirements
are
eligible for various exemptions from federal
securities laws.
In particular, unlike mutual funds, hedge funds are
exempt from SEC reporting requirements, as well as from
regulatory restrictions on leverage or trading strategies.
They also
face fewer limitations on the structure and size of
fees they may charge.
The sponsors of hedge funds that trade on organized
futures exchanges and that have U.S. investors, however,
are
typically required to register with the CFTC as a CPO.
Registered CPOs are subject to periodic reporting,
recordkeeping, and disclosure requirements.
To avoid the registration and reporting
requirements of the federal securities laws,
hedge funds generally do not raise funds via public
offerings of their securities, advertise broadly, or engage in
general solicitation.
Hedge funds also typically have either no more than
100 beneficial owners or require their investors to meet rigid
minimum size requirements.
Recent studies of hedge fund performance have
generally found that hedge funds as a group offer greater
return, yet greater risk, than investment benchmarks such as
Standard and Poor’s S&P 500 stock index.
Not surprisingly,
particular classes of hedge funds have at times
outperformed benchmark measures on a risk-adjusted basis, while
other classes have at times underperformed.
Importantly, the performance of many hedge funds
historically has not been highly correlated with overall market
performance, thus accounting for their inclusion in the
portfolios of wealthy individuals and institutional investors
who seek a broad diversification of their investments.
B. Trading Practices
Hedge funds are
only one example of a collection of institutions that
actively trade securities and derivative instruments.
An assessment of the public policy issues posed by
hedge funds might therefore benefit from a consideration of
hedge funds in the broader context of trading activity.
In today’s economy, the markets for traded securities
are performing an increasingly important role in the
intermediation of credit.
Among the
wide range of institutions participating in this
trading activity are hedge funds, trading desks of banks,
securities firms and insurance companies, mutual funds, and
other managed funds.
Some of these institutions engage in trading activity
more intensively than others.
The diverse collection of institutions, including
hedge funds, that engage in trading activity can be
characterized by similarities in their use of mark-to-market
discipline, leverage, and active trading.
Mark-to-market
Mark-to-market practices, the discipline of
periodically valuing positions at current market prices, may be
imposed through external accounting or regulatory requirements,
or through internal risk management practices.
In addition, mark-to-market practices may be imposed
through counterparties’ valuation of trading exposures and
collateral.
This discipline is useful for preventing the
concealment of losses and for encouraging the timely resolution
of problems.
While they
may not necessarily be required to do so, hedge funds
generally practice this discipline.
The use of
mark-to-market valuation for managing collateral and
variation margin to mitigate credit risk can impose cash flow
and liquidity strains on a trading entity.
Such liquidity and cash flow problems can be
particularly severe for a highly leveraged trading vehicle,
especially
during episodes of extreme price volatility when
mark-to-market driven collateral and margin calls can impose a
very short time frame for resolving liquidity problems.
Leverage
Leverage allows hedge funds to magnify their
exposures and, as a direct consequence, magnify their risks.
The term leverage can be defined
in balance-sheet terms, in which case it refers to the
ratio of assets to net worth.
Alternatively, leverage can be defined in terms of
risk, in which case it is a measure of economic risk relative to
capital.
Hedge funds obtain economic leverage in various ways,
such as through the use of repurchase agreements, short
positions, and derivative contracts.
At times, the choice of investment is influenced by
the availability of leverage.
Beyond a trading institution’s risk appetite, both
balance-sheet and economic leverage may be constrained in some
cases by initial margin and collateral at the transaction level,
and also by trading and credit limits imposed by trading
counterparties.
For some types of financial institutions, regulatory
capital requirements may constrain leverage, although this
limitation does not apply to hedge funds.
Hedge funds are
limited in their use of leverage only by the
willingness of their creditors and counterparties to provide
such leverage.
Hedge funds vary greatly in their use of leverage.
