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Central Bank Presentation II
 

Central Bank Presentation II

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Part 2 of a two-part presentation for an Asian Central Bank covering a The Credit and Liquidity Crisis: Recap, and Affect on The Hedge Fund Industry.

Part 2 of a two-part presentation for an Asian Central Bank covering a The Credit and Liquidity Crisis: Recap, and Affect on The Hedge Fund Industry.

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    Central Bank Presentation II Central Bank Presentation II Presentation Transcript

    • February 1, 2010 Part II The Credit and Liquidity Crisis: Recap and Affect on Hedge Funds Jason T. Wallace, FRM, CAIA [email_address]
    • Presentation Outline I. Hedge Funds A. Overview B. Hedge Fund Risk Management II. Credit and Liquidity Crisis A. Overview B. Crisis Affect on Hedge Funds III. Case Study 1: IV. Case Study 2: V. Question and Answer Session
    • II. Credit and Liquidity Crisis: Overview  Stage 1: Credit Expansion and Securitization (2003-2006)  Stage 2: Subprime Defaults Rise (2006- August 2007)  Stage 3: Securitization Stumbles (August 2007- March 2008)  Stage 4: Crisis in Confidence Goes Systemic (March 2008 - September 2008)  Stage 5: The Great Unwind (September 2008-March 2009)  Stage 6: Government Intervention and Market Rebound (March 2009 – current)
    • Stage 1: Credit Expansion and Securitization (2003-2006)  Short term and long term rates were low due to:  Inflation was low and stable during “The Great Moderation”.  Post dot-com bubble the FOMC reduced short rates.  Global savings by Emerging Market countries and oil-rich nations reduced long term rates.  Regulation changes such as the 1999 repeal of the Glass-Steagall Act separating commercial banks from investment banks allowed for more leverage (average assets/equity of 30 to 1).
    • Stage 1: Credit Expansion and Securitization (2003-2006)  Huge rise in mortgage lending, especially in the sub prime sector.  Teaser rate products (Option ARMs), “no doc” lending, “liar loans”, and NINJA (no income, no job, no assets) loans became prolific.  Home equity loans were taken out at will, due to the appreciation (or anticipated appreciation) of home values.
    • US Home Ownership Rates
    • Stage 1: Credit Expansion and Securitization (2003-2006)  The demand for mortgages and other credit products was driven in large part from securitization (RMBS, ABS, ABCP) and second order securitizations, or “resecuritizations” (CDSs, Mezzanine ABS backed CDOs, and even CDO 2 .  These structured products were held in banks ‘off-balance sheet SIV(Special Investment Vehicles) and Conduit entities, allowing the banks to “economize on bank capital” and bypass Basel I and II capital adequacy and leverage requirements.  SIVs and Conduits funded these long duration assets with short term duration paper issuance such as Asset Backed Commercial Paper (ABCP). This funding was rolled over frequently.
    • Stage 1: Credit Expansion and Securitization (2003-2006)  The theory behind securitized products is that they spread risk and are more economically efficient; those better qualified to bear the higher risk would invest in the riskiest tranches.  The securitization process was accelerated, and in large part relied upon, the rating agencies’ AAA rating, giving investors a level of security.
    • Stage 1: Credit Expansion and Securitization (2003-2006)  Additionally, investors gained assurance from monolines such as AMBAC and MBIA insured the higher rated tranches, investment banks kept the “super senior” tranches of the CDOs on MBS/ABDS on their books and committing to support SIV CP issues by purchasing any shortfall and providing emergency liquidity to the SIVs, and CDS protection was written and sold by counterparties such as AIG’s Financial Products division.
    • {www.piggington.com}
    • Stage 1: Credit Expansion and Securitization (2003-2006)  Correlation assumptions made by both the originating banks and the rating agencies were based on historical data which most often: 1. Used data from the past 20 years (data further back was hard to find). 2. Had never incorporated such vast quantities of subprime loans or loans with lower lending requirements. 3. Did not account for home price depreciation on such a wide geographic scale. 4. Under anticipated the contagion of defaults and delinquencies expressed through the correlation matrix (e.g. David Lee’s Gaussian Copula theory). 5. Did not account for the market-to-market affects or market illiquidity during a crisis in confidence.
    • Risk Indicators  Bloomberg US Financial Conditions Index  US Libor – OIS Spread  90d Commercial Paper – 3m T-Bills Rate  MOVE (1m Treasury Volatility ) Index  VIX  EURJPY 3m Implied Volatility
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • Stage 2: Subprime Defaults Rise (2006- August 2007)  Interest rates continue to rise to offset inflationary pressures.  ARMs start to reset which leads to an increase in delinquencies and defaults on subprime mortgages.  Foreclosures picked up, and home prices turned over.
    • Subprime Loan Delinquencies as a % of Total Subprime Loans
    • S&P/Case-Shiller
    •  
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • Stage 3: Securitization Stumbles (August 2007- March 2008)  The “mini quant crisis” of August 2007 wasn’t really subprime related, however it did instill some doubts for investors about the underlying structure of the markets or the longevity of risk trades.  Volatility picked up, and “vol of vol” began to climb.
