Hedge Fund Implosions Starting

We have noted several times in the last few weeks that hedge fund redemptions were likely to produce another ratchet-up of intensity of the financial crisis. Nouriel Roubini has also called it as the next domino to fall.

Hedge fund have had not-so-hot returns so far this year, on average delivering losses despite promises to be able to deliver positive returns in markets good and bac. Short-selling strategies were a lone bright spot , and the powers that be put the keebosh on that.

August was bad, September certain to be worse. And a separate impulse for investors to pull money out is loss aversion. Just as investors are running to cash and gold, they are seeking to exit risky strategies and assets.

Hedge fund redemptions are particularly damaging because, if they rise beyond a modest level, they force manager to sell positions at a time not of their choosing. Worse, at this juncture, they are forced to liquidate in weak markets, depressing prices further, If redemptions go beyond a certain threshold, funds can go into a death spiral. And the price-lowering effects of hedge fund sales force others carrying similar paper to mark them at lower values increasing the likekihood that they in short order will face investor withdrawals. Plus, as a result of falling prices, if a fund used leverage, they may be required, independent of investor action, to sell assets to meet margin calls.

Reader Saboor provided a list of sightings this evening. The fact that so many papers are running pieces on the same topic says conditions are getting acute.

One thing to keep in mind: just like any sort of new business, a lot of new hedge funds fail. But the discussion here focuses on established, larger funds that are hitting the wall.

This is another example of unintended consequences of regulatory intervention. As we have discussed, one of the features of our financial system, per Richard Bookstaber in his book A Demon of Our Own Design, is that the financial system is tightly coupled, that new information or inputs move through the system in a sequence that cannot be interrupted, Tight coupling is actually a sign of bad design. If our bodies were tightly coupled, stubbing your toe would give you, say, a heart attack. The damage would move to seemingly unrelated areas rather than staying localized.

In tightly coupled systems, interventions to dampen risk generally do not work and often make matters worse. In a tightly coupled system, the way to reduce risk is to find a way to interrupt processes. The trading halt that were created in the wake of the 1987 crash were that sort of move. Moving credit default swaps onto exchanges would also be consistent with that goal.

Conversely, as the article demonstrates, the effort to reduce risk by banning short selling is leading (among other things) to more hedge fund failures, which as discussed above, will increase systemic stress.

From the Times Online, “‘We are approached by hedge funds considering fund liquidations on a weekly basis’” (recall the UK is an even bigger hedge fund center than the New York metro area):

Every week at least one British hedge fund is considering winding up its funds as catastrophic investment performance puts the sector under unprecedented pressure, an industry expert said yesterday.

Andrew Shrimpton, the former head of hedge fund regulation at the Financial Services Authority who now runs Kinetic, a consultancy, said: “The credit crisis is definitely kicking in for the hedge fund industry now. We are being approached by hedge funds considering voluntary fund liquidations on a weekly basis.”

His remarks came as CQS, one of London’s best-known hedge funds, wrote to its investors to say that its flagship $4.25billion CQS Fund had fallen 9.42 per cent for the year to date…. The fund, which specialises in convertible arbitrage – or small price differentials between bonds and underlying equities – is down more than 11 per cent for the year.

Mr Shrimpton said that turbulent investment markets and worries that investors are rushing to redeem funds were taking their toll on a sector that had experienced unrivalled growth since the turn of the millennium.

He added that the FSA’s ban on short-selling shares in the financial sector was hitting individual investment strategies, including long-short equity funds and event-driven funds. “There is a shake-out going on. Everyone is being affected,” he said. He also called on the FSA to drop its temporary shorting ban as soon as stability begins to return to the markets: “Short-sellers add liquidity to the markets; there is a clear case for dropping the ban in more stable times.”….

There was no suggestion that the fund [CQS] would be forced to wind up.

It also emerged yesterday that Toscafund, the $6billion London-based hedge fund run by Martin Hughes, was sitting on substantial paper losses on its investments in Washington Mutual and Sovereign Bancorp..

Hedge funds were bracing themselves yesterday for a rush of redemption calls as investors, particularly the super wealthy, try to withdraw their capital by the end of the year.

One manager at a London hedge fund said: “Investors are scared – they want cash. We are not going to be immune from that.”

He said that it was likely that companies that run funds of hedge funds would be hit particularly hard. Hedge funds have recorded their worst investment performance for the year to date.

