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Gerhard Illing (2008) Money: Theory and Practise Preliminary Draft --- Comments Welcome Chapter xx Liquidity What is Liquidity? Quotes from traders: Liquidity is trust; Illiquidity means: I don’t like the spread We have to distinguish between liquidity, money and credit. Liquidity is a fickle concept – it can have quite different meanings. Students usually appreciate liquid assets mainly in a pub or a bar. It is pretty easy to determine the fundamental value of this type of liquidity. It is much tougher to define liquid assets in finance. Let us consider different notions of liquidity The macroeconomic view of liquidity From the macroeconomic point of view, liquidity refers to a generally accepted medium of exchange or, in brief, money. Money is the most liquid asset due to the fact that it does not need to be converted into anything else in order to make purchases of real goods or other assets. This feature makes money valuable both in the micro and the macro perspectives. But again, we need to distinguish between different types of money. Central bank money: Monetary base. Economic Focus A fluid concept Economist Feb 8th 2007 http://www.economist.com/finance/displaystory.cfm?story_id=8669202 LIQUIDITY is everywhere. Depending on what you read, you may learn that the world's financial markets are awash with it, that there is a glut of it or even that there is a wall of it. But what exactly is it? Again depending on what you read, you may be told that “it is one of the most mentioned, but least understood, concepts in the financial market debate today” or that “there is rarely much clarity about what ‘buoyant liquidity’ actually means.” An economics textbook may bring you clarity—or confusion. It is likely to define liquidity as the ease with which assets can be converted into money. Fine: but that is scarcely the stuff of dramatic metaphors. Liquidity thus defined is surely to be welcomed; floods, gluts and walls of water surely not. The micro view of Liquidity: According to the microeconomic or finance view, liquidity is the ability to sell assets quickly and without cost (with no discount or time lag). According to this view, liquidity is provided by traders on financial markets. It depends on their ability to obtain funding. We need to distinguish between market liquidity (the ease with which assets are traded) and funding liquidity (the ease with which traders can obtain funding). The feedback mechanisms between these two types of liquidity can result in drastic reversals of liquidity provision, as experienced 2007/2008 with SIV’s, conduits and Auction rate bonds (see focus boxes). Following Brunnermeier/Pederson (2008) we will analyze this feedback mechanism closer in section xx. In order to get a better feeling, we first have to understand the role of banks in creating liquidity. Banks, Liquidity, Credit and Money Banks perform two functions which do not seem to fit together: (1) They provide liquidity via bank deposits and credit lines and at the same time (2) they also fund illiquid investment. (1) Banks provide liquidity: Bank deposits are highly liquid, because they can be converted into means of payment immediately (or are means of payment) and have a predictable nominal value - they can be redeemed at par at any time. Banks provide liquidity not just to depositors, but also to firms by guaranteeing credit lines (both to traditional firms and to the “shadow banking industry” such as hedge funds and special purpose vehicles): prearranged credit lines can be drawn whenever needed. The terms for credit lines, however, can be adjusted according to economic conditions. (2) Banks fund complex, illiquid positions, invested in long-term projects which are difficult to evaluate by outsiders. These two functions, liquidity provision and funding complex positions, seem to be incompatible. As liquidity provider, banks must come up with money on demand. At the same time, their investments are hard to liquidate, because they rely heavily on the bank’s specific knowledge. Excessive investments in illiquid positions make illiquid banks susceptible to inefficient costly bank runs. Need for regulation. It seems odd that these two functions are tied together. Narrow banking has been suggested as a solution: strictly separate both functions. 