Nevertheless, compared with other trading
institutions, hedge funds’ use of leverage, combined with any
structured or illiquid positions whose full value cannot be
realized in a quick sale, can potentially make them somewhat
fragile institutions that are vulnerable to liquidity shocks.
While trading desks of banks and securities firms may
take positions similar to hedge funds’ investments, these
organizations and their parent firms often have both liquidity
sources and independent streams of income from other
activities that can offset the riskiness of their positions.
Like banks and securities firms, but
unlike most mutual funds, hedge funds lever their
capital bases to increase their total asset holdings by a
multiple of the amount of capital invested in the funds.
CPO reports, however, suggest that the significant
majority of reporting hedge funds have balance-sheet leverage
ratios (total assets to capital) of less than 2-to-1.
There are, of course, important exceptions.
According to September 1998 CPO filings, at least ten
hedge funds with capital exceeding $100 million leveraged their
capital more than ten times.
At the extreme, the most leveraged hedge funds in this
group levered their capital more than thirty times.
Active trading
Active trading, which is typical of hedge funds,
is a practice in which
investment positions are changed with high frequency.
Such trading may be conducted to maintain a desired riskreturn
profile as market prices fluctuate, or it may be conducted to
attempt to profit from shortterm changes in prices.
While turnover in hedge funds’ portfolios differs
widely, the typical hedge fund’s use of active trading
strategies is closer to that of financial intermediaries’
proprietary trading desks than to a mutual fund or pension fund.
Active trading strategies rely on market liquidity and access to credit to meet
funding needs.
However, an entity’s ability to trade actively can
diminish either because creditworthiness concerns cause
counterparties to cut trading and credit limits or because of a
broader disappearance of market liquidity.
The inability to execute active trading strategies can
lead to unexpectedly large mark-to-market losses as positions
that had been thought of as modifiable exposures become
longer-term positions.
C. Disclosure and Monitoring
A trading entity is often subject to disclosure
and monitoring of its financial condition, and these
requirements can serve to limit the trader’s activities.
Trading desks of a few major banks and securities firms are constrained
by internal risk management functions, by risk-based capital
requirements, and by public disclosure of the firms’ overall
trading activity.
No such limitations apply, however, to hedge funds. In
fact, hedge funds are subject to fewer public disclosure
requirements and less monitoring than many other financial
institutions.
Disclosures by hedge funds to counterparties and
investors are often made using accounting and balance-sheet
concepts. While such information includes notional amount and
market value of derivatives contracts, the typical accounting
statement is still not informative about the risk profile of
trading activity (e.g., the nature of the exposures to market
risk and credit risk).
D. Counterparty and Credit Relationships
In order for hedge funds to conduct their active
trading and to employ leverage, it is necessary for them to
enter into business relationships with other entities.
This section describes the nature of these
relationships.
Credit exposures
Credit exposures between hedge funds and their
counterparties arise primarily from trading and lending
relationships, such as through derivatives and repurchase
agreement (“repo”) transactions.
These exposures, which are often
reciprocal, are created when changes in market prices
cause the replacement values of transactions to rise above their
value at inception.
Thus, a default of either the hedge fund or the
counterparty would cause a loss to the other party because the
transactions can only be replaced at the market prices
prevailing after default.
The credit exposure of a
typical transaction has two components, the current
credit exposure and the potential future exposure.
The current credit exposure at a moment in time is the
market value of the contract, and represents the replacement
cost of the contract if one party to the transaction defaults at
that moment.
The potential future exposure is an estimate of the
possible increase in the contract’s replacement value from the
point of view of a particular firm over a specified interval in
the future, such as between the time of a potential default and
the time
the counterparty is able to replace the contract.
In addition to the credit exposures stemming from
trading relationships, further credit exposure may be realized
by counterparties when they extend credit to hedge funds through
credit lines.
Hedge funds
can face considerable liquidity risk through
mismatched cash flows of assets and liabilities.
