Investment banks and hedge funds: The death sentence

Written by Free Enterprise / Jean d’Orival

Thursday, 16 April 2009 19:51

THE good thing in a revolution is that it destroys myths and removes polluting players. If there is something we have learned (or relearned) from the current global crisis, it is that liquidity and funding capabilities are major risks to be analyzed before making any investment decision. When I started in the capital markets back in 1984 , that is the first thing you were taught. However basic, these investment criteria have been largely forgotten or ignored by the investment banks and hedge funds. The investment-bank model is dead THE world was shocked when Bear Stearns collapsed in March 2008. Then came the Lehman Brothers bankruptcy (the largest in US history) that sent shockwaves and threatened the world financial system in September 2008. This was followed by the collapse of Merrill Lynch and the quasi-collapse of Morgan Stanley. The world suddenly (and sadly, too late) realized that these banks were built on fragile and shaky grounds. What did all these banks have in common? • A low capitalization (compared with the massive risks they were taking); • Highly leveraged balance sheets; • A small and undiversified deposit base; • A large exposure on illiquid products; • Large funding needs; and • An overreliance on money markets for funding. They were structuring huge and complex deals, forcing them—sometimes willingly—to hold large positions of papers like lower-rated mortgage-backed securities while waiting to find buyers. These positions needed, of course, to be financed. I advised my clients as early as July 2007 to stop buying papers issued by US investment banks. Then, in late summer 2008, the “fear factor” set in and the funding markets suddenly froze. The explosion of the (real or perceived) credit risk led all funding markets to stop functioning. The heart of the whole financial system— the money markets—came to a halt. The banks stopped lending to each other, preferring to park their funds in government securities—even sometimes at negative yields!—or just leaving them on their current accounts. This sparked a violent reaction and affected the whole financing chain, from the banks to the financial intermediaries, down to the consumer finance companies that led to a full-blown economic downturn. The universal banks with sizable investment-banking activities were also severely hit, but managed to survive due to their bigger capitalization and, most of all, to their large and diversified retail-deposit base (UBS, Deutsche Bank or HSBC, for example). The purely investment banks with huge funding needs and overly relying on money markets, collapsed like a castle of game cards (as we say in French). The investment-banking model is dead and, given the tsunami we experienced, will never recover in its existing form. The remaining “independent” investment banks understood that quickly and morphed into banks. Goldman Sachs and Morgan Stanley are now fully licensed banks allowing them, among other things, to access the retail-deposit market. Long live the universal banks! A ‘purified’ hedge-fund model can survive THE hedge-fund model as we know it, is dead unless it transforms itself. The lack of regulation and supervision has been identified as the major factor behind their failure by all the screaming heads of government. It is partly right and needs to be addressed. But it is only one of the faces of the hedge funds evil. What happened during the crisis? First, like the investment banks, a large number of hedge funds relied on borrowings to finance their strategies. In addition, many were highly leveraged. And, cherry on the pie, they were often financed by the investment banks themselves! Imagine the minefield…. More important, and that is the main reason the hedge- fund model as we know it has to die, they showed a complete disregard for their investors. Their behavior came down to a simple sentence: “Give me your money and I will steal from you right and left, top and bottom, and front, back and center!” What many investors didn’t know, ill-advised by their greedy private bankers, is that the investment agreements for hedge funds were full of tiny written clauses allowing the funds to change the rules of the game right in the middle of the investment! The hedge funds were very imaginative in finding new concepts like market- value reduction in case of “poor market conditions.” As a result, when things turned sour, they decided overnight to freeze the redemptions, to stagger the redemptions over many months or years, or to purely and simply postpone the redemptions ad vitam eternam until conditions get better! It basically means that even if you wanted to, you couldn’t get out of your investment. What happened to the beautiful promises of weekly or monthly liquidations? Disappeared…. To add insult to injury, in many instances, the subsequent exit strategies proposed to their clients was that the client had to decide today if they wanted to sell in three months’ time at a price fixed in three months on a value, of course, entirely at the discretion of the hedge fund itself, and therefore unverifiable! It was take it or leave it. So after having stolen from their clients a first time, they did it again a second time…. The hedge-fund industry can survive but will have to be strictly regulated, much more transparent and, above everything, respect their clients. Rules to force the funds to ensure their own liquidity must be established. More important, the hedge funds must be obliged to provide liquidity to their clients according to its initial and preannounced liquidation policy and without any force majeure clause. The fund of hedge funds (FoHF) model is dead and buried FUNDS of hedge funds were very popular strategies used, among others, to diversify the risks by using many different fund managers and many different fund strategies. The FoHF would, therefore, invest in many different hedge funds, which would smoothen and level the risks and performance of the FoHF itself. But instead of reducing the risks, it multiplied the risks. The liquidity issues seen above became exponential. FoHF managers suddenly had zero control over their own liquidity and therefore couldn’t ensure the liquidity of their clients. They were completely dependant (hostages) on the goodwill of each of the underlying funds. Imagine: instead of one fund restricting redemptions, you have to deal with 20 funds, each of them having different ways of “stealing” their investors! It is obviously unmanageable but nobody thought about it before the disaster occurred. Even with very strict rules, and given what happened, this model will never recover, simply because in situations of intense stress, it becomes impossible to manage. S imple piece of advice: Do not invest in investment banks (if there are any left), do not invest in funds of hedge funds and do not invest in hedge funds until clear and mandatory liquidity rules are established. I much prefer private-equity funds: at least you know in advance that you are in for the long term, that it is a risky investment and that it has no liquidity. Analyzing the liquidity of your portfolio is something that I’ll be glad to do for you! **** Jean d’Orival is the chairman of Dorias Advisors Inc. Free Enterprise is a rotating column of members of the Financial Executives Institute of the Philippines (Finex), appearing every Wednesday and Friday.