2 But Douglas Diamond and Raghu Rajan (2001) have shown that there are strong synergies between these two functions for the following reason. Bankers’ specialized skills enable them to manage complicated positions. Therefore, they might be tempted to extract high rents from their investors simply by refusing to payout part of the available funds. Issuing demand deposits which give a "hard" claim to depositors is a clever way for banks to commit not to extract these rents in the future. Demand deposits play a disciplinary role: The threat of a bank run, rendering the bank ineffectual and extinguish its rents, provides incentives not to misuse the specific skills. More generally, by providing liquidity, a bank also can commit itself to lower compensation for managing complex positions. This reduces the bank’s cost of financing those positions. In contrast, industrial firms do not finance themselves with demandable deposits. Financial innovation, however, at first sight seems to have reduced the scope for traditional banking. In the United States, commercial banks’ share of total financial institution assets has fallen dramatically, from more than 70% around 1900 to just 30% in 2000. Bank share of corporate debt in the United States has declined from 19.6 % in 1979 to 14.5 % in 1994 to xx% in 2005. Competition on both sides of the banks’ balance sheet has increased. On the asset side, commercial paper and junk bond markets give large firms an alternative to borrowing from banks. On the liability side, rather than being forced to deposit at the local bank branch or make payments through a bank checking account, customers are able to use mutual funds that offer similar services. Traditional banks loose business to the (unregulated) shadow banking sector. However, if one looks closer, banks continue to provide their traditional functions, albeit through non-traditional products. Judging from the dramatic increase in volume of commercial paper issuances relative to bank commercial loans one might conclude that the role of banks in providing liquidity to borrowers is declining. But this would be the wrong conclusion. In fact, instead of providing liquidity directly to a large firm, a bank provides a backup line of credit that can be drawn down in case the firm’s commercial paper cannot be refinanced. It seems to be more effective for the bank to provide such contingent guarantees than to directly fund the firm’s liquidity needs: With contingent guarantees, the same unit of liquid reserves can back the needs of multiple firms - as long as, in line with the law of large numbers, aggregate liquidity does not fluctuate too much. By contrast, with direct funding, a unit of liquid reserve is fully locked up in meeting the liquidity needs of a single firm. As long as banks exerted their traditional roles of borrowing short and lending long, the trends in the banks' liabilities gave a reliable picture of liquidity creation. Since banks have begun to 3 use their balance sheets more cleverly, these old measures — such as the relative size of bank assets — does no longer provide the correct information. Financial innovations challenge traditional liquidity concepts and may lead to dangerous conclusions. So some regulators have praised hedge funds and other financial intermediaries in the ”shadow banking sector” for creating liquidity. But these institutions rely heavily on liquidity provision by traditional banks (credit lines). For that reason, it is crucial to get reliable information about the exposure of the banking sector to shadow banking. Many banks have been actively engaged in creating so called “structured investment vehicles” (known as SPV’s) and conduits in the shadow banking sector, trying to get around capital adequacy requirements for holding illiquid assets. The problem is that liquidity creation in the shadow banking sector works perfectly fine in good times (when volatility is low), but liquidity can suddenly dry out in bad times, exactly in those times when it is most urgently needed. Mark Twain had a colourful joke about the banking sector: A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. -- Mark Twain (1835-1910) This joke gives an even better characterisation of the modern shadow banking sector. In what sense do hedge funds provide/create liquidity? To a large extent, they use borrowed money. Their capital base comes from "real money" investors, such as insurance companies and high net worth individuals. The borrowed money comes from banks. Banks lend money to hedge funds accepting the assets of the hedge funds as collateral. The perceived quality of these assets determines how much money they are willing to lend. If the quality decreases, margin calls are rising; the banks lend less, so the liquidity in the system decreases. Ironically, the assets that the hedge funds buy are in many cases exactly those assets that have been securitised by the banks in the first place. So one may wonder what the difference is between a bank holding assets on its balance sheet; and a bank selling assets to a hedge fund, and then lending money to that same hedge fund to hold those same assets. 