Revolving lines of credit and broker loans are
sometimes used to bridge these mismatches.
However, these credit lines often entail high costs,
and thus are not typically used for establishing leverage.
Hedge funds can achieve economic leverage in their
positions more cheaply in other ways, such as through repo and
derivatives transactions.
Counterparties manage these exposures through a
variety of safeguards including due diligence, disclosure,
collateral practices, credit limits, and monitoring.
Due diligence and documentation
Due diligence reviews by extenders of credit to
hedge fund customers typically include assessments of:
offering circulars or private placement memorandums;
partnership agreements;
performance history;
investment authority;
management ability and reputation; capital, including
size, growth, investor concentration, and management share of
the capital base;
risk profile implications of the fund’s investment and
trading styles;
liquidity, including types of positions and investor
withdrawal rules;
leverage, including on- and off-balance-sheet
leverage, and fit with liquidity of positions;
risk management; and front and back office operations.
In addition to such reviews, maintaining up-to-date
documentation of all outstanding contracts is an important
component of credit-risk management.
Generally, signed master agreements are required prior
to initiation of transactions.
In cases where a continuing business relationship has
not been established and master agreements have not been signed,
“full” confirmations containing many of the provisions found in
a master agreement are used.
Master agreements
usually include standard ISDA (International Swaps and
Derivatives Association) and IFEMA (International Foreign
Exchange Master Agreement) default clauses, supplemented with
additional termination events covering the dissolution or liquidation of the fund,
the resignation of the fund’s general partner or principals, or
decreases in net asset values beyond a certain threshold.
THE LTCM EPISODE
A. Background
Long-Term Capital Management, L.P. (“LTCM”)
was founded in early 1994.
Although LTCM itself is a
Delaware limited partnership with its main offices in
Connecticut, the fund that it operates, Long-Term Capital
Portfolio, L.P., (“the LTCM Fund,” or “the Fund”) is a
Cayman Islands partnership.
The LTCM Fund was the investment vehicle for a number
of feeder funds, which were structured to meet the tax,
regulatory, or accounting concerns of different classes of
investors from different countries.
LTCM sought to profit from a variety of trading
strategies, including convergence trades and dynamic hedging.
Convergence trading (also sometimes known as relative
value arbitrage) refers to the practice of taking
offsetting positions in two related securities
in the hopes that the price gap between the two
securities will move in
a favorable direction.
In some cases, there is an underlying reason why the
favorable relative price changes are thought to be inevitable,
while in others the trade is more purely speculative.
Dynamic hedging refers to the practice of managing nonlinear price
risk exposure (i.e., from options) through active rebalancing of
underlying positions, rather than by arranging offsetting hedges
directly.
LTCM’s
principals included individuals with substantial
reputations in the financial markets and especially in the
economic theory of financial markets.
From its inception, LTCM had a prominent position in
the community of hedge funds, both because of the reputation of
its principals, and also because of its large initial capital
stake.
The LTCM Fund produced returns, net of fees, of
approximately 40 percent in 1995 and 1996, and slightly less
than 20 percent in 1997.
At the end of 1997, LTCM
returned approximately $2.7 billion in capital to its
investors, reducing the capital base of the fund by about 36
percent to $4.8 billion.
Despite this reduction in its capital base, however,
the hedge fund apparently did not reduce the scale of its
investment positions.
Put another way, the managers of the Fund decided to
increase its balance-sheet leverage by reducing its capital base
rather than by increasing its positions.
Approximately
80 percent of the LTCM Fund’s balance-sheet positions
were in government bonds of the G-7 countries (viz., the United
States, Canada, France, Germany, Italy, Japan, and the United
Kingdom). Nevertheless, the Fund was active in many other
markets, including securities markets, exchange-traded futures,
and OTC derivatives.
Its activity was also geographically diverse,
encompassing markets in North America, Europe, and Asia.
