Behind Buyout Surge, A Debt Market Booms

From the WSJ ($)

CLOs, as they're called, are giant pools of bank loans bundled together by Wall Street and sold off to investors in slices. They aim to spread default risk an inch deep and a mile wide. Last year, more than half of the loans behind the record wave of buyouts were parceled out to investors as CLOs, bankers say.

As corporate borrowing soars, however, concerns are growing that CLOs have made it too easy for shaky or debt-laden companies to borrow money. If economic conditions deteriorate, those loans could sour and investors in the riskiest CLO slices could face large losses. That, in turn, could make it harder for buyout firms to borrow money.

"We are witnessing a loan market rife with liquidity and disproportionate power in the hands of borrowers, arrangers and financial sponsors," said credit-rating firm Standard & Poor's Corp. in a June 13 report. S&P expressed concern that loans without strong covenants to protect lenders are showing up in CLOs. The rating company urged investors to "drill down" while researching the investments and to "hold CLO managers accountable" for questionable loans.

These days, banks that arrange large buyout financings hold on to very little of the loans themselves. Bank underwriting standards have slipped as banks have become mere intermediaries, some executives at buyout firms contend. Banks enable and encourage private-equity firms to load up their companies with debt, these executives say.

CLO investors are betting that there's safety in numbers -- that most corporate borrowers will pay off their loans even if a few don't. Last year, just 1.3% of corporations with credit ratings below investment grade defaulted on their debts, the lowest annual rate since 1981, according to Standard & Poor's.

Where have we seen this story before?

1. Originators shift role from underwriters to intermediaries CHECK

2. Credit standards slip to historic lows CHECK

3. Buyers of the security think that diversification of bad underwriting will make everything ok CHECK

4. Illiquid, opaque and poorly understood securities CHECK

5. Period of initial high returns CHECK

5. This will end badly JUST WAIT

Artificial Hedge Funds

Long article from the New Yorker about the ex-Equity Derivatives head at BoA who was built a mechanical hedge fund simulator. Worthwhile read

Kat had worked in the financial markets for almost fifteen years, but what he learned about hedge-fund fees shocked him. An investor who puts a million dollars in a fund of funds whose value goes up ten per cent in twelve months would face deductions of about sixty thousand dollars on the gains he makes. "Who wants to pay that kind of money?" Kat asked the executive who was interviewing him. "You can't seriously expect there to be anything interesting left after somebody takes out three and thirty." The executive was nonplussed. "I don't know," he said. "But they pay it."

The executive's firm offered Kat a job as the head of research, but he turned it down. The following year, he began teaching finance at the University of Reading, and in 2003 he became a professor of risk management at Sir John Cass Business School, which is part of City University in London. He continued to think about hedge funds. "When I became an academic," I said, "That's the thing I want to investigate," he recalled recently. "Is it really possible to generate investment returns to the extent that you can take out three and thirty and still be left with something you can call superior?"

However, Kat remained skeptical. As he conducted his research on hedge funds, he became convinced that it might be possible to generate similar returns in a mechanical way and with much less effort. Two years ago, he and Palaro began to sketch out ideas for a software program that could mimic the returns of individual hedge funds by trading futures. "We may be able to do without expensive hedge-fund managers and all the hassle, including the due diligence, the lack of liquidity, the lack of transparency, the lack of capacity and the fear of style drift (”changes in a fund's strategy) which comes with investing in hedge funds," Kat and Palaro wrote in a working paper about the project which they published last year.

In the London financial community, word of FundCreator's abilities has spread rapidly. As of last week, Kat said, two institutional investors were paying to use it, and more than fifty were experimenting with it. Kat and Palaro charge their clients an annual fee of roughly a third of one per cent of the money they invest using the software ”less than a fifth of what most hedge funds charge. The cost of executing futures trades must be added on to FundCreator's management fees, but, unlike at hedge funds, investors keep all the gains they make. "Why would you pay the high fees that hedge funds charge if you are able to get the same risk characteristics, in a statistical sense, by using a dynamic futures-trading strategy?" Bas Peeters, the head of structured products at ING Investment Management, said to me. "FundCreator is potentially a very cost-efficient solution." Pete Eggleston, the head of quantitative solutions at the Royal Bank of Scotland, one of the biggest banks in Europe, said of FundCreator, "Such approaches may revolutionize the industry in terms of providing investors with access to lower-cost investment returns."