'Capital is not synonymous with liquidity' Christopher Cox, Chairman, SEC, commenting on the fall of Bear Stern, an investment bank founded in 1923 and taken over in a Fed-led rescue operation by JP Morgan on Sunday March 16 2008. Whenever the perceived quality of these assets deteriorates, liquidity dries out: Leveraged firms are forced to sell part of their assets; this drives down the price of the assets, 4 deteriorating the quality even further, forcing to liquidate even more assets. A fire sale is triggered. In the extreme, if no-one wants to bid for them, there may even no longer be a quoted market price for these assets. As soon as the pre-arranged credit lines can be withdrawn, banks call their money back, no longer willing to accept these assets as collateral; but hedge funds cannot sell them, because they are offered-only. This is the modern equivalent of a bank run; ultimately it leads to a liquidity crunch. Focus Box: Structured investment vehicles (SIVs) and Conduits How financial innovation (liquidity created in the shadow banking sector) can turn sour Structured investment vehicles (SIVs) issue short-term notes to invest in longer-term securities with higher yields. They are often organized by banks but are not actually owned or held by them – in contrast to conduits which have a similar structure but are legally owned by banks. This new type of investment fund has been invented in the late 1980s by Nicholas Sossidis and Stephen Partridge-Hicks, two London bankers. They left Citigroup Inc. 1993 to set up their own company. The funds boomed because they allowed banks to reap profits from investments in newfangled securities, without setting aside capital to mitigate the risk. The advantage of SIV’s compared to conduits was that banks were not legally required to cover fully the fund's debts if the commercial-paper market dried up. SIV’s can also use leverage. Most of the SIVs (worldwide, there have been just the few dozen) typically are registered in offshore havens such as the Cayman Islands, but managed out of London. Both SIV’s and conduits issue short-term commercial paper to investors. They use the money to invest in higher-yielding long-term assets, typically pools of mortgage-backed securities and credit card debt. Of course, the short term paper has to be refinanced on a regular base. For a long time, this was profitable business. Outside the shadow banking sector, hardly anybody was aware of this innovation. In summer 2007, however, SIV-positive became a term spreading all over the world. Suddenly, investors stopped buying SIV-affiliated commercial paper, as the loss of confidence in the quality of subprime mortgage bonds tainted these securities, too. In late July, first a bank affiliate set up by German bank IKB Deutsche Industriebank ran into trouble. It had relied on extremely short-term financing in the commercial-paper market to finance investments in risky securities backed by subprime loans. A month later, Cheyne Finance, a $6.6 billion SIV operated by a London hedge fund, began liquidating assets to repay debts. There was the risk that all SIV’s would simultaneously unload billions of dollars of mortgage-related assets. That would have put intense pressure on prices. Wall Street firms and hedge funds faced potentially huge hits to their profits, since they mark the value of similar investments they hold according to the market value. But the impact on the biggest banks was even more severe. In times of crisis, they were committed — either legally (for conduits) or to maintain their reputations (for SIV’s) — to stepping in to buy these securities. Since August 2007, banks had been buying significant amounts of commercial paper, even though they did not have to. Being forced to bring those assets onto their balance sheets, they were less willing to lend to businesses and consumers. That could trigger off a credit crunch driving the economy into a recession. 5 Focus: Why does market liquidity dry out in times of crisis? procyclical nature Illustration: liquidity freeze on the Auction rate bonds The auction rate market was invented in 1984 by an investment banker at Lehman Brothers, Ronald Gallatin. The idea was to issue long-term securities that could pay their buyers interest rates only a little above short-term rates. To achieve that, interest rates on these longterm bonds are reset at periodic auctions held every 7, 28 or 35 days. As long as the auctions succeeded (as long as there were willing bidders for the securities), any holder could sell the security at face value whenever there was an auction. If, however, an auction failed, the interest rate would rise to a preset penalty level. No issuer with decent credit would like to pay the penalty rate for long; it would rather redeem the bonds. So long as the auctions worked, the only risk to buyers was that an issuer’s credit would go bad and the buyer would be stuck with the bonds. Banks and shadow banks (like investment banks and hedge funds) made sure that these investments are liquid despite the fact that the underlying bonds were long term bonds. The bonds have been issued by municipalities, student-loan providers, schools and other institutions. Investment banks as original underwriter supported the liquidity by acting as market maker (buying and trying to sell whenever other participants did not bid sufficiently). In February 2008, however, these banks refused to commit capital to the auction-rate market, even though auction-rate securities represent loans to borrowers that by any standard usually are deemed good credits. Many issuers of auction-rate securities have seen their interest costs soar after auctions for some of their debt failed. Traditional