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Bubble Talk Presentation for VBA May 2008 Wouter ten Brinke, CFA Agenda • Introduction Theta Capital Management • Financial alchemy: growth of the non-bank banking system • Deflating the credit bubble: the cycle in reverse • Long/short investing: how to benefit from upcoming opportunities Page 2 Theta Capital Management Independent Hedge Fund Boutique • Founded in January 2001 • Management of multi-hedge fund portfolios • EUR 950m AuM in customized mandates & funds of funds • EUR 600m in Medium Volatility strategy • EUR 200m in Low Volatility strategy • EUR 150m in Deep Value strategy • Staff of 8 investment professionals and 4 support • Research-driven investment process • Advisory board of hedge fund experts Page 3 Theta Capital Management Products Performance statistics since inception Product Return p.a. Vol Sharpe ratio Inception Theta Multistar Medium Volatility 10.34% 5.81% 1.29 Feb-04 6.10% 2.67% 1.23 Jan-04 VP Theta Hedge Funds Strategy 10.15% 5.11% 1.43 Jul-05 Vermeer Mid Volatility 10.88% 5.49% 1.47 Mar-03 Vermeer Low Volatility 6.29% 2.33% 1.49 Mar-03 11.33% 5.34% 1.59 Sep-01 7.10% 3.10% 1.38 May-05 31.55% 8.96% 3.21 Jul-06 Theta Multistar Low Volatility Theta Client Portfolios * Theta Master Fund ** Theta Deep Value Fund * C omposite of Theta managed accounts ** Underlying fund for Theta Structured Products Page 4 Agenda • Introduction Theta Capital Management • Financial alchemy: growth of the non-bank banking system • Deflating the credit bubble: the cycle in reverse • Long/short investing: how to benefit from upcoming opportunities Page 5 Financial alchemy Bank Balance Sheet AAA AA Loans Deposits Equity Source: Theta Page 6 12 X leverage Financial alchemy CDO Balance Sheet AAA AA Bonds / CDS A BBB Equity Source: Theta Page 7 Financial alchemy MBS Balance Sheet AAA AA Mortgages A BBB BBB- Equity Source: Theta Page 8 Financial alchemy CDO of ABS Balance Sheet AAA AA ABS / MBS / CDOs A BBB BBBEquity Source: Theta Page 9 Financial alchemy Monoline insurer Balance Sheet AAA AA Financial guarantees A BBB BBBEquity Source: Theta Page 10 94 X leverage ! Financial alchemy The result: a shadow banking system • CDO’s turned low quality assets into combination of high and low rated assets • CDO’s provided additional capital to weak lenders, adding leverage to the system • CDO’s segregated risk takers from risk assessors (leveraged & engineered pools of credit replaced old-fashioned credit analysis) • All these vehicles are effectively non-regulated banks, not required to hold reserves, except as negotiated with the rating agencies • Agents had similar incentives: banks, rating agencies, CDO managers Page 11 Inflating the credit bubble Leverage in US defies the long-term trend (10% of GDP) Page 12 Inflating the credit bubble Freely available credit • Low interest rates • Relaxed lending standards • Financial “innovation” • CDO demand More leverage / More buyers: Decreasing default rates Increasing asset values Page 13 Source: Theta • LBO Hedge funds • CDO Other investors Inflating the credit bubble Traditional finance: Rapid acceleration of debt for productive use Speculative finance: Companies pay back only interest Minsky Moment: Companies borrow more to pay back interest Lenders become cautious Debt structures are no longer accepted Profitable companies take on more debt Companies pay back interest & principal at maturity Ponzi finance: Most debt is used to roll over existing debt Relaxed lending standards: “Worst loans are made in the best times” High-profile entity has to liquidate assets Crucial element: it is the new liquidity that supports the asset values and keep existing investors happy Page 14 Source: Theta Inflating the credit bubble Financial Instability Hypothesis (Hyman Minsky, 1982) • Financial structure becomes more fragile over periods of prosperity • We fall in love with innovations (with no history, by definition) • In prosperity, we are gradually testing the limits of the market, but the adjustment and revaluation can be sudden