Liquidity Risk & Effective Leverage

Risk and leverage go hand in hand. It seems that many hedge funds are not only using massive leverage, they are using it on top of already leveraged financial instruments. This evening I was viewing an interesting eight page PDF by Fitch describing this phenomenon. Following is a condensed version of Hedge Funds: The Credit Market’s New Paradigm

Highlights

• Hedge funds’ influence on the credit markets clearly has accelerated. Credit strategies, particularly those involving credit default swaps (CDS), were one of the fastest growing segments for hedge funds. As a result, hedge funds now make up nearly 60% of CDS trading volumes.
• The recent credit boom, particularly for certain sectors of the credit markets, has been fueled in part by hedge funds. Hedge funds’ willingness to trade frequently, employ leverage, and invest in the more leveraged, risky areas of the credit markets magnifies their importance as a source of liquidity.
• The credit markets have undergone a structural paradigm change, even as they have experienced tremendous growth. The next credit downturn may very well involve more sudden, correlated declines in asset prices as hedge funds and prime brokers seek to unwind their positions in a more risk-averse market. This could be amplified by the financing of more complex, illiquid positions that are less easily valued.
• A deleveraging event is likely to affect most, if not all, sectors of the credit market, resulting in an increase in correlation as hedge funds and prime brokers seek to monetize their most liquid positions first.
• Given this paradigm change in the credit markets, liquidity risk is one of the more important considerations for credit investors today, as refinancing risk could be magnified in the next downturn.

Leverage Multiplier Effect

The impact of hedge funds on the credit markets can not be measured simply by trading volumes, but also must consider hedge funds’ willingness to be risk takers by investing lower in the capital structure. By investing in instruments that are themselves levered, hedge funds are able to create a multiplier effect by combining financial leverage with so-called economic leverage. The combination of the two can be thought of as the effective leverage.

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Most prime brokers agreed that there was continued pressure to provide more relaxed credit terms to hedge funds — through higher leverage or other lending terms — due to growing competition to attract hedge fund clients. Reportedly, some prime brokers are estimated to derive 20%–30% of total revenues/ profits from hedge fund relationships — sales and trading, investment banking, financing, and risk management/back office support. The trend by hedge funds toward using multiple prime brokers continues and can increase the pressure on credit terms while making it challenging for prime brokers to monitor overall leverage at a fund.

In addition, prime brokers have faced increased pressure to provide some degree of secured financing for hedge funds’ less liquid positions, although financing to date has been subject to having the ability to price the instrument and identify plausible exit strategies. For example, CDO equity and other complex structured products may be financed on margin (reportedly up to 50%) if the bank’s trading desks have familiarity with the transaction and the ability to arrive at an independent price.

Market Behavior — The Next Downturn?

The influx of hedge funds into the credit markets may well have resulted in a paradigm change in how the markets behave in the next downturn. Specifically, credit assets could behave in a more correlated, synchronous fashion if one or a number of hedge funds were forced to liquidate positions following some catalyst event in the markets. Investor redemptions and/or increased margin calls from prime broker banks could exacerbate a larger unwind of credit assets.

Forced Unwind Example

Assuming a hedge fund leveraged 4.0x (20% margin) were operating near or at maximum permissible leverage, the fund could be forced to sell as much as 25% of its assets in the event of an initial 5% price decline in the value of its assets. Any collective, downward pressure on prices in the market arising from the hedge fund unwinding or an increase in margin requirements from the prime brokers would magnify the total amount of assets the fund is forced to sell. For example, an increase in the prime broker’s margin from 20% to 25% on average would require a fund to deleverage as much as 40% to meet its margin calls and restore leverage to within acceptable limits.



The inherent instability of hedge funds as an investor class — arising in large part from their reliance on short-term, margin-based leverage — is distinctly different from more traditional buy-and-hold institutional investors and relationship-oriented bank lenders. Given the continued growth of hedge funds in the credit markets, the potential for a more synchronous, forced unwind of credit assets cannot be discounted. For example, Amaranth was reported to have sold leveraged loans and residential mortgage-backed securities to meet margin calls on its natural gas positions.

Credit Implications

Given the current environment, Fitch believes liquidity risk is among the more important issues facing credit investors. Tight credit spreads and abundant capital have allowed even the most distressed issuers to readily access funding and refinance maturing debt. This apparent in the low default rate for corporate debt — recently under 1% according to Fitch’s high yield default index — even as many credit metrics have eroded. For example, high yield issues rated ‘CCC’ or lower represented $125 billion of issuance at the end of March, or 17% of U.S. high yield volume.

Even a temporary dislocation in the credit markets could negatively affect funding access for more marginal credits with upcoming debt maturities, leading to a rash of defaults.

Of particular importance is an assessment of liquidity sources and liquidity uses, including on- and off-balance-sheet debt, loan maturities, and contingent liquidity claims. The growing role of hedge funds in the credit markets without question has introduced greater liquidity in the near term. Of concern would be an ill-timed event that led to a sudden reversal of this liquidity across multiple segments of the credit markets.

Money Has No Meaning

Money has no meaning yet the process continues with escalating leverage and bigger and bigger deals, with each player hoping for the big score, even though money itself has lost all meaning to the most important players. How else can one describe it when a simple painting called "White Center" sells for a cool $72.84 million?



Justin Rohrlich on Minyanville was writing about this very phenomenon just the other day in The Liquidity Boom: More Money Than People Know What to Do With.

As Jeff Cooper pointed out recently, the rich are feeling richer, and falling all over each other to get rid of paper and buy tangibles.

He mentioned Mark Rothko’s “White Center,” which became the most expensive piece of postwar art sold at auction after selling for $72.8 million, crushing a presale estimate of $40 million.

“Money has no meaning,” Angela Westwater of New York gallery Sperone Westwater told a Bloomberg reporter after the Rothko sold. “It’s a good work, but the whole marketplace is crazy.”

The painting had previously been owned by David Rockefeller.

“While it’s a spectacular painting, it’s clear the allure of having David Rockefeller’s painting in your house is going way beyond what you might otherwise consider reasonable,” said New York dealer Marc Glimcher of PaceWildenstein gallery. “That kind of thing is becoming irresistible to people.”

But as nearly all asset prices were correlated for the last 5 years on the way up, it is extremely likely they will be correlated on the way down. Let's return to the opening highlights once again:

The next credit downturn may very well involve more sudden, correlated declines in asset prices as hedge funds and prime brokers seek to unwind their positions in a more risk-averse market. This could be amplified by the financing of more complex, illiquid positions that are less easily valued.

A deleveraging event is likely to affect most, if not all, sectors of the credit market, resulting in an increase in correlation as hedge funds and prime brokers seek to monetize their most liquid positions first.

When The Credit Event occurs it will not matter that much to anyone who can afford to blow $72.84 million for the status of owning White Center. Losing half of a billion dollar fortune or even half of a $200 million fortune is realistically meaningless. For players at that level, money is only a method of keeping score. Unfortunately a deleveraging event will most assuredly matter to the average guy on the street whose pension plan is heavily invested in CDOs, CMOs, and other toxic waste and whose retirement is permanently put on hold as a result.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/