buyers of auction-rate paper are risk-averse investors parking short-term money. Money-market funds usually are major participants in the variable-rate demand notes market. Many such funds have 70% or more of their assets invested in those securities. But beginning of 2008, their interest was waning because of fears that ratings of these securities may be cut with bond insurers being on the verge of bankruptcy. Most of the bonds have been guaranteed by municipal bond insurers. Since insurance business has been pretty boring, these big insurers moved into a more dynamic market with higher profit opportunities: insuring subprime loans. When that market turned sour, solvency of the muni bond insurer came into doubt. Brunnermeier/Pederson (2008) Trading requires funds. When a trader - e.g. a dealer, hedge fund, or investment bank - buys a security, he can use the security as collateral and borrow against it, but he cannot borrow the entire price. The difference between the security's price and collateral value, denoted as the margin, must be financed with the trader's own capital. Similarly, short selling requires capital in the form of a margin; it does not free up capital. Therefore, the total margin on all positions cannot exceed a trader's capital at any time. Full Picture: needs to take into account leverage and banks equity! 6 Pro-cyclical leverage (due to counter-cyclical nature of value at risk) (Adrian/Shin) In modern 21st-century economies, financial intermediaries other than banks play also a decisive role in providing liquidity. Adrian/Shin (2008) emphasise the importance of balance sheets of leveraged financial intermediaries for understanding liquidity. They suggest a new definition of liquidity as a superior measure of liquidity in a market-based financial system: the growth rate of financial intermediaries’ balance sheets. They show that there is a strong correlation between balance sheet growth and the easing and tightening of monetary policy. more precisely: the rate of growth of repos (outstanding repurchase agreements), since repos and other forms of collateralized short-term borrowing are the tool that financial institutions use to adjust their leverage, that is their balance sheets. V the value at risk per dollar of assets held by a bank. The total value at risk of the bank is given by V×A where A is total assets. Then, if the bank maintains capital E to meet total value at risk, we have E= V×A. Hence, leverage L satisfies L = A/E = 1/V Active Balance Sheet Management! Leverage of commercial banks is typically around 10-12 E /A=0.08 ~ 0.10 Leverage of investment banks is typically around 20-25. Adrian/Shin (2008) Procyclical liquidity Spreads: give a market price for different degrees of liquidity. Liquidity premium (the willingness to accept a lower yield in return for a more liquid asset). Problem: Liquidity premium varies across time and across different types of assets; in quite unpredictable ways (changing with “risk appetite” of investors ~ volatility index). Sudden jumps in the spread. Cyclical component. Flight to quality. Liquidity holes. Lack of trust in counterparties. Systemic Risk Risk of the breakdown of the financial system. Financial meltdown. Crucial for smooth functioning of the economy: trust 7 Ashanti Goldfields - How a rising gold price nearly drove a gold mine into bankruptcy 25% of the world's gold production takes place in sub-Saharan Africa. Ashanti Goldfields, the Ghanabased company, owns some of the most productive gold mines in Africa—in 1999, it was worth altogether over $2 billion at current prices. After privatisation, it was a publicly traded company, but the government of Ghana retained a "golden" or controlling share in Ashanti of 20 %. For several years, the price of gold had declined steadily. In a surprise move, in September 1999 suddenly the "Group of 15 Central Banks" announced that they agreed to limit their sales of gold into the market. This announcement immediately reversed the price movement. Within 11 trading days, the gold price went up by 27%, rising from US$ 255$ to US$ 325. You would think that the share price of the company should soar after this unexpected happy event. But quite the contrary, just the opposite happened: Ashanti Goldfields, having been heavily engaged in hedging activities, betting on a further price decline, suddenly run into serious liquidity problems, on the verge of bankruptcy. As a result of its hedging activities, it found itself burdened with liabilities as much as $570 million. Potential buyers queued in the hope to purchase gold mines from the government at rock-bottom prices, expecting a good bargain. How could that happen? What went wrong? Ashanti Goldfields is a perfect example to illustrate the problems posed by illiquidity. Faced with the continuous decline of the gold price for a long time, the management of the company had decided to hedge against this trend. The Company's hedging activities was based on the expectation that gold prices would continue their steady decline. The sudden reversal in the