The great unwind

Stefan-Michael Stalmann, an investment banking analyst at Dresdner Kleinwort, coined the term ”the great unwind” in a research note. In February of 2007 he wrote a report examining the relationships between the investment banking industry and the hedge fund community in which he warned of the risk posed by leveraged hedge funds should positions unwind.

”The great unwind” has now become part of everyday market terminology to refer to the implosion of a number of leveraged funds triggered by exposure to the subprime mortgage market in the US. The report, written five months before the collapse of two Bear Stearns hedge funds, contains a frighteningly accurate picture of how things may, and some would argue, have turned out.

Mr Stalmann answers your questions on the turmoil in subprime and credit markets and the correlation between hedge fund strategies and returns in a live online debate on Monday from 2pm BST.

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Could you explain in a nutshell, in the sense connected to the credit crisis, why would stock indices fall since many major companies are reporting better-than-expected financial results?
Georgi Penchev, Bulgaria

Stefan-Michael Stalmann: In my view, equity markets and credit markets are interlinked in a number of ways. Most importantly, if investors feel that the credit problems will spill over in the real economy (for instance if individuals and companies will have less access to bank credit as a result and will change their spending or investment plans), then this could adversely impact companies’ earnings in the future and therefore possibly equity valuations. There is arguably also a sentiment link between these two major capital market segments. Finally, there is a technical link, if you will: some investors (for instance some hedge funds) are employing strategies accross asset classes. There could be moments when these investors want to (or need to) reduce their overall leverage, and if credit-related assets turn out to be less liquid, they may decide to sell more liquid equities instead.

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How strong is the link between subprime mortgages and the buyout pool, and the sensitivity of one to the other?
Patrick Ng, Houston

Stefan-Michael Stalmann: I think there are a number of interesting links between both credit markets. Most significantly, most markets have seen a far-reaching separation between those who underwrite or originate a loan (i.e. the banks or mortgage companies), and those who hold the loan on their balance sheet and hope to recover it at maturity from the borrower. To some degree, this creates a moral hazard, because the originating banks may be tempted to loosen lending standards in order to earn a fee upfront, while the risk of delinquency is borne by someone else (e.g. an institutional investor, hedge funds or insurance companies). Clearly, the underlying credit quality appears to remain sound on LBO debt, while US sub-prime mortgages have already deteriorated a lot. Given the leverage involved in many LBO deals and the lack of contractual controls (covenants), I think the credit quality of LBO debt would suffer quite noticeably as well, if the macroeconomic environment would deteriorate.

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If statistical arbitrage funds had to liquidate their positions because of statistically unexpected divergences, surely these are only temporary phenomena? Stat arb usually doesn’t say when convergence will happen, it just predicts that it will happen with a calculable degree of probability. So surely stat arb funds will make back these losses in the near future, and this was just a giant margin call on many highly-leveraged stat arb positions?
Greg F, New York

Stefan-Michael Stalmann: There could very well be a good point in what you say here. The problem is that even though your trading positions may be perfectly rational in the medium or long-term, you may still go out of business if you become illiquid in the interim. This risk increases, the more leveraged your strategy is. An investor like LTCM in 1998 has fallen victim to exactly this “temporary” problem, I believe.

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Are the financing lines committed by banks to hedge funds and investment vehicles accounted for in the calculation of risk weighted capital? How likely is the mortgage market in Europe to experience a crisis as it is happening in US?
Marco, Sao Paulo

Stefan-Michael Stalmann: Yes, they are included in risk-weighted assets. Given that they are generally collateralised, the risk-weighting will tend to be quite favourable, relative to, let’s say, an unsecured corporate loan, though. As far as I am aware, only the UK has a market segment resembling US sub-prime mortgages. That is not to say that you won’t find overextended mortgage borrowers in other countries as well. It appears as if - besides the UK - countries like Spain and Ireland, where you have seen substantial house price appreciation as well (like in the US) could be most exposed. Then again, in countries like France, Italy or Germany, we have not seen either the same degree of house price appreciation and/or the general level of household indebtedness relative to income remains modest. In an nutshell, while there could be pockets of problems reminiscent of the US situation in some places, I would not expect it Europe-wide.

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Which one will react more to the credit collapse, the credit spread of a CDS or the corresponding defaultable bond? And what’s the reason behind this discrepancy?
Z Liu

Stefan-Michael Stalmann: I am afraid this is hard to generalise. What we have seen in recent weeks is that credit derivative contracts (in particular index derivatives) have seen larger price moves than cash assets, which arguably reflects the fact that many derivatives have been more liquid (ie easier to trade) than the cash assets. I would say that this does not have to be the case under all circumstances, though.

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What percentage of these hedge funds are comprised of everyday people’s 529 and retirement plans? Especially those retirement plans such as 403(b)s that are lightly regulated and managed by insurance companies?
Toni Hagan, Wichita, Kansas

Stefan-Michael Stalmann: I am afraid I am not close enough to the various savings plan structures in the US and their restrictions. In general, I think it is fair to say that in the US and many other countries, hedge fund investments have only been open to wealthy individual investors or institutions. So the average individual is unlikely to be directly affected by losses incurred by hedge funds. There could be some indirect exposure, via your insurance company or pension fund, if these have allocated some money to hedge funds. While institutions have been raising their allocations to hedge funds lately, I would think that the overall exposure remains very modest.

