A tale of two hedge funds

This is about two hedge funds-where one made profit and the other made loss during Global financial crisis...

1. By, Karan BaBBar(08) Manju Natarajan(10) Presentation on, A Tale of two hedge funds

2. 2007-2008 Financial crisis Fed’s Lowest Interest rate in 40 years. Homeownership reached an all time high of 70%. Lending practices became extremely loose with no proof of income. Many home loans were sold to major investment banks. Investment banks –Securitized into CDO’s and sold to investors.

3. Instruments involved

4. CDO Securities backed by pool of fixed income assets. Consist of CLO, CBO and RMBS. Provide liquidity as traded daily on secondary market. Pay slightly higher interest rate than corporate bonds. CDO is complex and costly process. Enables a bank to design loans to homeowners to make more loans as bank can sell loan to third party. Bank can originate more loans and fees. Many CDO’s became liquid due to size ,investor breadth and rating agency coverage. This led to investment banking losses of 30$ billion between 2007-2008.

5. CDO A structured financial product that pools together cash flow-generating assets and repackages this asset pool into discrete tranches that can be sold to investors. A collateralized debt obligation (CDO) is so-called because the pooled assets – such as mortgages, bonds and loans – are essentially debt obligations that serve as collateral for the CDO. The tranches in a CDO vary substantially in their risk profile. The senior tranches are relatively safer because they have first priority on the collateral in the event of default. As a result, the senior tranches of a CDO generally have a higher credit rating and offer lower coupon rates than the junior tranches, which offer higher coupon rates to compensate for their higher default risk . Senior tranche Mezzanine tranche Equity tranche

6. Interest waterfall of a sample CDO

7. LBO Leveraged buyout (LBO) is the acquisition of another company using a significant amount of borrowed money to meet the cost of acquisition. The assets of the company being acquired are often used as collateral for the loans, along with the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

8. Junk Bond A Bond rated ‘BB’ or lower because of its high default risk These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four % points higher than safer government issues. Rating Agencies Help bringing liquidity to CDO market as per the following reasons, Analyzed each tranche of a CDO and assign ratings accordingly Used historical models to predict risk Limited Manpower Had to allocate risk to appropriate tranche and understand correlation of loans.

9. Correlation Most difficult part of valuing a CDO tranche is determining correlation. Diversification e .g , a housing crisis in California will be isolated from one in New York, so the CDO simply needs to diversify the geographic makeup of its assets in order to offer stable returns. Low correlation, an AAA rated senior tranche should be safe and the interest rate attached is close to U.S treasury.

10. Correlation This does not affect the price of CDO in total, because expected value of each individual loan remain same. It affects the relative price of each tranche, any increase in the yield of a senior tranche will be offset by a decrease in the yield of the junior tranches. If a security related to the housing market contained geographically diverse collateral, it was generally assumed to have low correlation. This is because there had not been a nationwide housing crisis in recent history and local downturns had been isolated Because of this senior tranches received very high debt rating often AAA and correspondingly paid low interest rates.

11. The Two Hedge funds... Magnetar & Peloton

12. This case analyzes the strategies of the two hedge funds, focusing on how money can be made and lost during a financial crisis. The role of investment banks as lenders to hedge funds such as Peloton is explored, as well as characteristics of the CDO market and an array of both mortgage-related and credit protection-related instruments that were actively used (for better or worse) by hedge funds during the credit crisis of 2007 and 2008.

13. Hedge fund Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed with the goal of generating high returns. It is accessible to accredited investors. Hedge funds face less regulation than mutual funds and other investment vehicles. Investments in hedge funds are illiquid, as they often require investors keep their money in the fund for at least one year, lock-up period. A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything like land, real estate, stocks, derivatives, and currencies. They often employ leverage: Hedge funds will often use borrowed money to amplify their return. Leverage can also wipe out hedge funds. Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of any gains generated

14. Magnetar Founded in 2005 Magnetar Capital return 25% in 2007. The return was achieved with significantly lower risk than S&P 500. Its diversification, low leverage and capital call restrictions offered additional stability, but not to be relied for future success. Alec Litowitz ,chairman and CIO provided guidance to his team, evaluate and prioritize their ideas and his own. Considered its return in 2007 as a brilliant strategy. Strategy-certain tranches of CDO were systematically mispriced(due to turmoil in markets), which they considered as new investment opportunity. Unaffected with the subprime market held up or collapsed.