trend of gold prices turned Ashanti's hedge activities into a dangerous liability. The mark-to-market valuation of the hedge book turned from being positive to the enormous negative amount of US$ 570 million. This represented an effective increase in the credit exposure of the hedge counterparties to the Company. They were entitled to call for margin which the Company could not meet. Even though the long-term profitability of the company was not in question, its short-term liquidity crisis made it vulnerable to takeover bids. The company has later been accused that its “hedge” book did not protect against fluctuations in the price of gold but rather was a dangerous “reckless” bet that the price of gold would fall, in an attempt 8 to generate revenue for Ashanti. Obviously, the company had sold call options on the price of gold; it was short in call options. How does that strategy work? What other hedging options would have been available? We have to go into some details of hedging to understand what was going on. The underlying risk of a gold mine is the uncertainty about the price of gold in the future. If the gold price rises, the value of the company will increase proportional, but the other way round if the price falls. So without insurance, the value of the company fluctuates proportionally with the gold price. Financial innovation offers plenty of wonderful new instruments to insure against these risky outcomes. Insurance is more costly the higher the volatility. Let us do a simple example. Assume Ashanti owns a gold mine with nuggets of 8 million ounces of gold. But for technical reasons, it will take 5 years to dig out these nuggets. Neglecting interest rates, in 5 years time the company will be worth $2 billion if the gold price P stays at 250$. If the price goes up, the value rises proportionally. The other way round if the price falls. Thus, without hedging, the value of the firm changes proportionally with the gold price as shown with the red line V=8 P (million $) in figure xx. When the average price of gold in 5 years is 250$, the expected value of the firm is $2 billion. Prices, however, fluctuate a lot, so the true value in 5 years is highly volatile. One way to eliminate this risk is to sell the stock forward already today at the future market buying a contract with the price in 5 years fixed at 250$. This forward contract can be split in two parts. It is equivalent to selling gold in 5 years at the market price and at the same time arranging insurance with a counterparty paying the difference between the fixed price 250$ and the market price. This perfect hedge via future markets eliminates all risks as long as contracts are honoured. No need to worry even if the price would fall down to 0: the counterparty has promised you to compensate for the difference. The other party’s implicit insurance payment as part is I= 2000 – 8 P (captured by the green line). Of course, if the gold price rises above 250$, the counterparty will make a lot of profit which you cannot capture anymore – but that is the nature of insurance contracts. As long as the counterparty sticks to its commitment when the price falls and as long as you don’t renege on the contract when the price rises, the insurance contract just works fine. A natural hedging partner for the goldmine would be a company using gold as input for its own production – say a goldsmith or a dentist. They thrive when gold prices are low and can easily pay compensation to the goldmine; when prices soar, they might run into troubles and are happy to get 9 insured against that outcome by the goldmine. Mutual insurance is valuable for both parties. Usually, insurance is done via companies pooling different types of risks. As goldmine, you may not like the idea that you won’t profit from the upside potential: Wouldn’t it be better to keep the gold mine when prices are rising? So why not just insure against the downside risk – the risk that prices fall. Options are the perfect way to do just that: As a holder of an option (we say you are on the long side), you have the right, but not the obligation to enforce the contract. Here: Explain briefly put and call options A put option gives the holder the right (but not the obligation) to sell at some fixed price – the so called strike price. So rather than buying the forward contract sketched with the green line in figure xx (forcing you to sell at the agreed price even if P> 250$), we might just buy the option to sell whenever the price in five years is below some strike price which, to make tings easy, we set at 250$. This hedge against downside risk seems to be just what Ashanti needed. The drawback of this option, however, is that hedging can be quite costly: In contrast to the contract on the futures market sketched above, the issuer of the option will never profit from the upside potential. So he has to be compensated for taking the downside risk by getting paid the option 10 premium OP. The green line in figure xx gives the net payment of the option (the effective insurance after deducting the option