Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [70]
Many hedge funds use total return swaps, a type of credit derivative, in order to borrow money and leverage up their investments.Warren saw the negative consequences of this strategy first-hand with Long-Term Capital Management.Total return swaps easily thwart the intent of margin requirements, they create much more leverage, and it is virtually invisible. At the end of April 2007,Warren told Susan Pulliam at the Wall Street Journal that the global financial system is so leveraged that it makes the leverage used before the Crash of 1929 “look like a Sunday-school picnic.”6 I told her that if cash-strapped funds are forced to sell assets in a market downturn it “could lead to a vicious cycle of selling that would feed on itself.”7
The collateral the hedge funds put up to back their borrowings is often illiquid and difficult to trade, and prime brokers such as Credit Suisse and JPMorgan do not disclose the amount of total-return swaps that they have made to hedge funds on their books.The strategy is very risky since the assets a hedge fund “buys” may come back on the balance sheet of the bank (the lender) if the fund implodes. For example, if a hedge fund uses 15 times leverage, and asset prices irreversibly drop just a tiny amount, investors lose some principal. If prices irreversibly drop just seven percent or more, investor capital is wiped out, and creditors have no choice but to seize the assets, some of which were sold by the investment banks in the first place.
Regulators fed the folly.Within days of Warren’s warning, the New York Fed claimed that despite market similarities to the risk levels at the time just before LTCM blew up, there were different causes then, so the existing market environment now was less alarming.8 England’s Financial Services Authority (FSA) piled on pablum. The FSA released results from a partial survey of hedge funds and thought that “average” leverage had declined.9
Dr. Sam Savage coined the term “flaw of averages.” He asserts that using an average number to forecast an outcome can lead to huge errors. For example, if a swimming pool’s average depth is four feet, but the deep end of the pool is eight feet, a nonswimmer is presented with lethal risk. A drowning man learns the hard way that the “average depth” mischaracterizes the peril. The average leverage number might suggest that hedge funds on balance are safer, but if an individual hedge fund employs a high degree of leverage, the average for all hedge funds is meaningless. Furthermore, hedge funds had massive hidden risks—inherently risky overrated assets. On May 7, 2007, I wrote the Financial Times that the regulators were dead wrong.The current situation was not less alarming that that presented by LTCM, it was more alarming. Hidden leverage does not show up by polling prime brokers. Hedge funds, structured investment vehicles, and other investors use structured products combined with derivatives and leverage, “illiquid structured products will experience a classic collateral crash when hedge funds try to liquidate these assets to meet margin calls.”10
A few weeks later, Bear Stearns Asset Management proved my point.
In May 2007, Ralph Cioffi was the senior managing director of Bear Stearns Asset Management (BSAM), a subsidiary of Bear Stearns, and cochief executive officer of Everquest Financial Ltd., a private financial services company. He reported to Richard Marin, the chairman and chief executive officer of BSAM. Warren Spector, cochief operating officer of Bear Stearns and a former trader of exotic mortgage products, was the key sponsor of Bear Stearns’ foray into hedge funds. Bear Stearns Asset Management managed several CDOs and it also managed several hedge funds. Before the summer of 2007 ended, my former colleagues