Absolute return – but only when the market goes up

Hedge fund managers have always claimed that they possess investment skills that can produce absolute returns no matter how the market weather. Investors in hedge funds obviously believed in this when they were willing to be charged several percentage points of the returns as management fees. It is now almost one year after the Dow Jones saw its peak around 14,000 and it has seen fallen by a scaring 40%. Oil is also down more than 50% from its peak and many other commodities have performed even worse. Against the backdrop of global fire-sales of asset, the typical hedge funds seemed to have done not too poorly: it has lost 20% in a year. But it definitely hasn’t lived up to its promise of generating absolute returns.

Why have hedge funds fared so badly? Most of the fund managers point their fingers at the ban on short-selling of financial stocks in recent weeks. Being able to sell short is necessary for hedge funds to hedge away the risks in their portfolios. So when the government abruptly banned short-selling, it prompted a simultaneous fire-sales of suddenly non-hedgeable risky assets. This hurts everybody and particularly hedge funds which employ the “convertible arbitrage” style, the type of hedge fund that lost most, 42%, a year to now. However, although the ban can partly explain why this September was the worst month for hedge funds since statistical data is available, it cannot explain why hedge funds have been constantly losing money in each month since the credit crunch broke out last summer.

The sudden disappearance of cheap money is one obvious cause. Skeptics have long argued that the huge returns of hedge funds come from nothing but leveraging on mediocre returns. When credit stopped flowing and interest rates went up to the roof, hedge funds’ interest costs surged and they had to liquidate some of their positions when re-financing became impossible.

Another plausible suspect, who naturally has not been blamed by fund managers, is their own client. When hedge fund first became popular in the 1990s, most of their assets under management came from super-rich individuals and banks. These are mainly loyal investors who do not ask their money back when times are bad. But as hedge funds become more and more known to the public, the picture is now totally different. Among the $2 trillion assets under management, almost 40% of them came from funds-of-hedge-funds which are the first to leave in the prospect that something bad may happen. The past month alone has seen a worrisome withdrawal of $20 billion from the industry. Most hedge funds employ strategies that require them to stay in the positions long enough to make profits. They are thus indeed hit hard by their own clients.

If the markets bounce back, capital may as well once again flow back to hedge funds. It is thus hard to say the current credit crisis would lead to a debacle of the whole industry. But certainly, as the promise of absolute returns is not realized, their clients would make the business much less profitable by demanding a reduction in performance fees.

Regulation or Deregulation

Capitalism has never been so challenged since the Great Depression. And state interventions in markets now seem the only way out. Without the American and European governments buying stakes in banks and lending directly to corporates, the credit market would seemed to be clogged forever. And consequently much more businesses would go bankrupt and unemployment would soar and a depression would be certain. Alan Greenspan, the former Fed Chairman, has always claimed that deregulation is a main driver for the past two decades of fast growth in the U.S. How true it is we are not certain. But obviously, many of the root causes of the current crisis come from not regulating the financial system properly. The important question for the future is, how big a role should the government play in the market.

With the scale of the mess seen in past weeks, those in favor of more regulation is quickly gaining ground. It is true to certain extent that regulations can stop financial instutions from taking excessive risks, but they may also have unintended consequences which encourage risk taking. For example, the Basel Accord requires banks to put a portion of capital as reserves to cushion against bad times. This by all means seem an effective method as it restrains banks from putting all its capital at stake. However, what happened was that financial firms come up with innovations to move the risky assets off balance sheets and take advantage of it as far as possible. It is one reason why securitization of mortgages, collateralizated debt obligations and credit default swaps have become so popular in recent years.

So the correct question is not asking how much regulation we need, but how to regulate better. In terms of this, one principle stands out: transparency. The main reason why banks now are not lending to each is the opacity of banks' financial health. Counterpary risk is hard to estimate when toxic assets are held off balance sheets. Therefore, a reform of accouting rules requring disclosure of highly risky assets is necessary. But that is still not enough because these assets are often complexly strctured and hard to price fairly. As models that are accepted industry-wide can only be found in Alice's wonderland, a better and simpler solution is to restrain the exposure of banks to these opaque products.

Without doubt, the regulations can hurt banks' profitability, in short term. But it is now evident that excessive profitability in the short term often is the preclude to going bust in the near term.

Unprecedented bailouts in historic times

Governments in both the U.S. and Europe had failed to restore confidence in financial markets until today. Last week, in spite of the co-ordinated half-percentage-point rate cut by the central banks and various aggressive bail-out packages, the costs of overnight interbank borrowing broke record every day and stock markets around the world had slumped by more than 20 percent. The fire sales seemed never-ending.

After the G7 nations gathering last weekend, the governments in the industrialized nations at last found themselves determined to rescue the financial system. The Fed and the European Central Bank pledged to provide unlimited amount of liquidity, in dollars and in euros, respectively, to unclog the credit markets. The European governments in total came up with a bail-out package of more than $2 trillion. Britain will inject capital directly into its ailing banks and guarantee any new debt they issue. Other European countries are likely to follow suit. The Treasury of the U.S. had also started discussion about buying stakes in banks, in contrast to its strong disapproval of it in the past weeks. With all the efforts, the G7 officials announce that they will "use all means to prevent a systematic collapse of the global banking system."

Stockmarkets around the world soared on Monday after the news, with the Dow Jones making the biggest percentage-point gain since the Great Depression. Investors rush back as they see investment values in stocks after the fire-sales last week. However, it is too early to claim that confidence is back. Although the stock market has bounced back strongly, the spreads in the credit markets are still near record highs. Moreover, as housing prices in both continents are unlikely to hit bottom soon, mortgage-related losses will continue to stress the financial system. With thier unprecented moves, the governments may be able to avert a severe global depression. But a global recession is now without doubt.

Money Market still Frozen

The $700 billion mortgage-rescue plan was unexpected rejected by the House on Monday. The stockmarket then was immediately in panic. The Dow Jones industrial average slumped by more than 400 points in 10 minutes after the result of the vote was shown on TV screens, and eventually plunged by 778 points, its largest point drop ever.

The shock from the House prompted Henry Paulson, the treasury secretary, and Ben Bernanke, the chairman of the Fed, to make more concessions on the bail-out. These include capping executives' pay in rescued institutions and increasing the limit of the Federal Deposit Insurance from $100,000 to $250,000. With these changes and more effortful lobbying, the Senate passed the bill in the middle of the week and the House finally passed it on Friday. However, confidence did not seem to be restored. After the bail-out plan was approved, the DJIA first gave up its 200+ gains and finally ended down more than 150 points.

One big problem to worry about is the money market. In the wake of the collapse of so many financial institutions in such a short period of time, banks are now extremely reluctant to lend money to each other for more than an overnight in fear of counter-party risk. This pushes the spread of LIBOR over the Treasury rates to more than 4 percentage points. Even credityworthy institutions are now paying punitive rates to get their necessary funding.

After seeing collapses of financial institutions all over the continent, the European money market has become even more clogged than the American one. In usual times, banks and investors arrange foreign-exchange swaps to get their needed funds in dollars or euros. But the market is now completely dried up. To help dealing with the problem, the Federal Reserve provided a credit line of $620 billion to its counterpart, the European Central Bank, for lending dollars to European banks. At first glance, it may look like a back-door bailout. However, there is a big difference with respect to the collateral the banks need to put at the central bank. In the American bail-out plan, or the TARP, troubled mortgage-related assets would be accepted as colleteral. In contrast, the European Central Bank would only accept colleteral of much higher quality. Moreover, the Fed in fact is lending directly to the ECB and so there is no real credit risk.