premium) for the holder as a function of the gold price. Whenever P is above the strike price, no holder would be crazy enough to exercise the option. But you had to pay the premium OP, reducing your profit by OP. You exercise the option as soon as the price is below the strike price. Such a put option would have allowed Ashanti the flat payoff of 250-OP (represented by the red line) whenever the gold price falls below 250. At the same time, Ashanti would have benefited in case the price rises above 250$, except that your net profit is reduced by the premium OP. It seems that Ashanti considered the option premium for buying the put option as too expensive. Feeling that prices are more likely to go down (so you may hardly profit from the potential upside), you may be better off by issuing a call option instead. A call option gives the holder the right to buy the good at the strike price. Of course, he will exercise his option only if the price is above the strike price. Since you are now on the other side of the market – you are short on a call option – you agreed to sell the good at the strike price whenever the holder wants to buy. So now you insure your counterpart against prices rising (with, possibly, the risk of unlimited losses). As compensation for issuing this risky option, you initially earn a sure payment – the option premium. Expecting a falling gold price, Ashanti chose to hedge its mines by issuing (being short of) a call option. This allowed the company to cash in the nice revenue OP (even in case gold would drop to zero). At the same time, however, it implied that it had to deliver the ounces of gold at the strike price of $250 even if the price of gold shoots up. When Mr. Margin is Calling Issuers of options run the risk of unlimited losses (as characterised by the falling green line in figure xx-x; see also figure xx-x a). Many intermediaries use to short sell without holding the commodity (or assets) they promised to deliver. When prices shoot up, they are likely to default and exit. So the holder of the option may get a little nervous, being not sure whether the counterparty will really be able to deliver on its promises. For that reason, issuers of options have to fulfil margin calls immediately whenever the price moves: You have to put some cash (the margin) on the table as proof (collateral) that you are able to fulfil your obligations. Margin calls increase with higher volatility. When Mr. Margin is calling, liquidity constrained traders may really run into serious trouble. That was exactly what happened to Ashanti: The counterparties called the company and asked it to put cash on the table. But all what Ashanti could offer was gold in the pit which could not be turned 11 into cash immediately; Ashanti lacked the liquidity to fulfil its margin calls. Margin calls are an enforcement mechanism to proof that the counterparty is able to meet its obligations. Short sellers betting on a falling price may be forced to buy the good at astronomically high prices and so become bankrupt. Now you may ask: This certainly makes a lot of sense for those financial intermediaries not owning the goods they have to hand in to the holder of the option. But it seems a bit odd to fear that a mining company will not be able to deliver. With gold prices rising, there should have been no question about Ashanti’s long-term solvency – so why did counterparties get worried and raise margin calls? After all, there was really just pure liquidity risk. Why would option holders not safely wait till the gold was taken out of the mine and sold on the market? Perhaps the counterparties had doubts about the political risk the government of Ghana would renege on its contracts, possibly socialising the gold mines. Perhaps they did not trust geological evidence. Well, maybe the counterparties just wanted to use the liquidity crisis to take over the company at fire sale prices. The Search for Solutions The Ashanti Board tried hard to find a solution to the lack of liquidity caused by the right of the hedge counterparties to call for margin. This proved to be quite a challenge since it involved dealing with 17 hedge counterparties, each with different positions and exposures to Ashanti, and each with different vested interests in the variety of options being pursued. The Ashanti Board sought to secure Government guarantees for the hedge book backed by a major Central Bank and explored World Bank/IFC assistance in the form of a supranational guarantee. It even sought quotes for political risk insurance to enable the hedge banks to grant margin-free trading. It further sought to secure additional funding from Ashanti's senior lending banks, from "white knights" and a variety of other investor sources. None of these options could provide a solution acceptable to all parties in the time available to resolve the crisis. One option the Company considered was raising funds by the sale of assets. Due to restrictions in Ashanti's corporate loan covenants, the only candidate for sale was a mine owned in Tanzania. However, the disposal