15. Magnetar Structured Finance Arbitrage Trade Made profit of more than $1 billion-By equity tranche of CDO’s and derivative CDO instrument relatively mispriced. Bought CDO equity and CDS(credit default swaps) protection on mezzanine tranches(considered as less risky). Performed its own calculation of risk for each tranche of security and compared that with its return. It found irregularity: two classes of securities had very similar risks but different yield. They took long/short strategy to take advantage of this anomaly.

16. . They replicated the same basic trade many times across many securities, with little effect on market prices, little risk and locking return that was certain. If we see the ABS CDO, it consisted of slim mezzanine tranches of multiple ABS notes, which were then packaged together and sold in different tranches. So the risk and yield should be similar, both holders must be paid off, but due to illiquidity in the equity tranche and market’s misunderstanding of correlation across tranches the yield of the equity tranche was higher than mezzanine. Trades could be structured-Equity long position yield>mezzanine yield In the event of high defaults, the principal balance on the mezzanine shorts would be higher than that of the equity longs, so the strategy would have a large pay off. Magnetar focused on locating relative pricing anomalies that should profit no matter what happened in market. Magnetar Structured Finance Arbitrage Trade

17. Peloton Founded in 2005, with Ron Beller as chief. Top performer in hedge funds in 2007 Returns in excess of 80% In early 2008, after getting two prestigious awards-at Black-tie Euro Hedge ceremony , one month later became bankrupt. It borrowed heavily to boost returns. For every $ of client money it had borrowed at least 9$ to buy some bonds.

18. Peloton Falling strategies Shorted the US housing market before subprime crisis and was profited. Misunderstood the subprime crisis, He believed that panicking investors were throwing out the proverbial baby with the bath water. Went long for AAA-rated securities backed by Alt-A mortgage loans(between prime & subprime). He levered up the investments at an average of 9x. In 2008, the trade moved against Beller. UBS disclosed that they own $21.2 billion of high rated Alt-A, market urged UBS to sell in a hurry. It had marked down the value of highly rated mortgage securities. The Alt-A backed securities dropped by 10 to 15%. Troubled bank tried to pull back the borrowed money.

19. Peloton Falling Final Try:- Beller lined up additional funds from investors, liquidated positions where possible to raise cash. Tried to persuade banks to delay their margin calls. Unable to sell the securities as brokers were unwilling to bid. Collapse:- Banks and investors were unwilling to help due to conflict of interest and the firm ran out of liquidity, lost $17 billion and was forced to close. Peloton’s assets were seized by lenders.

20. Market Evolution

21. Leveraged Profits The market for new CDO origination was dead by mid-2008. Many Hedge funds thought CDO market will be back. But it will take time for the banks to work their existing backlog ,which made progress. Many CDO investors, i.e. hedge funds relied on leverage to earn their targeted returns. During 2006, The investors purchased the senior tranche of CDO, yielding LIBOR + 50bps By leveraging the investment 25x ,earned a return commensurate with equity tranche or LIBOR +1250 bps.

22. Bank Debt & Cov-Lite Loans Fuelled by leveraged buyout boom Covenant- lite Corporate bank debt allowed companies to operate with no maintenance covenants for leverage or interest coverage ratio LBO firms(sponsors) demanded loose terms to generate fee for banks. By 2007 the covenant- lite deals had ballooned,

23. Equity cures are also permitted. Bankers began marketing debt deal for companies with no comfortable cash flows. In mid 2007,Bank loan and leveraged securities prices fell. Bank loans were hit hard because of large inventory held by investment banks, which needs to be liquidated. Lenders passed on the weak Cov-Lite loans by syndicating them to CLO. Investors in CLO analyzed at summary level only. This masked the problems of worst loans, many of which were LBO-backed covenant deals. Rating agencies gave false sense of security. Bank Debt & Cov-Lite Loans

24. Bank Debt & Cov-Lite Loans The Bank loan market bottomed during 2008. An investor needed to assume default rates would hit levels not seen since the Great depression and stay there until maturity of the loans. With this mindset, investor increased their exposure to the bank loan market.