Worldwide, hedge funds have lost more than 10 per cent, according to Hedge Fund Research (HFR), the Chicago-based research firm.

Almost every hedge fund investment strategy has recorded losses for the year so far, according to HFR data. Only macro investments and merger arbitrage strategies have posted gains.

Now the New York Post, “Hedge Hellfire” (the Post may seem to be an odd source, but is has broken stories on losses at some of the big Connecticut hedgies):

With once-highflying funds seeing their performance worsening, investors are pounding on the door to get their money out,…

“I’d not be surprised if, for some funds, September 2008 is their last month in business,” said Veryan Allen, who advises institutional investors on hedge-fund investments…

The summer’s volatility has already taken down commodity player Ospraie Management, which announced plans to close its flagship fund following a 27 percent drop in August. London’s RAB Capital’s Special Situations fund also has locked up investors’ money following losses of more than 54 percent.

More are expected to follow, although the full extent of the damage could take months to shake out.

That’s because investors who seek to yank out their dough as a result of the most recent turmoil may have to wait until the end of December – the result of strict withdrawal timelines.

Hedge funds often require investors to provide as much as three months’ notice before they can pull their money out. For example, today marks an opening for some redemption requests made in June, when many investors first started rushing for the exits.

To be sure, improving conditions may spur investors to withdraw their most recent redemption requests. But even if things turn around, some of their losses may not be reversible.

A long standing fund manager (Guy Wyser-Pratte was a famous risk arbitrageur in the 1980s) has barred investor withdrawals, which is generally a sign that the end of a fund is nigh. From the Financial Times:

Guy Wyser-Pratte has blocked withdrawals from his hedge fund after the veteran New York arbitrageur and activist warned that the “calamitous” market conditions were the worst since he started trading in the 1960s.

Wyser-Pratte Eurovalue, a $500m fund campaigning for change at mid-sized companies across Europe, suspended withdrawals on Tuesday after some clients asked for their money back…..

Mr Wyser-Pratte said he was blocking withdrawals to protect investors.

“I have come through ’68, ’72, ’86, ’87, ’98 and 2002,” he told the Financial Times. “But this is the worst and one has to act prudently in times like this. It is batten-down-the-hatches time.

Bloomberg discusses a narrower problem, but no less painful for the affected funds, namely, that of having assets frozen in the Lehman bankruptcy:

The list of funds trapped in the Lehman morass keeps growing. London-based MKM Longboat Capital Advisors LLP said last week it will close its $1.5 billion Multi-Strategy fund in part because of assets stuck at Lehman, according to an investor letter.

LibertyView Capital Management Inc. of Hoboken, New Jersey, owned by Lehman’s Neuberger Berman unit, told investors on Sept. 26 it had suspended “until further notice” attempts to calculate the value of its funds. LibertyView wasn’t included in the Sept. 29 sale of Neuberger to Bain Capital LLC and Hellman & Friedman LLC.

Diamondback Capital Management LLC, a Stamford, Connecticut-based hedge fund, told investors that it had assets of $777 million stranded in Lehman. A spokesman declined to comment.

Managers with a smaller percentage of assets in Lehman limbo include Harbinger Capital Partners, Amber Capital LP and Bay Harbour Management LLC, which are each based in New York, and RAB Capital Plc and GLG Partners Inc., both in London. Olivant Ltd., run by former UBS AG President Luqman Arnold, said today it can’t access a 2.78 percent UBS stake, worth about $1.4 billion, it held at Lehman…

PricewaterhouseCoopers, Lehman’s bankruptcy administrator in the U.K., where its European prime brokerage was based, doesn’t know how much money is at stake. PwC said last month it’s trying to recoup about $8 billion in cash that Lehman’s parent company allegedly withdrew from its European unit before the collapse. It will take weeks, if not longer, to sort out the mess, according to PwC.

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  1. future shock

    I agree with Russ Winter’s thinking on this one. Hedge fund failures are only positive in the long run. We need a much larger pool of small and savvy investors, instead of a handful of Big Playahs churning the markets in search of tomorrow’s big score.

    Doesn’t look like there’s going to be the cascade of hedge fund failures everyone thought there would be. The last day of September was Redemption Day and the world didn’t end.

