A 100-Year Hedge Fund Storm 7 Years Later?

Date: Friday, May 13, 2005
Author: Caroline Baum- Bloomberg

May 13 (Bloomberg) -- All week, there's been a not-so-subtle undercurrent in financial markets of potential hedge fund losses; of popular General Motors trades (long the bonds, short the stock) gone sour, courtesy of Standard & Poor's and Kirk Kerkorian, respectively; of untoward responses in the riskiest tranches of collateralized debt obligations; and even of ``correlation trades'' becoming uncorrelated.

Wasn't it the same sort of problems, compounded by a ton of leverage, that got Long-Term Capital Management into trouble in 1998? Could this be another case of losses felt 'round the world, with repercussions rippling through the financial system and the U.S. economy?

Not likely. While the number of hedge funds and assets under management has exploded since 1998, so have the safeguards put in place to prevent against sudden losses.

``There is not a large hedge fund that doesn't have sophisticated risk management,'' said Ron Papanek, a market strategist at RiskMetrics Group, a risk-management company that provides analytics and software to hedge funds and financial institutions.

Risk managers regularly ``stress test'' a portfolio -- ``shocking'' it with a big move in interest rates, credit spreads or currency values -- to determine the sensitivity and the losses that could be incurred given a worst-case scenario.

Risk Awareness

While one can never protect against the unknown -- the next 100-year storm won't be the same as the last -- historical stress- testing is another standard way to assess a portfolio's sensitivity, Papanek said. Two popular events to test for are 1987's ``Black Monday,'' when the Dow Jones Industrial Average plummeted 508 points, or 23 percent, and August 1998, when Russia defaulted on its debt.

LTCM, which specialized in a strategy known as fixed-income relative value -- buying securities that were cheap and selling securities that were expensive, betting on the spread to converge -- watched as everything they were long got cheaper and everything they were short went up in price.

Lenders are more sophisticated today as well, with many of them ``requiring a complete understanding of the portfolio's sensitivity prior to lending funds,'' Papanek said. ``Even prime brokers are moving into risk-based margining.''

Prime brokers, who provide a range of services (trading, clearing, lending) to hedge funds, evaluate how risky the assets are before determining how much they will lend, he said.

Less Leverage

Sure, there are the cases of a hotshot trader with a Goldman Sachs pedigree opening a hedge fund with $3 billion, no questions asked. In general, however, there's a greater awareness on the part of investors, lenders and money managers about risk.

Today some 8,000 hedge funds (including funds of funds, which invest in a diversified basket of hedge funds for their clients) manage $1 trillion in assets, compared with about 3,000 funds with $375 billion under management at the end of 1998, according to Chicago-based Hedge Fund Research Inc.

The biggest influx of money started in 2001, once the stock market stopped providing double-digit returns just for showing up.

More hedge funds and more assets doesn't necessarily mean more risk. Back in the golden years, LTCM used leverage, or borrowed money, of 28 to 1. Today two of three hedge funds use leverage, according to Hedge Fund Research Inc. But ``of the funds we work with, the average leverage is less than 2 to 1,'' Papanek said.

Countering Partner

Reduced leverage and increased risk management can't guarantee there won't be some blow-ups. The explosion in derivatives and greater concentration among a few participants have Fed Chairman Alan Greenspan worried.

``The Federal Reserve remains concerned that the stress tests that some large participants are using to evaluate potential losses in the event of a large participant's default do not fully capture the potential interaction of counterparty credit risk and market risk, especially in concentrated markets,'' Greenspan said in an address to the Chicago Fed's annual Bank Structure Conference last week.

Transferring risk to those who can bear it is good, Greenspan has always said. Just make sure the guy on the other side of the transaction isn't a deadbeat. Buying protection against default (via a credit default swap) isn't any protection if the counterparty can't make good on it.

Anticipatory Losses

GM's and Ford's downgrade to junk status by S&P on May 5 created a lot of speculation about what if. Markets, as is their wont, react first and analyze later.

``It's a testament to the quiescence of capital markets these last few years that this is a noteworthy event,'' said Paul DeRosa, a partner at Mt. Lucas Management Co. ``With credit default swaps, you can suffer a mark-to-market loss, but you need an actual default to shell out money.''

To contact the writer of this column:
Caroline Baum in New York at  cabaum@bloomberg.net.