and violent 2000 Page 15 2007 Agenda • Introduction Theta Capital Management • Financial alchemy: growth of the non-bank banking system • Deflating the credit bubble: the cycle in reverse • Long/short investing: how to benefit from upcoming opportunities Page 16 Deflating the credit bubble: cycle in reverse Catalyst: unexpected defaults Reduced availability credit • Higher interest rates • Tigther lending standards • Stop to financial “innovation” • CDO demand halts Less leverage / less buyers: • LBO Hedge funds • CDO Other investors Decreasing asset values Page 17 Rising default rates, lower recovery Deflating the credit bubble: mortgage credit Long-term investment theme: US Housing market Page 18 Deflating the credit bubble: mortgage credit Long-term investment theme: US Housing market Page 19 Deflating the credit bubble: mortgage credit Long-term investment theme: US Housing market S&P Case-Shiller US Home Price Index 20% Home Price Appreciation (HPA) YoY 15% 10% 5% 0% -5% -10% Page 20 Mar-06 Mar-04 Mar-02 Mar-00 Mar-98 Mar-96 Mar-94 Mar-92 Mar-90 Mar-88 -15% Deflating the credit bubble: mortgage credit Long-term investment theme: US Housing market Mortgage pool Credit support for ABX tranches 4y Cumulative HPA AAA 23.9% -40% AA 14.0% -20% 8.6% +5% 5.6% +20% A BBB BBB4.5% 0% Source: Citi, Theta Page 21 Deflating the credit bubble: mortgage credit Long-term investment theme (2006): US Housing market Moody’s expected loss: 0.001% 0.025% 0.180% 1.309% Page 22 Who’s next? The weakest hands Funding liquidity risk • Funding risk = liabilities reprice before assets reprice • Who can post collateral when the market moves against him? • Weak hands: the importance of long-term funding (SIV, CLO, TRS) Counterparty risk • CDS market has grown 10X in last 4 years • Who is selling CDS? (source: BBA) • • • • • Page 23 34% 21% 15% 14% 16% Banks Insurance companies Hedge funds Securities houses Other Who’s next? Corporate credit Compostion of High Yield Market and Default Rates 60% Default Rate (%, RHS) % New HY Issues Rated B- or below 51% 50% 41% 39% 40% 33% 33% 30% 30% 30% 27% 23% 20% 34% 21% 19% 18% 14% 14% 10% 0% 1993 Page 24 1994 1995 Source: E. Altman, NYU Salomon C enter 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Who’s next? Corporate credit Never before have we turned the credit (and economic) cycle with so much leverage in the system Page 25 Who’s next? Commercial real estate Lending standards are tightening... Page 26 Agenda • Introduction Theta Capital Management • Financial alchemy: growth of the non-bank banking system • Deflating the credit bubble: the cycle in reverse • Long/short investing: how to benefit from upcoming opportunities Page 27 How to benefit? 1. During the credit unwind (short positions): • Mortgage credit: residential & commercial, US & Europe • Other US consumer credit: credit cards & autoloans • Corporate credit: focus on HY and lower rated tranches with default risk rather than spread risk 2. After the credit unwind (establish deep value long positions): • Distressed ABS • Distressed corporate credit 3. More volatility/price dispersion in all risky assets (example trades): Page 28 • ABS, corporate debt, equity long/short • Emerging markets sovereign debt • European sovereign debt The credit opportunity set Page 29 Long/short emerging markets No broad decoupling but divergence between countries Components: inflation, fiscal balance, debt/GBP ratio, current account, FX reserves, trade/GDP, FDI/GDP Page 30 Long/short emerging markets Example portfolio Page 31 European Sovereign Divergence The Stability Pact is dead and the ECB will not bail out Page 32 European Sovereign Divergence “EU bond markets begin to diverge” Wall Street Journal, 7 Feb 2008 “Europe ministers call on France to meet budget pledge” Bloomberg, 12 Feb 2008 Page 33 Theta Capital Management Contact Details Theta Capital Management B.V. Johannes Vermeerstraat 9 1071 DK Amsterdam The Netherlands Telephone: Fax: E-mail: Website: Page 34 +31 (0) 20 5722733 +31 (0) 20 5722744 [email protected] www.thetacapital.com