Vol 4 (2007) - Issue 6

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So, What's All the Fuss About?

Some apparently momentous changes occurred recently – things that apparently nobody could have foreseen, things so unlikely that they beggar belief.Worth examining further, given how momentous these occurrences seem to have been.
What could possibly be such a phenomenon as to make such waves? A tsunami perhaps? Well, yes and no. Let’s think further about that. There are certainly
things as unlikely as a tsunami currently occurring in the financial markets. And therein lies the rub.

The human paradox which encompasses both the search for the most logical answer to a problem, together with the naturally selfish tendencies of the human syche, causes people to live in earthquake zones or hurricane regions (because the weather is good …) and also creates apparently unforeseen turmoil out of the
financial markets. People see an attractive opportunity and analyse the risk relating to that opportunity – once satisfied with the parameters of that risk versus the reward, a decision is made as to whether they are a ‘buyer’ or not.
Those who have encountered tougher times recently are likely to have been caught out for reasons which are based on a similar theme – their assumptions underlying their investment thesis is not able to function in the financial circumstances presented to them. To a vast extent, those assumptions have been based on the ongoing liquidity of the financial markets in two discrete areas – the market for structured credit products and the market for short term lending.


The effects to date – hedge funds and SIVs


Several hedge funds have been going slightly 'wonky' recently. Some of those are ‘quantitative’ funds – effectively a large computer model deciding what assets
you should or should not buy or sell on a daily basis. They have suffered by reason of lack of liquidity in the market for structured credit products. Their three principal issues resulting from the disappearance of liquidity have been:
– the mark-to-market losses suffered by their fund – without any buyers for structured credit products,the prices of those products have, to an extent, reflected
a liquidity ‘discount’ on pricing in addition to any fundamental change to the perceived credit quality of a particular investment;
– the complete lack of any balance to their lending arrangements (the leverage the fund uses to improve returns for its investors) leaving them at the
whim of their lenders – hedge funds tend to borrow from their prime brokers and under ‘repo’ (sale and repurchase agreements) (being the cheapest cost of funds available to them) – arrangements which give the lender the ability to call for repayment effectively at its own discretion; and
– the desire for investors to seek redemptions from the fund. Structured investment vehicles (SIVs), a special purpose vehicle established with the sole purpose of repackaging an investment portfolio of asset-backed securities, have also suffered. Unlike the flexibility and 'light touch' of the conditions under which a hedge fund often operates, a SIV has a very prescriptive structure which was designed to help ensure the integrity of the vehicle in being able to pay back investors. This integrity was then analysed by the rating agencies and ratings assigned to the investments. The senior ‘piece’ of the capital structure for a SIV is generally borrowed in the short- to medium-term wholesale markets (commercial paper and medium-term notes).

The prescriptive nature of a SIV has also had its shortcomings in the current market. Those which remain funded to a greater extent in the short-term wholesale market found themselves in a position where they were not able to efinance their senior debts falling due with ‘more of the same’. Their liquidity facilities available soaked up some of the problem, but following that, the documents required them to become forced sellers of assets to repay maturing commercial paper.

Prices for assets fell further as the number of sellers increased and no new significant market demand arose.In many instances, mark-to-market losses which were occurring as the SIV took measures to protect it from default caused prices to fall to a point where the SIV failed its financial covenants. Consequences of a failed financial covenant vary depending upon structure,but at that stage a SIV either sells all assets or requires restructuring.