Sowood Gets Taken Out

In what is easily the highest profile victim to date of the newly awake credit markets, Sowood is gone. Jeff Larson came out of Harvard Management Company a few years ago when many of the investment professionals were semi-forced out because of faculty anger at their performance-based compensation scheme. So all the managers left, set up their own funds and put in place standard pay for performance schemes that far exceed the cost of the internal comp needed to pay the managers. The distinguished faculty at Harvard were not able to make the mental leap that whether you pay the fees internally or externally, it still costs the same (and in fact more) and so quieted down.

Sowood lost 50% of its NAV in one month.

Sowood Letter to Shareholders (PDF)

The manager writes

Our actions over the weekend followed severe declines in the value of our credit positions and non-performance of off-setting hedges...the NAV [of their funds] will have declined 57% and 53% month to date. During the month of June, our portfolio experienced losses mostly as a result of sharply wider corporate credit spreads unaccompanied by any concomitant move in equities and exacerbated by a marked decline in liquidity.

So without knowing anything about anything:

a) Sowood was leveraged in some way through the structure with which they held their credit portfolio (you would not have lost 50% in one month otherwise)

b) It hedged based on some predictive model of how equities would perform when credit spreads widened. The model probably predicted that equities would decline in that scenario which they did not last month. We would have thought by now that we would have learned that these probabilistic hedges fail with some regularity exactly when you want them not to when markets turn messy illiquid.

LTCM fell victim to the same belief in their models.

This is the "picking nickels in front of a bulldozer" of Nassim Nicholas Taleb (website; wikipedia)

That said, we can't be too harsh with Sowood. Like all hedge funds risk is asymmetric between manager and shareholder to manager is always tempted to take "too much" of it. Alternatively Sowood might have made a perfectly sound bet that went bad, but on the face of it, that is not what it looks like.

Anyway, must watch Citadel now. They did the bailout and are turning into a real force for distressed assets.

Posted on July 30, 2007 and filed under Finance.