Monday, August 20, 2007

Hedge-Fund Guy Atones for His Subprime Bond Sins

By Mark Gilbert - Aug. 16 (Bloomberg) --
Dear investor, we'd like to take this opportunity to update you on the recent performance of our hedge fund, Short-Term Capital Mismanagement LLP.

As you know, market selection for the entire fund is guided by a proprietary investing tool we like to call ``a dartboard.'' Once the asset classes are decided, individual security selections are generated by digitizing our unique hexagonal cuboid models.

Unfortunately, it transpires that our hexagonal cuboids are not as unique as we thought. Hundreds of other hedge funds possess identical dice. The technical term for this is a ``crowded trade.'' You may also see it referred to as ``climbing on a bandwagon already headed for the wall.''

As our alpha generation collapses, our beta has turned negative, our delta hedging has gone toxic and, trust me, you do not want to hear about our gamma. We can't even find our epsilons in the dark with both hands.

You will appreciate that accurate pricing is essential for evaluating our investment strategies. This has proven to be extremely challenging in recent days. Previously, we have relied on Bob, the sales guy at Hokey-Cokey Bank. Bob assured us the securities were still worth 100 percent of face value, so everything was cool. Bob sold the collateralized debt obligations to us in the first place, so he knows what he's talking about.

Bob, however, appears to have had a nervous breakdown, judging by the maniacal laughter that greeted our requests for price verification this week. Our efforts to implement an in- house CDO valuation framework, using a technique the ancients knew as ``making things up,'' proved unsatisfactory.

Where's the Bid?

Currently, all of the portfolios we manage are undergoing a rigorous screening known as ``crossing our fingers and praying that we don't have to try and find a bid in the market.'' This is supplemented by a cross-market statistical analysis originally developed by the U.S. military called ``don't ask, don't tell.'' This ``unmarking-to-unmarket'' procedure has been the benchmark for the hedge-fund industry for the past, ooh, 72 hours.

We have, of course, been in touch with the rating companies to update our default-probability scenarios, particularly on the AAA rated investments we own. They recommended a forecasting method using stochastics to regress the drift-to-downgrade timescales for the past 100 years and throw them forward for the next five minutes. The technical term for this is ``induction,'' though those of you of a less quantitative bent may know it as ``guessing.''

AAA or Toast?

We are pleased to report that, contrary to what current market prices might suggest, all of our top-rated securities remain absolutely AAA. Provided, that is, the future performance of the underlying collateral is identical to its history. Otherwise, the rating companies say our investments are likely to be reclassified as ``toast.''

We have also been checking our back-up credit lines with our friends in the investment-banking world. As soon as they return our calls, we'll be able to update you on our emergency liquidity position. We are sure they are fine.

Some of you have written to us asking for your money back, citing clauses in the fund documentation called redemption rights. Frankly, we never expected you to actually read that prospectus, which came prepackaged when we bought the Microsoft Hedge-Fund Guy software. We certainly have no idea what all those long words mean.

We have filed your letters in a special drawer in the filing cabinet marked ``trash'' for now. Do you have any idea how much trouble you all would be in if we actually sold this stuff in the market today? At these crazy prices? Fuhgeddaboudit. You'll thank us later.

Not a Rescue

Speaking of crazy prices, we know you'll be thrilled to learn that we've invited a bunch of our rich pals into the fund to participate in this once-in-a-lifetime opportunity. But this is not a rescue. Do not even think the word rescue. This is an opportunity. Not a rescue. An opportunity.
In fact, we think this is such a fantastic opportunity, we've agreed to forgo our usual management fee, and we'll only take half our usual slice of the profits. Provided there are any profits to slice. You, of course, are absolutely invited to participate in this offer by sending us yet more of your money on exactly the same revised terms as our rich pals.

Finally, a word for all of you who have been kind enough to inquire about my personal financial situation. I am relieved to report that my directors and officers insurance is fully paid up. Furthermore, my Bentley Continental was paid out of the 2 percent fee we levied when you wrote your first check to us, so I will still be able to trundle into the parking lot each morning in an open-necked shirt to ignore your telephone calls and e-mails.


Hedge-Fund Guy.


freako said...

Here is an interesting cut/paste from Ben Jones' blog:

“Joseph and Lu-Ann Horn bought their 1,200-square-foot, three-bedroom home in South Windsor, Conn., in 2002, paying for nearly all of it with a $150,000 loan. The mortgage was a 30-year loan with a fixed rate of 7.5 percent. Two years later, they decided to refinance to pay off their truck and their credit card debt and to buy a $4,000 motorcycle.”

“The new mortgage was for $198,000, at a fixed rate of about 8 percent for two years and variable rates afterward. The monthly payment was about $1,600.


“Mr. and Ms. Horn make about $70,000 a year, but with two children and other expenses they fell behind on the mortgage. They have been served with foreclosure papers, and have filed for Chapter 13. ‘We’re fighting to hold onto the house now,’ Ms. Horn said.”

