What Can We Learn From the Summer?

Market turmoil poses some awkward questions

Originally published in the October 2007 issue

As we ease into the seemingly calm days of autumn and find equity indices hitting new highs at the close of September, the summer that proved problematic for both traders and central bankers seems a distant nightmare. This was really characterised by a malaise that left traders just plain tired from dodging the flak flying about. The usual summer lull never did appear as the bull run suddenly gave way to a violent downslide.

The problems initially seemed to affect just credit managers but then spread across the spectrum of asset classes. Even the most experienced confessed to being taken aback by the extent of the chaos few bears could have predicted. We saw hedge funds of a significant size collapse while others halted investor redemptions and were left nursing heavy losses.

Another bloody August

Hedge fund indices compiled by HFR or Credit Suisse/Tremont were nearly all in the red in August. These declines reflected the abrupt decline in investor confidence as sentiment did an about-turn. The strength of the slump in stocks stunned managers as the sell-off was indiscriminate, displaying little regard for strong corporate balance sheets or potential LBO targets. This stemmed largely from a wide-scale deleveraging by funds and prop desks seeking to cut exposures and, or raise cash in readiness for prime brokers seeking more collateral.

The market turmoil called time on the era of easy money and exuberance. So far this had been reflected by gains in every asset class from art to real estate. Low volatility over the last five years lulled traders into a false sense of security. But this had vanished by early September, when traders confessed to being scared that they couldn’t even find a bid for tier 1 bonds. But the Fed put came into play in mid-September as the 50 basis point cut helped give some sustenance to the equity markets – despite the growing uncertainty over the outlook for the US economy and the extent of its impact on the global economy. Even as credit markets start to thaw as managers begin to put money back to work, it is too early for us to turn our backs on the summer that belied its name.

There are several themes from the market turmoil which merit review and discussion going forward. The pain traders have been feeling was magnified at quantitative funds which have now been forced to question some of the assumptions they used to construct their trading models. Some of the flaws resulted from crowding of their trades. Indeed, quant funds need to question how they can avoid a recurrence of this episode given that their models seemed to converge on similar trading patterns. The problems which have stymied quants were summed up well by Matthew Rothman, the chief quant strategist at Lehman. Commenting on the turmoil that threw quantsoff-course in August, Rothman said: “events that models only predicted would happen once in 10,000 years happened every day for three days”.

While individual hedge funds have been buffeted by the storms in the markets, the industry has emerged as well as it could from this crisis. As we put aside the usual knee-jerk reaction from politicians and media blaming hedge funds for the panic, it is worth noting that these events have defied criticism of the industry in recent years. Economists and central bankers had been lining up to warn that a string of hedge-fund failures would result in wider systemic disruption. This did not happen this summer. These views were also expressed by EU Internal Markets Commissioner Charlie McCreevy in a speech to the European Parliament this September. McCreevy said: “Many people demonise hedge funds. You cannot put the blame for today’s market problems on these funds”.

Hedge funds were not trading risk on their own. Proprietary trading desks had also taken on a great deal of risk – with several losing substantial sums.

It’s all about risk

Indeed, the real source of systemic disruption has been mis-pricing of risk by market participants. Low interest rates fuelled demand for debt and thus leverage, as private equity firms embarked on a spending spree and investment banks turned to securitisation to boost profits and meet demand for new products from investors chasing higher yields. Agencies set ratings for collateralised debt obligations and residential mortgage-backed securities that failed to perform as expected in the midst of the credit crunch. It is clear now that investors did mis-price risk as CDOs, CLOs and other instruments mushroomed around them. One lesson from this episode is that the nature of risk hasn’t changed all that much. As Claudio Borio, head of research at the Bank of International Settlements warned recently: “The primary cause of financial instability has always been, and will continue to be over-extension in risk-taking and balance sheets”.

This time, the unhealthy exposures to risk came from the process of securitisation. It imposed too great a distance between the buyers of CDOs, CLOs and other such securities – and the actual value of the underlying assets. Fuelled by the excess liquidity awash in global markets, this financial innovation has now woven a web that central banks and investors have spent the last few months fighting to untangle. But market participants, hedge funds and investment banks alike, exacerbated the problems further with their opacity about losses and sub-prime exposures. This stoked fear, creating an environment where even the most absurd rumours have been circulating.

The finance industry’s penchant for selective disclosure, is to blame for this confusion. Banks’ or funds’ trenchant denials of problems with exposure to sub-prime have only been contradicted a week or two later. This only served to increase suspicion and distrust in the system – giving rise to the crisis of confidence. The Q3 earnings from most of the bulge-bracket firms in mid-September, coupled with a profit warning from a well-known firm, helped defuse the situation.

The uncertainty about the extent of exposures stemmed in part from the rise of securitisation, which helped spread risk all too well through capital markets from Asia to the Continent. A world map of sub-prime and credit victims shows us just how well risk was dispersed – from the Californian mortgage lender, Australian hedge funds to the German landesbanks. This also undermined confidence as traders found their terminals infested by a steady drip of news of exposures at funds or banks they knew little of. It has clearly been a trying time for banks and hedge funds which have been left steeling themselves for the next piece of bad news.

Is regulation on the cards?

The industry’s reluctance to initiate an active debate about measures to improve transparency meant that politicians and regulators waded first into the fray to call for greater oversight of the financial system. These measures were also extended to plans to protect US consumers.

In some eyes, the recent spillover into Main Street in the US, and the high street in the UK, where we witnessed an old-fashioned run on the bank, has strengthened in favour of direct regulation of the hedge fund industry. Treasury Secretary Paulson and McCreevy have warned against a knee-jerk backlash but this is likely as we are heading into a period where there is considerable opportunity for the debate to become politicised – as elections loom in the US and the UK. Measures to address levels of transparency in capital markets are also high on the agenda for the G7 summit in late October.

It is to be hoped that calls for greater disclosure from the UK hedge fund working group in the run-up to the summit will help ease pressure from governments seeking more controls on the industry. State intervention could change the rules for the playing field. This uncertainty will add to the worries weighing on traders’ minds, especially as the financial services industry braces itself for continued volatility – and a possible chill it could catch this winter.