Greenspan Is Worrying Again

June 2005 Dr. Hans Black

Although equity markets around the world were hit hard in April, the inevitable headlines accompanying such a move were particularly visible throughout May as hedge funds once again moved into the global financial limelight, reminiscent of the great Long-Term Capital Management (LTCM) debacle of 1998. While there can be no doubt it has been a difficult year, with equity markets down everywhere and the majority of participants surely nursing negative returns, the story of most hedge funds over the past six to eight weeks is worth a closer look.

Hedge funds as a new asset class have been around for over twenty years, but have only gained popularity in the past seven to eight years and particularly in the past three. Hedge fund assets have now passed the one trillion dollar mark, up from approximately $650 billion just two years ago, which makes 2004, in terms of money flowing into hedge funds, a landmark year. With equities still showing negative 5-year returns, such alternative investments as hedge funds and private equity funds were the place to be. Nevertheless, by 2003 returns had begun to lag, showing gains substantially below equity index returns; 2004 offered equally disappointing returns. So far in 2005, hedge funds as a whole would appear to be down approximately four percent, or roughly equal to the losses suffered in equity markets. Although proponents of hedge funds will likely compare their results to other types of funds in order to get a more accurate overall picture, the data given by CSFB / Tremont is nevertheless clear. Irrespective of whether one invested in commodity funds (which were the winners of 2004, and which unfortunately are one of the big losers of 2005), or in other categories such as macro funds, long/short funds, convertible arbitrage funds, etc., the conclusions are largely the same: performance has been decidedly lacking, particularly in the convertible arbitrage funds, which have long been considered one of the more steady return-type funds available today. What makes this even more important is the additional leverage that is often applied to these kinds of funds. Convertible arbitrage as a whole has been marketed as a way of achieving a steady one-half to one per cent return per month. What could be easier than to simply leverage this 3 or 4 to 1 in order to return absolutely wonderful numbers? Unfortunately, this practice — used by many fund of funds-type outfits — has been badly burned, leading to the recent spate of headlines with which we are all too familiar. Some of the world’s leading convertible arbitrage funds are showing returns of anywhere from minus ten to minus thirty per cent, year-to-date, and it does not take much math to calculate what an additional degree of leverage would mean to such strategies. With eight thousand hedge funds now in business, these kinds of headlines have also had a very understandable effect: redemptions. What has also become clear is the degree to which redemptions have been building in recent weeks as investors, frightened by the headlines and disgruntled with their returns, head for the exits.

Another remarkable feature of what has occurred in hedge funds in particular and to investors in general has been the incredible shrinkage in the spreads between high-quality bonds and lesser-quality bonds over the past three years. Although this is an issue we have discussed on these pages before, it is worth pointing out that in the fearful months of summer 2002, these spreads reached levels not seen in many decades. Investors at the time, in trepidation of more bankruptcies along the lines of Enron or WorldCom and others, decided to dump high-yielding bonds causing spreads to trade at huge premiums. By December 2004, the spreads between high- and low-quality bonds had shrunk to the narrowest margins in the past 35 years. We are convinced this phenomenon is largely the result of hedge fund activity. A combination of a plentiful supply of new money spread over many new hedge funds resulted in no really good investments for much of this new money. Finally, with no choices around, many new funds simply added to or initiated the same kinds of trades that had worked so well during the past two-and-a-half years. Together with the problems in convertible arbitrage this year, there is clearly a further difficulty imposed on this strategy by the widening of spreads. In addition, borrowing U.S. dollars at one or two percent and capturing high yields has also disappeared and, in our judgment, will likely need much more time to unwind.

It should come as no surprise that the increasing attention being paid to hedge funds and alternative investments in general should bring these developments to the attention of central banks and securities regulators. Although Alan Greenspan, chairman of the U.S. Federal Reserve Board, has often commented on the usefulness of hedge funds in providing added liquidity to various markets, he has in recent speeches increasingly emphasized the risks entailed by these kinds of funds. No doubt in an attempt to cool some of the intense speculation of the last two years, Mr. Greenspan has actually stated — reminiscent of his comments on “irrational exuberance” in 1995 — that “highly leveraged hedge funds could pose risks to market liquidity.” Such comments undoubtedly bring back memories of the LTCM crisis of 1998, which was eventually resolved by the timely but last minute intervention of central banks desirous of maintaining orderly markets. As a way to emphasize the changing perceptions of risk, it seems the Fed has recently created the ominously named “counter-party risk management policy group”.

Gerald Corrigan, who is currently at Goldman Sachs after a prominent career at the Federal Reserve of New York, is leading this initiative. The goal of this group would appear to be to monitor risks before they become dangerous and to educate banks and prime brokers to system-wide difficulties. It should also be pointed out that in the latter half of April it was reported that Timothy Geithner, head of the New York Fed, gave a speech to the Bond Traders Association which has since been widely quoted. In the interests of clarity, we will likewise offer the following five excerpts from this speech:

“While critically important, capital alone does not define an institution’s strength. It is vitally important for firms to continue to invest in strong internal controls and to make sure that advances in the operational infrastructure keep pace with rapid growth, particularly in complex transactions.”

“Efforts underway to automate matching and confirmation of credit default swap transactions should help address these concerns. But we need to see a stronger collective commitment by the principal dealers in these markets to reduce the outstanding backlog of confirms, shorten confirm times and move larger share of transactions in the more standardized instruments to automated platforms.”

“Consolidation has produced a system in which a smaller number of financial institutions, banks, and non-banks, account for a substantially larger share of financial intermediation. Therefore, while the probability of a major crisis induced by the financial failure of a major institution may be lower, the damage associated with such an event could be higher. An event large enough to threaten the solvency or liquidity of one of these core institutions could have more severe impact on the stability of the system than was the case in a less concentrated market.”

“Among the major non-bank financial institutions, the most important part of the financial system today where we need a stronger capital regime relates to the GSEs (Government Sponsored Enterprises). Even with the improvements in risk management at these institutions over the last years, we are some distance from the point where their regulatory capital requirements appropriately reflect their risk.”

“But the macroeconomic environment may not prove to be as benign in the future as it has in the recent past. And it is important that the major financial institutions in particular sustain a strong capital cushion at levels that will enable them individually and the U.S. financial system as a whole to manage safely in a more uncertain and perhaps more volatile world.”

With many thanks to friends at Goldman Sachs for providing us the above passages, is there any surprise that the markets have reacted so skittishly to the combination of these words and to the recent headlines on hedge funds? Clearly the fifth point made by Timothy Geithner is most alarming as there cannot be a clearer message to banks than the one given here. Taken at face value, one has to be impressed with the combination of these warnings and the recent (frequently altered) reservations by many Fed officials on the speculation going on in the real estate market. This is quite a sudden change of perception within the Federal Reserve, which, after supplying the world with virtually free money for almost two years, has only now moved the fed funds rate back up to three percent (3%) from the absurdly low one percent (1%). Should there be any surprise that so much capital has flowed into real estate and other alternative investments? Having survived the great bubble of 1999 and 2000, we are back in the midst of yet another bubble. While the emphasis has changed to real estate and alternative investments, it is a bubble just the same.

Our dear clients and friends will forgive us for portraying these events so candidly, but we are afraid that the yield curve may be telling us something. Despite all the fears of inflation, longer-term bonds yields have declined in recent weeks signaling perhaps that the combination of higher interest rates on the short end, climbing asset values in many sectors and slowing broad money growth is a harbinger of a much harsher set of economic conditions than were previously anticipated.