    The tight coupling in the system is by design (and yes, it’s a bad design). You want asset equivalence – every asset class in existence is as good as cash (redeemable at a moment’s notice) and therefore every asset is linked (through redemptions) to every other. How could this not lead to tight coupling in everything that’s traded in the open markets?

    The tight coupling between the markets and the ‘real economy’ comes in part from our dependence on credit to get anything done. I’m surely not the first person to point this out, but the volatility and instability we’re seeing isn’t going to go away until a lot of credit is destroyed.

    Declines in house values and other fictious asset prices are to be welcomed, not shunned.

  2. doc holiday

    I always thought this person was way smart:

    Wall Street Trading Gets Zero Value From Lehman, Merrill Owners
    Lack of Transparency

    Lehman would be crippled more than its rivals if it sold its asset-management division, he said. While Morgan Stanley and Merrill have retail-brokerage divisions to bring in revenue, Lehman would be hard-pressed to replace the income it earns from asset management.

    Investors are having a hard time valuing the rest of the business at Lehman because there's no transparency about the mortgage securities on their books, said Janet Tavakoli, author of “Credit Derivatives & Synthetic Structures.'' Lehman, Merrill and Morgan Stanley borrowed heavily to fund their mortgage investments, which is coming back to hurt them, she said. The three investment banks' total assets were about 30 times their capital levels last year.

    “When you're highly leveraged, you need to be very careful about the quality of your fixed-income assets,'' said Tavakoli, president of Chicago-based Tavakoli Structured Finance Inc. “Even if you held Treasuries, you could lose big money when interest rates moved against you. When you take credit risk as well, which was the case with mortgage bonds, then you're really in trouble.''

  3. EvilHenryPaulson

    I don’t think the problem is hedge funds, but I do think they are excellent at finding weak points and unbalancing our broader financial system.

    You want to loosen the coupling of financial markets?

    Then you need to stratify central banks to respond to subsets of the economy, each of which are likely larger and more specialized than the economy was 50 years ago in proportion to the central bank.

    Housing, Technology, Manufacturing, Commodities are connected to each other but they are much more tightly linked within themselves. We need to recognize separate credit markets akin to how there are different genres of music so that mortgage rates are not tightly correlated to a loan’s interest rate to a semi-conductor company.

    International banks and multi-national corporations already take advantage of interest rate differentials, but usually only to a minor extent in the countries they operate. Continuing business as usual will leave the burden to be delivered via the FOREX markets like in the Asian Flu and in the present crisis (well there is still the possibility of growth prospects offsetting the borrowing vast sums internationally.) I think these are signs that a once adequate control system is now incapable of maintaining stability.

    The entire world would not have one single central bank and one key lending rate because it would be unmanageable. Why should that truth be any different within a country?

    Implicitly I must be arguing the that global supply of credit is greater than the demand for it to be able to slosh about with enough momentum to unbalance the optimal allocation of credit. Leverage may enable the problem, but it is still the financial system’s control-system that is failing stability testing.

  4. d

    Ummm, bonus footage for the eyes and ears:

    Tavakoli Calls Government Financial Bailout `Dangerous': Video


    Janet Tavakoli, president of Tavakoli Structured Finance, talks with Bloomberg's Betty Liu from Chicago about her opposition to the U.S. government's rescue plan for the financial industry. Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson are pushing Congress to quickly approve a $700 billion plan to remove illiquid assets from the banking system. (Source: Bloomberg)

    Also see: “It is not in the interests of U.S. citizens and taxpayers to abandon mark-to-market accounting for a proposal in which taxpayer funds are being used,” says Janet Tavakoli, founder and president of Tavakoli Structured Finance and one of the best market analysts on the dangers of credit derivatives.

    Tavakoli adds: “If we would have to sell the assets at a loss due to downward moves in market prices, we have a right to know that. If the assets have permanent losses so that even if we hold to maturity we would have losses, we have a right to know that too. At any given time, we have a right to know what our ‘investment’ is worth.”

    Tavakoli adds that the danger is that the government’s new portfolio managers “can claim they are making money” while “the assets are declining in value due to defaults or permanent value destruction of collateral. This situation can continue for a long time to create the false appearance of profitability.

    Tavakoli notes that “in other words, U.S. taxpayers can be told they are making money on their $700 bn investment, when in reality they are losing money. I would rather know the market price, even if the news is bad news.”

