Where are all the hedge fund losers?
Hedge fund turmoil is, notably, number nine on Nouriel Roubini’s 12 steps. Commentators are harping back to LTCM at every opportunity and yet, the hedge fund blowups to date have been rather… unfulfilling.
Felix Salmon asks the question, via Option Armageddon:
There have been some nice fortunes made from the spread widening (Paulson, Hayman, Blue Ridge, Lone Pine, etc.) but I have yet to see where the fortunes are being lost on the other side of those trades…
Within six months it’s possible the term “counter-party risk” will have become almost as colloquial as “subprime” has.
First, of course, there’s hedging. Most funds trading in the credit markets aren’t going to be taking a naked position - long or short - against any particular index or financial product. Hedge funds may well be big investors in mezz or equity CDO tranches, but mark-to-market fluctuations in those tranches will have been hedged out - typically by buying protection on a broader index, for example.
Rather than damaging hedge funds, a lot of the current credit spread widening may actually be benefiting them. The FT’s John Dizard noted last week that there were significant profits to be made on any number of glaring arbitrages in the current market. It was just all a (Keynesian) question of markets remaining irrational longer than you can remain solvent.
Onto then, the second point. Remaining solvent. Hedges against mark-to-market losses are costly to maintain, insofar as funds are in hock to their prime brokers - and dreaded margin calls. (Of the iron bar breaking LTCM’s back variety). Are prime brokers allowing hedge funds to remain solvent? This time, so it would seem.
Which all helps towards explaining why few hedge fund blowups have been hitherto forthcoming.
That doesn’t mean, of course, that they won’t be.
In the credit markets, the hedges many funds are performing are correlation driven: that is, the higher implied correlation in the market, the more profitable they are. A typical “delta-hedge” might involve a fund selling protection on an equity tranche of a synthetic corporate CDO, while buying protection on the broader credit index. Mark-to-market losses are hedged out, and the trade becomes more profitable as correlation increases (the relative riskiness of the equity tranche decreases). The current environment of hugely widening spreads but no defaults is very profitable.
As long as there are no defaults, that is. Delta hedging relies on implied correlation being grossly out from actual correlation. Hedge funds will lose money (a lot) if corporates actually default, since they are exposed to equity tranche default risk.
While default risk in investment grade CDS indices is mitigated by the six monthly index roll, it’s still there. And in the current, volatile, extreme market, it’s very much on the agenda. It wouldn’t take much to spark a massive unwind of the correlation trade either, however, as even one default would massively reduce implied correlation.
The danger is then, that liquidity in the CDS markets would dry up in an almost grand ah-whoom kind of way: a repeat of the May 2005 correlation crisis but much worse.