Specifically:
• The LTCM Fund
participated in government bond markets,
mortgage-backed securities markets, corporate bond markets,
emerging bond markets, and equity markets.
The LTCM Fund
held long and short positions in these markets, and
supported these positions in many cases through repo and reverse
repo agreements and securities lending agreements with a large
number of other market participants.
• The LTCM Fund took on futures positions at about a dozen major
futures exchanges worldwide, including some very sizable
positions.
These were primarily concentrated in two areas —
interest rate (including bond) futures and equity index futures.
• The LTCM Fund engaged in
OTC derivatives contracts with several dozen
counterparties.
These positions
included swap, forward, and option contracts, and were
predominantly focused on interest rates and equity markets.
• The LTCM Fund
participated in the foreign exchange markets to
support its activities in multiple national markets.
Although the Fund sometimes held open foreign exchange
positions, it was not substantially engaged in efforts to profit
from foreign exchange fluctuations.
• The LTCM Fund’s
involvement in the markets for physical commodities,
if any, was negligible.
Overall, the distinguishing features of the LTCM
Fund were the scale of its activities, the large size of its
positions in certain markets, and the extent of its leverage,
both in terms of balance-sheet measures and on the basis of more
meaningful measures of risk exposure in relation to capital.
The Fund reportedly had
over 60,000 trades on its books, including long
securities positions of over $50 billion and short positions of
an equivalent magnitude.
At the end of August, 1998, the gross notional amounts
of the Fund’s contracts on futures exchanges exceeded $500
billion, swaps contracts more than $750 billion, and options and
other OTC derivatives over $150 billion.
Moreover, the Fund held large relative positions
in several markets, such as in U.S. and foreign futures
exchanges.
For example, a number of the Fund’s futures positions
represented more than five percent of open interest, and in a
few cases, well above ten percent.
Relative to daily turnover in those markets,
the scale of the fund’s positions were even larger.
In addition, the LTCM Fund also held very significant
positions in specific securities.
With regard to leverage, the LTCM Fund’s balance
sheet on August 31, 1998, included
over $125 billion in assets.
Even using the January 1, 1998, equity capital figure
of $4.8 billion,
this level of assets still implies a balance-sheet
leverage ratio of more than 25-to-1.
The extent of this leverage implies a great deal of
risk.
Although exact comparisons are difficult, it is likely
that the LTCM Fund’s exposure to certain market risks was
several times greater than that of the trading portfolios
typically held by major dealer firms.
The
LTCM Fund’s size and leverage, as well as the trading
strategies that it utilized, made it vulnerable to the
extraordinary financial market conditions that emerged following
Russia’s devaluation of the ruble and declaration of a debt
moratorium on August 17 of last year.
Russia’s actions sparked a “flight to quality” in which
investors avoided risk and sought out liquidity.
As a result, risk spreads and liquidity premiums rose
sharply in markets around the world.
The
size, persistence, and pervasiveness of the widening
of risk spreads confounded the risk management models employed
by LTCM and other participants.
Both LTCM and other market participants suffered
losses in individual markets that greatly exceeded what
conventional risk models, estimated during more stable periods,
suggested were probable.
Moreover, the simultaneous shocks to many markets
confounded expectations of relatively low correlations between
market prices and revealed that global trading portfolios like
LTCM’s were less well diversified than assumed.
Finally, the
“flight to quality” resulted in a substantial
reduction in the liquidity of many markets, which, contrary to the assumptions implicit in their
models, made it difficult to reduce exposures quickly without
incurring further losses.
B. LTCM’s Near Failure
On July 31, 1998, the
LTCM Fund held $4.1 billion in capital, down about
fifteen percent from the beginning of the year.
During the single month of August, the LTCM Fund
suffered additional losses of $1.8 billion, bringing the loss of
equity for the year to over fifty percent.
The Fund’s capital base was
now $2.3 billion, and LTCM reported to investors that
it was seeking an injection of capital.