of an interest in this mine at that time would have involved the sale of associated hedge contracts. This would have eroded the net cash proceeds receivable given the heavy negative mark-to-market exposure. The net cash proceeds to the Company would have been approximately a quarter of the value of the offers. It quickly emerged that the sale of assets to solve the hedge crisis was not the optimal solution. In the end, following numerous discussions with its hedge counterparties, the Board finally succeeded to arrange margin-free margin free trading with its counterparties until 31 December 2002 and get increased margin thresholds until 31 December 2004. In 2004, the company merged with the South African mine AngloGold to create the world's second-largest gold producer, AngloGold Ashanti company. 12 Hedge Funds Other hedging companies have been less lucky. In 1998, the hedge fund LTCM was nearly bankrupt and got rescued in a dramatic operation organised by the Fed New York, In 2008, the investment bank Bear Sterns was the first investment bank to get wiped out, not able to answer calls from Mr. Margin. The hedge fund LTCM: How arbitrage goes wrong when liquidity dries out Hedge funds are private investment pools, funded by a small number of wealthy investors. As unregulated private investment pools, hedge funds can adopt unconventional investment strategies such as short selling, leveraged positions, program trading, swaps, arbitrage, and derivatives trading. They take both long and short positions, use arbitrage, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. There are different types of hedge funds. Macro hedge funds attempt to identify dislocations in asset prices using macroeconomic principles and so make leveraged bets on price movements in equity, currency, interest rate, and commodity markets. Relative value funds make bets on the relative prices of closely related securities (e. g. treasury bills and bonds). They try to identify arbitrage possibilities by buying undervalued securities and at the same time selling overvalued securities with nearly identical risks. Being long in undervalued and short in overvalued securities allows them to profit from subtle differences. This arbitrage activity should, in principal, reduce volatility and risk on financial markets. For a long time, Long-Term Capital Management (LTCM) was the most successful relative value fund, earning returns of more than 40% per year. LTCM engaged in convergence trades, betting on the fact that when certain markets go out of sync with each other they eventually will return to what is considered equilibrium. One of their first trades used the fact that newly issued 30 year US treasury bonds, traded on a perfectly liquid market, earn lower returns than slightly older US treasury bonds with nearly the same maturity - those issued half a year earlier with a maturity of 29 ½ years. Because most of the older bonds are no longer traded but kept by long term investors, they are called “off the run.” Being less liquid, they are traded only with a premium (they are cheaper) relative to newly issued bonds (those “on the run”), despite nearly identical default risk. LTCM spotted handsome arbitrage profits by betting on this spread: Being long in “off the run” and short in “on the run” bonds allowed the hedge fund to capture the difference as soon as their returns converged. In theory, this is a nearly perfect hedge, a low risk strategy. But for exactly that reason, arbitrage profits are fairly small (the spreads are not really juicy). In order to get attractive returns, the fund used heavy leverage. The more successful the fund became, the more confident it got, extending hedging strategies to much more complex markets, such as betting against yield differences among different countries. One of these strategies in 1998 was to bet on the convergence of yields of Italian and German bonds with similar maturity. At that time, before the start of the Euro, it was still unclear 13 whether the Italian lira would be able to join the Euro area. One of the entry conditions was the convergence of long term government bonds. No wonder that Banca d Italia, the central bank of Italy, was actively involved in that hedging strategy. In summer 1998, LTCM run into trouble when the Russian government unexpectedly declared a debt moratorium, defaulting on its local Ruble bonds. Suddenly, investors realised that emerging market debt was not as safe as expected. Driven by panic, investors fled into safe US treasuries - running not just out of emerging markets, but out of all riskier assets such as Italian bonds. Long term US bonds rallied, whereas riskier debt plunged, so spreads were soaring. At that time, LTCM was long in Russian Bonds and short in U.S. Bonds. The LTCM group thought it had cleverly spotted a market anomaly. Betting on world wide convergence of yields, it tried to arbitrage these and similar spreads. But now the market turned against their model. LTCM began to run up huge losses. These losses were exacerbated by LTCM's choice of financial