It is notoriously difficult to distinguish between genuine investment skill and random variation. But firms like Renaissance Technologies, Citadel Investment Group, and D. E. Shaw appear to generate consistently high returns and low volatility. Shaw's main equity fund has posted average annual returns, after fees, of twenty-one per cent since 1989; Renaissance has reportedly produced even higher returns. (Most of the top-performing hedge funds are closed to new investors.) Kat questioned whether such firms, which trade in huge volumes on a daily basis, ought to be categorized as hedge funds at all. "Basically, they are the largest market-making firms in the world, but they call themselves hedge funds because it sells better," Kat said. "The average horizon on a trade for these guys is something like five seconds. They earn the spread. It's very smart, but their skill is in technology. It's in sucking up tick-by-tick data, processing all those data, and converting them into second-by-second positions in thousands of spreads worldwide. Its just algorithmic market-making."

Almost by definition, there can be only a handful of genius investors, Kat continued. "And even if they are there, the chances that you will find them and that they will let you in are very, very slim," he said. "That's what I tell people. If you are really convinced that you can find those super managers, then don't waste your time with our stuff. Go look for them. But if you are a bit more realistic, if you know that eighty per cent of hedge-fund managers aren't worth the fees they charge, then the rational thing to do is to give up trying to find a super manager, and just go for a good, efficient diversifier instead."

Good Articles from the WSJ

How CDOs work (from the WSJ $)

So investors often have to estimate the value of a CDO and have a lot of leeway in how they do it. That's a worry for investors in hedge funds, big buyers of CDOs. Hedge-fund managers make most of their money through performance fees. This gives them added incentive to use price estimates that work in their favor, even if they might not reflect the price at which they could actually trade the CDO.

Or it could mean that the managers themselves don't know exactly what their holdings are worth, because they are so far removed from the underlying investment. In the case of Jane's loan, that means the CDO buyer will have a tough time gauging whether she's a good risk or not. And if she defaults, it may take a while before that affects the value of the CDO, even though market conditions overall might have already changed.

Amid Financial Excess, a Revival of Austrian Economics (WSJ Economics Blog)

It notes that “the prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.” While fundamental economic improvements are at the root, “the market reaction to good news might have become irrationally exuberant. There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking… [S]uch endogenous market processes … can, indeed must, eventually go into reverse if the fundamentals have been overpriced.”

Apart from financial imbalances, the report argues the world economy also displays dangerous misallocations of capital. In its “recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms” to Japan in the 1980s. “In the United States, it is the recent massive investment in housing that has been unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible and long-lived good.” In other words, the U.S. could be stuck with a lot of houses that are hard to sell to each other and impossible to sell to foreigners, and won’t need replacement for a long time.

Wall Street Fears Bear Stearns Is Tip of an Iceberg WSJ ($)

Now, the problems at the Bear Stearns funds -- which prompted the firm to lend one of them up to $3.2 billion in a bid to rescue it -- show how hedge funds bent on short-term gains can go astray when holding assets that can't be easily valued. That has stoked worries on Wall Street that other funds with similar types of investments will suffer losses as fund managers reassess the value of those investments. Those concerns contributed to last week's 279.22-point, or 2.1%, drop in the Dow Jones Industrial Average to 13360.26.

Many hedge funds and other institutions are paid in part on performance, so it is often in their interest to price, or "mark," their assets aggressively, attaching the highest possible value to them. The higher the value, the more compensation the fund manager receives from the fund's investors.

Moreover, hedge funds typically don't keep investors abreast of the details of day-to-day trading. As a result, any losses the funds suffer may be significant by the time investors learn of them. That can be especially true for illiquid assets, which may not show much price movement for months and then dip sharply when confronted with the one-two punch of declining fundamentals and nervous investors.

The combination of illiquidity and leverage has long been a mainstay of financial crises. In 1994, hedge funds run by Askin Capital Management sustained huge losses on leveraged bets on infrequently traded mortgage-backed securities. The collapse of Long-Term Capital Management, which roiled markets around the world in 1998, was sparked by its inability to unwind leveraged bets.

Some tremors in the credit markets

From the WSJ ($)

In another sign of growing investor unease toward riskier classes of debt, Thomson Corp.'s Thomson Learning yesterday significantly restructured a planned junk-bond offering, reducing the amount of money it planned to raise to $1.6 billion from $2.1 billion. The textbook publisher also had to drop a feature -- known as a payment-in-kind toggle provision -- on some of its bonds that would have allowed it to pay interest in the form of additional debt if it ran short of cash in the future.

Such provisions are an example of the kind of easy terms for borrowers that have gotten some investors worried about loose lending terms in the corporate debt market.