  5. moss

    This is healthy. What did Warren Buffet call these entities? Compensation schemes for the principles.

  6. Anonymous

    Moss, you fail to mention that Warren Buffet also said this bill should be PASSED!!!! I for one would listen to Mr. Buffet way before any of these nuts on the internet. Thanks

  7. River

    ‘I would listen to Warren Buffet before I would listen to any of the other wing nuts on the internet’

    Then listen up as Warren Buffet issues ‘endorsements’ by going public with his purchases of Golaman and now GE. Those purchases will not only make Buffet a lot of money but allows him to talk his book in a very big and public way. Buffet is admirable as a business man but do not be overcome by his endorsements any more than you would purchase a $250 pair of sneakers based on some professional athelete wearing those sneakers and proclaiming their advantages in tv commercials.

    Goldman and GE now have the Good Housekeeping Zeal Of Approval from Buffet…

  8. Matt Dubuque

    I will be sure to read Bookstaber’s book, but I have a pretty thorough knowledge of systems theory and information theory, having studied closely with Gregory Bateson who participated in the original Macy conferences with von Neumann, Ashby, Weiner, Shannon and others. I recall encountering Bookstaber before and seem to remember he was also a student of Bateson’s.

    I’m not trying to brag or boast, I’m merely trying to establish that I have dealt extensively with the dynamics of coupled systems.

    And it would seem to be a mischaracterization of the issue to say that tightly coupled systems are the problem.

    When tens of millions of cells process the information you are now reading are directed to your visual cortex, Wernicke’s area, Broca’s area and to higher brain centers so that you can understand what I say, that is an example of a tightly coupled system functioning beautifully. Without millions of cascades of neural arrays firing in harmony and in tightly coupled fashion, human speech and interpretation would not be possible.

    Your neuroendocrine networks are another example of a tightly coupled system. And there are numerous others I could mention; the heart/kidney complex comes to mind.

    The reason you do not suffer a heart attack when you stub your toe is not because you are not a tightly coupled system. Rather, it is because your various tightly coupled subsystems are linked up in parallel rather than hierarchically, with an overlay of a regulatory meta-network that distributes shocks through the system on a stepped-down logarithmic (i.e. Weber-Fechner type ratio) basis.

    The point being that because of computer networks and other factors our financial networks are DESTINED to be tightly coupled.

    I’ll be sure to read Bookstaber’s book, but I do hope this commentary sheds some light on describing and engineering coupled systems.

    I offer it in the hope that if we all align our fundamental approaches to solving these problems, our solutions will be more consonant in the future.

    Matt Dubuque

  9. Moopheus

    Isn’t a hedge fund set up explicitly for folks who can afford to take risks with large amounts of money? I haven’t paid that much attention to them, since I’m not one of those people, so maybe I missed something, but didn’t they understand that there was a chance they could lose? Shouldn’t the fund managers have been prepared to act at moments not of their choosing? Did they really think that would never happen?

  10. Anonymous

    What is that? You think a “qualified investor” qualification means something?
    This is the political class we are talking about here, rules don’t apply to them.

  11. Anonymous

    Mr Wyser-Pratte said he was blocking withdrawals to protect investors.

    “I have come through ’68, ’72, ’86, ’87, ’98 and 2002,” he told the Financial Times. “

    Sir, I doubt you’ll make it through 2008. May I also remind you that the managers at Bear Sterns did the same thing and cost the investors about 50% of their money.

  12. Anonymous

    Matt, when will you ever learn that there is no point in going on and on about your credentials, even if you offer a disclaimer about whether the purpose is to boast or not. Do you not grasp the fact that it is impossible to establish your credentials this way? Readers are not going even get to the question of whether the credential are meaningful since they don’t know in the first place if you are even telling the truth about them. Stop, already. Argument based on credentials is always a logical fallacy, but especially so on a blog. Your only credibility on a blog arises from the quality of your argument and evidence. Surely not even you can think that somehow the teachers who taught your teachers matters to anyone? So shut up about the that crap, no one cares, and it is annoying. If this blog had an “ignore” feature on it, everyone would have used it on you a long time ago.

  13. Matt Dubuque

    Matt Dubuque


    It is not clear to me what role personal attacks should play in a blog. The record of this blog does demonstrate that not “all” people choose to ignore me. I have received numerous compliments both publicly and privately. On what basis do you speak for all other persons?

