Hi Jay, insurance buying we know, like insuring a house against fire accident, LA against earthquakes, Florida against Typhoon, Taiwan against invasion, and now perhaps less sensibly, insuring against the big financial market players against big financial loss ... (no, not picking on the Maestro again, too easy)
economist.com
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Hedge funds
Swing, swing together
May 31st 2001 | NEW YORK
From The Economist print edition
Investment banks risk getting burned by hedge funds. Again
INVESTING in hedge funds is hot again, but this time with a difference: many investors are buying insurance against losing money. A curious concept, you might think, for such a risky game. Yet investment banks are selling capital protection, for a price. Some financiers fear that the risks their rivals are taking in offering such protection will be unhedgeable in times of market distress. That, after all, is why portfolio insurance failed in October 1987, accelerating the markets’ free-fall.
Net inflows to hedge funds totalled nearly $7 billion in the first quarter of this year, bouncing back to levels last seen before the crash of Long-Term Capital Management (LTCM) in September 1998. Most of that flow has been into equity or equity-linked funds, where the capital-protection racket is most rife.
The top Wall Street firms, such as Morgan Stanley and J.P. Morgan Chase, say they are alive to the danger, and rather disparage their second-tier rivals, among them French and German banks and insurance-company subsidiaries, for winning hedge-fund business by taking on greater risks. They would say this, wouldn’t they—and these firms had to put $3.6 billion into LTCM after it was hit so hard in the Russian crisis of August 1998. It seems, whatever they say, that they are all in the game to some extent, and getting in deeper. In a market downturn, their hedge-fund positions could hurt them and amplify panic.
The majority of hedge funds are not like LTCM. They take small, well-managed bets on debt or equity trends, or on anomalies in market pricing. They do not borrow too much. And they can produce returns well above those available in share and bond indices (although they charge high fees and keep a big chunk of the profits). One reason for this is that they are not forced to run with the herd.
Which does not, however, stop the herd from running with the hedge funds. Since the LTCM debacle, the financing of hedge funds has become a far tighter game. Banks will not allow them to borrow more than three to seven times their capital, if at all. By comparison, commercial banks borrow as much as 12 times their capital, and investment banks often leverage as much as 30 times. LTCM was leveraged more than 100 times.
The banks have been reducing their own credit exposures to hedge funds by bringing in outside investors. But most investors are cautious, particularly insurance companies and pension funds. Their statutes often will not let them invest in entities of low credit standing.
So banks and investment houses have been offering notes linked to hedge-fund performance, with a guarantee that at maturity they will get back at least the capital they started with. “Principal protected notes” have become big business, and thanks to them, several billions of dollars of fresh money each month are being poured into these small—or now not so small—hedge funds. Société Générale, a French bank, says it has issued more than $3 billion of such notes, in private or public form. The fashion for pension funds or insurance companies to invest a small proportion of their portfolios in hedge funds will, if it continues, provide a wall of money. That would not in itself be a problem for the hedge funds. But it would be a problem for the banks that have offered money-back guarantees.
How can a bank afford to offer such guarantees? The simplest way is to reinsure the risk with an insurance company. Several will oblige, including Swiss Re and Zurich Re. A more complex way is to invest a proportion of the capital in something safe, such as zero-coupon Treasury bonds, so that at the target date it yields most or all of the principal sum. The rest of the capital is invested in the hedge fund or funds, on a leveraged basis or in positions which mirror what the hedge fund is doing. If the hedge fund starts achieving spectacular returns, either positive or negative, the bank must adjust its “delta” position quickly in order to track the profit or avoid the loss.
In many agreements with hedge funds, banks can take the investment out of the fund when there is severe underperformance. But—here is the catch—hedge funds are not very liquid investments. At best they allow disinvestment once a month. Some require an investment “lock-up” for a year or more. If the bank can see all the positions in a hedge fund’s portfolio, it can guard against a downturn more quickly. But there is a potential conflict of interest if it is acting as the fund’s prime broker as well. Morgan Stanley, an investment bank, says it will not act as prime broker for a fund which it is tracking in this way. Other banks are apparently not so squeamish. Such a conflict of interest could become acute in periods of market turbulence.
Delta-hedging is a game which requires not just vigilance, but also liquid markets. In a sense, the banks have substituted the credit risk of financing hedge funds with the market risk of their underlying investments, which they believe they are better at quantifying and hedging. Many of them skip the investment in zero-coupon bonds, believing they are agile enough to create “virtual” zero-coupon structures.
But, as is often the case, the risks are getting higher and the returns lower as more firms join the fray. Moreover, with the decline in interest rates, the zero-coupon structure demands a higher proportion of the capital to protect the investment, leaving less to invest in the hedge fund itself.
Two things are likely to happen, says a risk manager close to the business. First, investors will begin to see that investing in a diversity of hedge funds, without principal protection, will provide nearly as stable returns. (Principal protection is bought at the expense of some of the hedge funds’ profits.) Second, the hedge-fund industry will become mainstream—not, as it is now, an “alternative investment strategy”. Hedge funds’ performance will then become more correlated with the rest of the market (and so perhaps will their fees).
That assumes, however, that there is no spectacular blow-up as in 1998. “People have programmed 1998 into their models: 1998 can’t happen again,” says a risk strategist at a big Wall Street firm. But with their eyes on the rear window, today’s risk managers are quite likely to miss the next big event until it hits them. Could delta-hedging of hedge-fund portfolios be it? As long as the business is hot, few on Wall Street or in the City, or those who watch over them for that matter, seem worried.
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