During the first two weeks of September 1998, concern
about LTCM was a major topic of conversation in the financial
markets.
The LTCM Fund suffered substantial further losses and found it
difficult to reduce its positions because of the large size of
those positions.
In addition, as its
condition deteriorated, previously flexible credit
arrangements became more rigid and the daily mark-to-market
valuations for collateral calls by counterparties became more
contentious.
These factors added to the liquidity pressures
facing LTCM.
By Friday, September 18, these liquidity
pressures, together with continuing declines in the Fund’s
capital, were causing serious concerns among the Fund’s
principals about the ability of the Fund to continue meeting its
cash flow obligations in the event of further shocks to its
market value.
As LTCM’s
efforts to raise new capital remained unsuccessful,
its condition was also a source of major concern to numerous
market participants.
These market participants were concerned about the
possibility that LTCM could abruptly collapse in the very near
term and about the consequences that such a collapse might have
on what already were extremely fragile world markets.
By
September 21, the LTCM Fund’s liquidity situation was
bleak. Bear Stearns, LTCM’s prime brokerage firm, had required
LTCM to collateralize potential settlement exposures, reducing
the fund’s overall liquidity resources.
LTCM’s repo and OTC derivatives counterparties were
seeking as much collateral as possible through the daily
margining process, in many cases by seeking to apply possible
liquidation values to mark-to-market valuations.
The cash-flow strains were raising the risk that the
LTCM Fund would be unable to meet payments due at the end of
September.
Moreover,
in the absence of additional injections of liquidity,
further unfavorable market movements could have led to a default
as soon as Wednesday, September 23.
Thus, a very short period of time remained for the
participants to explore resolution alternatives.
While LTCM’s plight had been known to some market
participants to varying degrees, no one had as yet stepped
forward to offer an alternative that would avoid a default.
The primary trading counterparties and creditors to
the LTCM Fund were themselves the firms most exposed in a
default scenario.
These firms had played an important role in allowing
LTCM to build up such large positions.
The self-interest of these firms was to find an
alternative resolution that cost less than they could expect to
lose in the event of default.
On Tuesday, September 22, a Core Group of four of
the most concerned counterparties began seriously exploring the
possibility of mutually beneficial alternatives to default.
The
main alternative the Core Group focused on came to be
known as the consortium approach and involved the
recapitalization of the LTCM Fund through mutual investments by
its major counterparties in a recently set up feeder fund and a
relatively small investment in a newly set up limited liability
company which became a new general partner of the LTCM Fund.
Under this approach, the stake of the original owners
would be written down to 10 percent and the consortium would
acquire the remaining 90 percent ownership share, as well as
operational control of LTCM.
Following lengthy discussions in the afternoon and
evening of September 23, fourteen firms agreed to participate in
the consortium. The Federal Reserve Bank of New York provided
the facilities for these discussions and encouraged the firms
involved to seek the least disruptive solution that they
believed was in their own collective self-interest.
The agreement was reached
This alternative offer is described more fully by
William J. McDonough, President of the Federal Reserve Bank of
New York, in his statement and subsequent testimony before the
House Committee on Banking and Financial Services, during its
October 1, 1998, hearing on hedge fund operations.
The agreement followed the unraveling of a last minute
alternative resolution which was presented to LTCM late in the
morning of September 23.
Another investor group had offered to purchase LTCM’s
portfolio, and at that time, all discussions related to the
consortium approach were suspended.
The consortium discussions reconvened only after it
became clear that this alternative would not take place.
The firms participating in the consortium invested
about $3.6 billion in new equity in the fund, and in return
received a 90 percent equity stake in LTCM’s portfolio along
with operational control.
The responsibility and burden of resolving LTCM’s
difficulties remained with the counterparties that had allowed
the hedge fund to build up its positions in the first place.
The
principals and investors in LTCM suffered very
substantial losses on their equity stakes in the fund when their
claim was reduced to ten percent.
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