Ok, if these guys who make $70,000 get in trouble on a $198,000 mortgage, what does that say for a typical buyer in Vancouver? You will have three times that mortgage buying the GV median SFH. Nuts I tell you.

AndrewJ said...

A local anecdote from someone selling their house in North Van and buying 3 houses in Nanaimo to become landlords. They paid down the mortgage with a lot of foreign exchange students.

Anyway we were talking about credit card debt and when I said I had none the person respond with: "We were like that too but then we figured we were building equity and didn't need to worry about it.".

This story illustrates many things:

1) You can buy *3* houses in Nanaimo for 1 in North Van.
2) Foreign exchange students can help you grind down your mortgage faster.
3) The wealth effect is real.

Yup it's just nutty out there.

scoop said...

rentingsucks, your story sounds familiar. In a similar vein, a friend explained to me the other day how housing doesn't have to be affordable when measured against average incomes, as we have moved from an income-based economy to an asset-based economy. Continued increases in asset values will keep everything going smoothly.

scoop said...

I would venture a guess that Mr. and Mrs. Horn's "other expenses" include a whack of credit card debt run up after their 2004 refinancing. Probably more car loan payments too, as who wants to be seen driving a 4 or 5 year old truck. Looks like they are having trouble kicking the easy credit addiction - it's not only about the mortgage.

freako said...

I would venture a guess that Mr. and Mrs. Horn's "other expenses" include a whack of credit card debt run up after their 2004 refinancing.

Very possible, but our Vancouverites that much different?

Funshine said...

I think it's ridiculous every time I read in a Canadian newspaper along the lines of "Oh it's different in Canada. We don't have a sub-prime mortgage problem and therefore there will be no housing price crash."

Vancouver and Victoria may not have a sub-prime lending problem, but there has to be a lending problem behind these price run-ups. The only explanation for locals continuing to buy houses in Vancouver and Victoria is that they have borrowed more than they used to. And if they are borrowing more, they're likely borrowing more than they would have like to.

I've heard of snobs buying in East Van because they can't afford to live where they want to live. You see ugly houses in good neighbourhoods selling and not getting knocked down. And of course there are the people who have conceded to live in rabbit hutches downtown.

Taken together- having borrowed much more than they wanted to and accepting to live in places they didn't want to- I expect there is a serious quality of living problem mushrooming in this city. Add, a bad weather summer, too.

It will be difficult to admit for people who have bought into it, but it suggests to me that the run for the exits will be pretty frantic when the buying stops.

At that point perhaps it will become clear that the west coast did have a lending problem just like the US. Our problem is that people have borrowed too much to escape "being priced out forever" when there's not enough justification for the values attached to property here.

All of the fallacies suggesting there is value are illusory. For instance, we are not "running out of land." Rather, there is still a great deal of vacant land in the GVRD. For example, all of the Guinness property in West Vancouver being artificially held off the market. And consider that huge property in Coquitlam (the old Riverfront psych hospital) which is going to be developed with 7500 homes. What's happened to the untouchable UEL? All of a sudden building opportunities exist that hadn't formerly because of changes in policy. There are many, many similar places in the GVRD that will likely be built on in the future.

Our lending problem arises from hype surrounding absence of land, 2010 olympics, quality of life etc. It's not the same problem as the US, but it is still a credit problem.

Nancy said...

new meat,

You are so right. We have a large family (4 kids which is large by today's standards) and need a larger house. We are in Victoria and the jump from what we have to somthing bigger is huge. Many times I have said to my husband - just borrow the money - its cheap. Luckily he has more sense than I do (ex investment banker). We could be very screwed.

scoop said...

freako, yes, I'd guess much the same problem here. Probably on average a greater housing debt burden, and a lesser problem with other spending. But a dollar owed is a dollar owed.

What struck me about this anecdote is that it doesn't illustrate a subprime lending problem so much as a complete failure to live within fairly substantial means. Lenders certainly bear some blame for contributing to the mess but I'm horrified at the financial decisions some people make.

freako said...

Lenders certainly bear some blame for contributing to the mess but I'm horrified at the financial decisions some people make.

It was a mass psychosis. Everybody was doing it and trying to keep up with the Joneses. I can't wait for those f*cking unrealistic flipper shows to get off the air. I don't have as big a beef with the home reno/beautification shows, but they have been grossly overdone too.

casual observer said...

If I see any more house flipping, house hunting, take this house and sell it, buy-RE-with-no-money-down-and-get-rich-quick TV programs come to air, I am going to barf!

I'd even take those old Tom Vu infomercials over the recent crop of RE programs. Take my seminar, you'll make melons!

Unknown said...

" It was a mass psychosis. Everybody was doing it and trying to keep up with the Joneses".

True, but we are also becoming more comfortable with the idea of debt. A generation ago, people tried to get free of debt and paying off the mortgage was an important milestone. Now, we expect permanent debt-servicing to be a part of our lives. Few seriously expect to pay off their mortgages.