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • Stage 4: Crisis in Confidence Goes Systemic (March 2008 - September 2008)  In March of 2008 Bear Stearns suffered a run on the bank by counterparties concerned with Bear’s ability to meet short term credit obligations and meet collateral calls on structured credit product trades that had suffered in value.  U.S. Treasury orchestrated a rescue by JP Morgan Chase, and took $29 billion on their books.  Banks moved to fund their own SIVs and conduits and an interbank funding liquidity crisis ensued.
    • Stage 4: Crisis in Confidence Goes Systemic (March 2008 - September 2008)  Margin and haircut requirements spiked.  ABS sales began but market illiquidity (bid-ask spreads) surfaced, showing the migration from credit risk and funding liquidity risk to market liquidity risk.
    • {Federal Reserve Bank of San Francisco}
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • Stage 5: The Great Unwind (September 2008-March 2009)  Post Lehman bankruptcy all market indicators of confidence went to unprecedented levels.  Investor’s confidence in SIV sand conduit asset quality cratered.  When the confidence in, and the price of, the collateral behind ABS and MBS wavered the issuance of ABCP and short term funding dropped. SIVs and conduits couldn’t refinance.
    • Stage 5: The Great Unwind (September 2008-March 2009)  The wholesale lending markets, including commercial paper, completely seized up.  Banks had to step in and supply the liquidity on terms that were now too generous given the quality of SIV and conduit assets.  The weeks following (and slightly before) Lehman’s demise saw many changes in the financial landscape: AIG, Merrill, Wachovia, Washington Mutual, Fannie Mae, Freddie Mac, Goldman and Morgan Stanley.
    • Stage 5: The Great Unwind (September 2008-March 2009)  Capital injections came via TARP, originally cast as an asset purchasing mechanism, and more liquidity provisions followed.  However, markets continued to decline.  Money market funds, like Reserve Management Company’s $62 billion Primary Fund ‘broke the buck’, an unprecedented return of less than face value of the investment.  Massive redemptions in funds of all stripes led to a race to sell assets in all markets, especially onerous in illiquid markets.
    • {Federal Reserve Bank of San Francisco}
    • {Federal Reserve Bank of San Francisco}
    • {The New York Times; Bloomberg}
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • Stage 6: Government Intervention and Market Rebound (March 2009 – current) Examples of liquidity provisions:  Primary Dealer Credit Facility (PDCF) – liquidity directly to Primary Dealers, and opened the PD function to additional banks.  Term Securities Lending Facility (TSLF) - weekly term lending to offer Treasuries on 1mth loan.  Term Auction Facility (TAF) – auction based term lending against a wide range of collateral.  Term Asset Based Security Lending Facility (TALF) – direct lending facility to ABS backed by underlying credit cards, student loans, auto loans.
    • US Financial Conditions Index
    • US Libor – OIS Spread
    • 90d Commercial Paper – 3m T-Bill Rate
    • MOVE (1mth Treasury Options Volatility)
    • VIX
    • EURJPY 3mth Implied Volatility
    • IV. Credit and Liquidity Crisis: Hedge Fund Industry  Hedge Fund Industry by Stage  Crisis: Affects on Hedge Fund Industry
    • Hedge Fund Industry by Stage  Stage 1 – Cheap Leverage and Correlation Drift  Stage 2 – Crowded Trades Accelerate  Stage 3 – Decision Time  Stage 4 – Holding On  Stage 5 – “Unprecedented Effects”
    • Stage 5 – “Unprecedented Effects”  Prime brokers abruptly withdrew their previously agreed lines of credit to hedge funds, or drastically raised “haircuts” and margin requirements.  This forced deleveraging by hedge fund managers, which further drove down prices in the markets.  Counterparty risk management became paramount when Lehman went under. Some managers had funds frozen at Lehman Brothers International Europe (LBIE), which had rehypothecated clients assets as its own collateral.  In the UK such use of a customer’s assets by a prime broker could be for an unlimited amount of the customer’s assets.
    • Stage 5 – “Unprecedented Effects”  Investors disappointed with hedge fund returns placed redemption notices  Investors in hedge funds that did well placed redemption notices due to their need of cash and rebalancing needs.  Investors predicting a hedge fund ‘run’ submitted redemption notices to get ahead of the crowd (classic prisoner’s dilemma).  These redemption notices led many managers to suspend redemptions, “throw gates”, or ‘side pocket’ assets in order to avoid selling assets into falling markets, or markets with no bids.  These managers were forced to grapple with the issue of investor preference for exiting investors vs. remaining investors.
    • Crisis: Effects on the Hedge Fund Industry  Negative Effects  Positive Effects
    • Crisis: Effects on the Hedge Fund Industry Negative Affects  Counterparty Risks  Liquidity Mismatch Issues  Beta Masquerading as Alpha*  Crowded Trades Unwinding*
    • Correlation Study: HFRI Fund Weighted Composite Index vs. S&P 500
    • Crisis: Effects on the Hedge Fund Industry Positive Affects  Beta Masquerading as Alpha*  Crowded Trades Unwinding*  Better Future Liquidity Matching  Ponzi Schemes Revealed  Reduction in Industry Size  Better Returns and Risk Management than Traditional Asset Management
    • Crisis: Effects on the Hedge Fund Industry {www.hedgefundresearch.com} Better Returns and Risk Management than Traditional Asset Management  HFRI Composite = 20.12% for 2009 and 2.27% for 3yr return.  SPX = 26.46% for 2009 and -5.63% for 3yr return.  HFRI Composite = -18.36% for 2008.  SPX = -39.3% for 2008.
    • HFRI Fund Weighted Composite Index vs. S&P 500
    • HFRI Macro Index vs. S&P 500
    • HFRI Convertible Arbitrage Index vs. S&P 500
    • February 1, 2010 Part V. Question and Answer Session Jason T. Wallace, FRM, CAIA [email_address]