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Many pension funds have been including hedge funds as part of their asset allocation in order to get a higher return. Given the current great unwind, do you think it was a wise move on the part of pension funds to venture into hedge funds? Is there a future for hedge funds after this crisis?
Peter Koh, Rome

Stefan-Michael Stalmann: I do think there will be a future for hedge funds. While we seem to see an “unwind” in some corners of the market (e.g. in fixed income arbitrage, macro and quant strategies), many other funds seem to be fine or are actually making good returns. That said, part of the industry may have a public relations problem: if your selling proposition is to provide low-risk steady absolute returns (essentially implying capital protection), then all the current problems in the industry, with hedge funds closing or incurring losses, could be bad for business. I think some investors may start to reassess how much money they want to commit to hedge funds, and banks may reassess how much leverage they will provide to hedge funds going forward. All of this could mean that the hedge fund industry matures from red-hot to somewhere a bit cooler.

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Since, once again, the source of the current crisis is the toxic combination of risky debt and pliant ratings agencies emanating from the US, do you feel that after the current crisis has run its course and the initial flight to the safety of US treasuries abates, there will be a longer term aversion to US based securities on the part of international investors?
Alex Ezazi, Beverly Hills, California USA

Stefan-Michael Stalmann: I don’t think we will see longer-term aversion to US based securities per se. What I do believe firmly is that once things calm down again, you will find that certain products and certain investment strategies will be much less acceptable than during the last two years, and that things will return to a much healthier level of activity. For instance, I believe there will still be residential mortgage backed securities (and probably even subprime), but the loan underwriting process will become much stricter, and certain complex instruments (like CDS of ABS) may not be structured any more. I also believe there will still be LBOs and thus leveraged debt, but with a reduced level of leverage and with better covenant protection for lenders. This means a more robust system, but it should also mean somewhat less business for the banks involved.

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Who are the lenders to the hedge funds that are facing losses or liquidation? What is the magnitude of the loans to the losing hedge funds?
Stanley Waterman, Alberta Canada

Stefan-Michael Stalmann: Unfortunately, there is very little disclosure available on which banks provide how much funding to hedge funds. It is fair to assume, in my view, that all the top global investment banks have very active business relationships with hedge funds. In particular those global investment banks which are leading prime brokers (i.e. the key banks to a hedge fund) will tend to be very active providing their clients with funding requirements. We can take some comfort from the fact that banks generally provide only collateralised funding. So far, it seems as if banks have not been hurt by the problems of hedge fund clients. But we do see situations where banks like Bear Stearns or UBS have decided to essentially “help” their own hedge funds, e.g. by providing additional funding or by buying out third party investors. Even collateralised exposures to hedge funds can become vulnerable if market moves are extreme and/or the liquidity in the collateral assets dries up.

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I fail to understand why the Fed/ECB should step in and bail out the Wall Street sophisticators who dared to make these leveraged bets with other people’s money; should not these experts and their companies literally pay the price themselves, instead of being cushioned by the Fed? The prudent investor, who did not indulge in the casino atmosphere, ends up subsidising them, and indirectly gets penalised. Why not let the market forces, which are usually proscribed in any modern economic discussion, be allowed to play out without government intervention?
M. Namdar, Houston

Stefan-Michael Stalmann: I think you have a good point here. So far, it looks to me as if the central banks are quite willing to let investors lose money as a consequence of market developments. They have not bailed out hedge funds. But as soon as market problems threaten to seriously affect the banking system, central banks and regulators are facing a dilemma. They have to make sure that the banking system remains fully functional (for the sake of the economy as a whole), but at the same time, they have to (or should) make sure there are no moral hazards for the future. I don’t think there is an easy answer to how this can be achieved, and I think it is too early in this current situation to tell in which direction the balance of intervention (or the lack of it) will tilt.

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How do you believe homeowners and lenders will approach and pass through the interest rate reset in October? Mortgage rates on ARMs are scheduled to rise then. Will we just wait for it to happen and see what blows up, or can something be done in anticipation?
Mitch Weaver, Eastchester NY, US

Stefan-Michael Stalmann: In my view, the reset of mortgage interest rates in general is inevitable. But things can happen or can be done in the interim to alleviate the burden. For instance, the Fed may decide to lower interest rates towards year-end. Borrowers may also decide to tighten their belts in anticipation of a higher monthly mortgage bill, for instance by restricting consumption. While this should help the individual concerned, it would not be good news for the US economy at large. Banks and borrowers may also engage in a dialogue before the repricing happens, e.g. by restructuring the mortgage in question. Finally, borrowers who see a painful repricing coming may decide to sell their home and move downmarket. Again, this may look like an option for the individual involved, but it is obviously a difficult remedy for the market as a whole, as it would result in further price pressure on property prices.

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