25. Covenant- l ite Loans A type of loan whereby financing is given with limited restrictions on the debt-service capabilities of the borrower. The issuance of covenant- lite loans means that debt is being issued, both personally and commercially, to borrowers with less restrictions on collateral, payment terms, and level of income. Some hedge funds were more intrigued with cov-lite. The existing cov-lite loans were traded heavily. Was thought to have limited near term default as companies ran until cashless Once defaults occur, what could be the recovery rates, See fig. The cov-lite were traded at discount as compared to cov -heavy loans. There is spread which continues to widen. Funds got profited out of this.

26. Arbitrage-Bank Loans and Bonds Relative value trade-Yield on secured cov -lit bank loans and compare it with unsecured bonds of same company. If yields are close , trading opportunity exist. Long the secured loans and short unsecured bonds. Bank debt recovered more than bonds in a bankruptcy. More risk the company , more wider the spread. Bet on difference in recovery rate on various securities. Default rates were identical ,because issued by same company. Large holders of bank debt have been forced to sell bank debt for regulatory and liquidity reasons. Bonds on the other hand, are less frequently held by banks, so no such pressure of selling.

27. Arbitrage-Bank Loans and Bonds

28. Some Behavioral Finance aspects

29. Biases Cognitive Errors Emotional Biases Loss-Aversion Bias Overconfidence Bias Self-Control Bias Status Quo Bias Endowment Bias Regret Aversion Bias Belief perseverance biases Conservatism Confirmation Representativeness Illusion of control hindsight Processing errors Anchoring Mental accounting Framing Availability Biases:-an inclination in favor of a particular view point especially a personal and sometimes unreasoned judgment. Cognitive errors – based on faulty cognitive reasoning Emotional biases – based on feeling or emotions

30. Magnetar Used System 2: is effortful, deliberate, and slow. It requires mental activities that may be demanding, including complex calculation. Overcame Muller Lyer Illusions:- While your System 2 knows that the lines are equal in length, you will still see the bottom lines as longer. Both equity and mezzanine tranche has similar risk & yield. Magical thinking may be defined as believing that one event happens as a result of another without any plausible link of causation. Put differently, magical thinking attributes causal relationships between actions and events which seemingly cannot be justified by reason and observation. Magnetar strategy would have failed if the equity got wiped out, but they said the probability of such to happen is a remote.

31. Magnetar Asset Segregation – System I Asset segregation refers to our tendency to look at investment decisions individually rather than as part of a group. The portfolio may be up handsomely for the reporting period, but the investor will still be concerned about the individual holdings that did not perform well. Arbitrage opportunity was there due to mispricing and they were able to overcome the limitations to achieve the gain.

32. We could see that Beller made decision based on his belief-He believed that prices for highly rated mortgage securities were being unfairly punished and also panicking investors were throwing out the proverbial baby with the bath water. Used System 1 many places. i ).Cognitive Error: Belief perseverance biases: Illusion of control is a belief perseverance bias, in which people tend to believe that they can control or influence outcomes when, in fact they can not. Estimating & Forecasting trap: It is an information processing biases. Making estimates or forecasts about uncertain events is challenging. Peloton had $750 million in cash and believed its funding from banks was secure, thought the situation could be handled. Peloton

33. ii).Emotional Biases: Overconfidence Bias: Overconfidence Bias is a bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments and cognitive abilities. Overconfidence often results in underestimating the losses. Self-control bias: is a bias in which people fail to act in pursuit of their long-term goals because of lack of self-disciple. Peloton

34. Peloton Endowment Bias: is an emotional bias in which people value an asset more when they hold rights to it than when they do not. Regret Aversion Bias: is an emotional bias in which people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly Regret bias has two dimensions – actions that people take (Error of commission) actions that people could have taken (Error of omission) Regret is more intense due to error of commission than omissions In this Beller has made error of commission.

35. Peloton Herding-System 1: Herding refers to the lemming-like behavior of investors and analysts looking around, seeing what each other is doing, and heading in that direction. Once the value of the of the securities started to fall, the lenders tried to pull back the money and the investors started taking back their money. Anchoring-System I: Our decisions can be influenced by extraneous information contained in the problem statement. Many CDO investors, hedge funds relied on leverage to earn their targeted returns. So even after the 2008 there was a belief that new CDO will be originated with the same interest from the investors.