    To address your point directly, I hope that the merits of my argument are persuasive.

    I’m fully persuaded that people are composed of subsystems that are extremely tightly coupled.

    I think the peer-reviewed science demonstrates that.

    Matt Dubuque

  14. Anonymous

    Matt, it’s not a personal attack. Calling you an egomaniacal, probably-untruthful blowhard would be a personal attack. I didn’t do that. I pleaded with you to keep the crap out of your posts. Give it a shot.

  15. doc holiday

    An Unbelievable Yield


    Telephone reps at mutual fund companies usually read from a script. Not the fellow I got Monday afternoon on Vanguard's line, name of Irwin. He was a live wire, speaking extemporaneously and with enthusiasm when I asked whether it's true that Vanguard Tax Exempt Money Market Fund (symbol VMSXX) yields more than 5%. In fact, on September 29, the fund's seven-day yield was a fat 5.18%.

    "I know, is this a typo?" Irwin said, anticipating my next words by saying he "jumped on that" yield with his own money and got his brother in as well. "I don't know if you'll get this break for three days or three weeks, but that's the seven-day yield," he went on.

    >> Interesting take on credit and money flow

    P.S. Yves, I like that sidebar that shows most recent posts, it really saves time!!

  16. Anonymous

    No one expected hedge funds to be fully capitalized, then of course no one expected everything to blow up all at once where they needed to be fully capitalized. Same with their insurers.

  17. Matt Dubuque

    OK Anonymous, I will do my best.

    Now let’s discuss the merits of the matter.

    Yves posited a thesis, as near as I can tell, that one of the issues we face is that our financial system is tightly coupled and that makes regulation much more complicated because of unintended effects. Yves, forgive me if I have mischaracterized your view.

    As supporting evidence, she pointed to the glory of the human body, which is not so tightly coupled as to suffer a heart attack when we stub our toe.

    I responded by saying that perception, speaking and endocrinology are just three quick examples of extremely tightly coupled systems within the human body.

    I stated that what is far more accurate to say is that using logarithmic somatic buffering processes like the Weber-Fechner relation to regulate external shocks among VERY tightly coupled subsystems is a far more accurate description of the human body.

    You asked me to confine my discussion to facts.

    Along those lines, I am a firm believer in peer-reviewed literature, whether it be in medicine or finance.

    I can provide numerous citations to the peer-reviewed medical literature to support my position that the human body is composed of numerous tightly coupled subsystems buffered and regulated by logarithmic processes such as the Weber Fechner relation.

    I am unaware of any peer-reviewed work in the medical literature that supports the position that humans do not possess tightly coupled systems.

    Are you?

    This seems like a perfectly legitimate way to proceed, without acrimony or conceit, but merely by exchanging citations to the professional literature directly on point.

    And I do not view this as a trivial discussion. Yves went on at some length about the problems of tightly coupled systems in financial regulation and has drawn repeated analogies over the last month to the human body in that regard.

    In closing, I would point out that this notion of regulatory “buffering” was one reason why the Fed chose to abandon targeting the monetary base in the early 1980s, because of the extreme volatility in interest rates that resulted.

    This is why, at the urging of the Kansas City Fed, they switched to Fed funds targeting instead, according to Gordon Sellon and others.

    I will provide cites to the appropriate pages of the papers demonstrating this, if asked.


    Matt Dubuque

  18. doc holiday

    Sorry, I need to point out that higher yields from those tax free securities are probably a sign of stress, i.e, this is like Indy bank or WaMu offering higher rates as they search for cash. I would keep thinking in terms of a liquidity trap and try to remain calm and stay out of debt!

  19. Anonymous


    I think your postings are well thought out and very informative.

    And I don’t mind at all your ‘background’ comments regarding your areas of knowledge.

    Keep it up.

  20. Anonymous

    What, exactly, do tightly coupled biological systems have to do with the current US financial system? One is the result of millions of years of evolution while the other is merely the expression of a mutant species baser instincts.

    Reading this crap reminds me of Nietzsche’s dictum: “Man is more ape than any ape.” Indeed.

  21. Juan

    interpenetrating semiautonomous processes have, as a whole, organic characteristics which can help one grasp the capital system, including finance, as a larger process of contradiction driven REproduction (that while generally expanded can also become simple or contracted).
    IOW, so far as he goes, Matt is correct.

Comments are closed.