instrument, which necessitated that they make daily "margin calls". The default of Russia had made Russian bonds worthless, creating huge margin calls. At the same time, the short positions by LTCM on US, UK and German bonds caused further losses to them. LTCM traders claim that some US investment banks, being aware of positions in their hedge book, even followed a front-running strategy: they acted as big buyers of US bonds, a profitable strategy when you know that LTCM will be forced to unwind its short positions. As prices fell LTCM was forced to liquidate other assets in order to raise money for such margin calls. Their capital base, already very small compared to the level of their exposures, was being substantially reduced. They were rapidly reaching a position where they would no longer be able to meet their "margin calls" and hence risked becoming insolvent. The Federal Reserve Bank of New York (FRBNY) judged that the potential fall out from the forced liquidation of LTCM was so significant that it was to the advantage of all parties "... to engender ... an orderly resolution rather than let the firm go into disorderly ... liquidation." On September 23rd, it forced 14 major Wall Street banks (involved as LTCMS’s counterparties) to inject $3.5 billion needed to meet LTCM’s margin call, so as to stay in its portfolio. Only Bear Sterns, the investment bank which was clearing agent of LTCM with little exposure itself, refused to contribute to the rescue operation. At the beginning of 1998, LTCM had equity of $4.72 billion. After heavy losses in the first half of 1998, at the end of August equity was down to $2.2 billion. With this as a base, the firm had borrowed over $124.5 billion with assets of around $129 billion. They used these assets to build up off-balance sheet derivative positions with a notional value of approximately $1.25 trillion. Most of these were in interest rate swaps, but they also invested in equity options. High leverage can create big profits: A mere 5% profit in its operation would have doubled its original equity. But leverage works both ways. When investments go sour, modest equity is easily impaired, even wiped out. LTCM management claimed that their trading strategies were basically sound (after all, two of their adviser, the finance professors Robert Merton and Myron Scholes, won the Nobel Prize in 1997). Temporary market anomalies just created short run liquidity problems. Being forced into fire sales the 14 anomaly was aggravated, simply delaying the convergence predicted by sound models. Frequently it is argued that those Wall Street banks which have been forced into the rescue operation made a handsome profit later out of their investment. But according to Roger Lowenstein, that is not the case. Lowenstein wrote a fascinating account of the personalities and academic expertise behind the failure of the hedge fund in his bestseller “When Genius Failed. The Rise and Fall of Long Term Capital Management.” New York, Random House 2000. His book ends as follows: On September 28 1999, exactly a year after the bailout, swap spreads remained at 93 points and equity volatility was at 30% - each far higher than when Long-Term had entered the respective trade. In the first year after the bailout, the fund earned 10 percent – hardly a dramatic recovery. Then, in addition to this modest profit, the fund redeemed the consortium’s $ 3.65 billion in capital. For practical purposes, the fund had liquidated by early 2000. Driven by the fear that competitors can easily mimic their ingenious trading strategy, arbitrage the spread away and so eliminate profits, the hedge fund LTCM was a role model for secrecy. The managers have been very careful in using different counterparties for off-setting trades so as to prevent competitors from detecting and copying their sophisticated hedging strategies. This opaqueness allowed them to capture monopoly rents. In some sense, arbitrage hedge funds provide a public good: they do the job the Walrasian auctioneer is supposed to do. They seem to make illiquid market more liquid. In normal times, this volatility is indeed reduced by their activity. But it is a fallacy that they create liquidity. When things go wrong, liquidity dries out completely. Reason: Arbitrage is based on markets being liquid ~ leveraged hedge funds rely on market liquidity being available to perform arbitrage; they don’t provide liquidity themselves. Quite in contrast, when liquidity dries up, things can get much worse. Inherent in-transparency: Shleifer Vishny model Reading: Daníelsson (J.), Taylor (A.), and Zigrand (J.-P.) (2006) “Highwaymen or heroes: Should hedge funds be regulated?”, Journal of Financial Stability, 1:4:522– 545, www.riskresearch.org Brunnermeier Markus K. and Lasse Heje Pedersen (2007), Market Liquidity and Funding Liquidity Princeton University Shleifer, Andrei and Robert Vishny (1997), The Limits of Arbitrage, Journal of Finance 52, 35-55 Cao/Illing Endogenous Systemic Liquidity Risk http://www.sfm.vwl.uni-muenchen.de/aktuelles/news/end_sys_liqu_risk.html 15