We wrote earlier that the hedge fund industry was facing significant redemptions due to lousy performance and the desire of many investors to reduce their risk exposures.
The Lehman bankruptcy, the biggest to date, is pouring gas on that fire. Hedge funds in the US report their net asset values monthly (evidently the convention in the UK, an even bigger hedge fund center, is quarterly), so the next reporting date is imminent. Many have positions frozen in the Lehman bankruptcy and in the absence of a resolution (which is expected to take months), they will need to take sizable, perhaps excessive, writedowns now.
Regardless of whether the marks these hedge funds take on their stuck positions are too high or turn out to be roughly correct, this situation is likely to add to the exodus from hedge funds. More redemptions mean more sales of securities, depressing prices. The administrator is trying to speed up the Lehman wind-up, but the options appear to be limited.
The great unwind is on.
From the Times Online (hat tip reader Saboor):
Hedge funds and institutions could be forced this week to write down billions of dollars related to trading positions that were frozen when Lehman Brothers was put into administration two weeks ago.
More than 90,000 trades worth $13.9 billion (£7.6 billion) were left unsettled when Lehman collapsed and it will take “many months or years” to sift through the wreckage, said Tony Lomas, the lead administrator at Price Waterhouse Coopers (PWC). Until every counterparty’s position is determined, PWC said it would be unable to remunerate creditors or settle trades. “We have to be fair to all creditors,” Lomas said. “It will take months, even years.”
For some hedge funds already nursing heavy losses from the volatility of recent weeks and a ban on short-sell-ing, the slow pace of Lehman’s unwinding will do damage. Tomorrow the industry must send its quarterly valuation figures to investors. “They will need to form a view on the value of their relative position with us,” Lomas said. Many are expected to write down the value of their trades substantially, or to zero.
Lomas said that about 30 hedge funds made urgent pleas for the return of shares or cash. Complicating PWC’s task is a $27 billion negative position that Lehman has in borrowed stock. When the European business collapsed, it had $87 billion worth of stock on loan, versus $60 billion it had lent out. PWC has offered to cancel trades with counter-parties on a bilateral basis, but has refused to do so wholesale.
Efforts to sell the rest of the business continue, though talks for its fixed-income business ran aground after Nomura failed to table an offer by Friday’s deadline. No other bidders have emerged. PWC is also negotiating with potential buyers for Lehman Brothers Asset Management, which looks after $3.5 billion of funds.
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Matt Dubuque
What is unfortunate is that the loss of Lehman removed a substantial amount of clearing capacity for various trades to settle.
Conceptually it would be similar to having a major oil pipeline rupture in a time of a severe oil shortage.
The loss of Lehman means that a major set of arteries that supply the heart of finance has been eliminated.
So the backup systems have to work that much harder.
Matt Dubuque
mdubuque@yahoo.com
Yves: Please help us with something. Brad Setser in his most current post indicates that almost 300 billion
of Lehman Bonds (unclear if all were issued BY Lehman
or “linked” to Lehman ) were owned by Chinese state
or central banks. I know the balance sheet was supposed to be around $600 B. Any light you can shed on this?? I thought Lehman only had around
$110 B of bonds outstanding.
Great Freudian slip – “stuck positions”. I couldn’t do better if I tried.
Yves:
It would be interesting to figure out how much Buffett is on the line if a market crash were to occur. Berkshire received $4.5 billion for writing puts on the S&P and 3 other foreign indexes over the past year or so. The mark to market losses on these could be pretty astounding if the Dow were to fall to, say, 8,000. I think the liability here totally dwarfs the investment in Goldman, though I can't say by how much. It would be amazing if the sage were brought low by the financial crisis, having employing AIG-like strategies in writing insurance on the stock indexes.
The details of the Buffett transaction are summarized below, from the futureblind blog back in March, though we may fairly doubt if it was such a brilliant speculation after all.
http://www.futureblind.com/2008/03/berkshire-part-2-selling-puts/
"Buffett has pulled it off again. He’s made a creative, favorable bet that may pay off handsomely for long-term Berkshire shareholders.
Over the past year, Berkshire Hathaway sold put options on the S&P 500 and three foreign indices. Expiration of these puts range from 12 to 20 years out, and Berkshire collected $4.5 billion in premiums. Unlike regular puts, these are exercisable only at their expiration dates. On those dates, Berkshire makes a payment only if the index has lost money over the period of the option.
Selling these puts is essentially saying: In 15 years, I promise to buy the S&P 500 from you at a price of $1,468 (closing 2007), if it trades below that price. In exchange, you give me $4.5 billion right away.
Buffett doesn’t disclose the size of the actual options. The $4.5 billion in premiums tells you they are big, but apparently not big enough relative to Berkshire to cause any problems.
The counterparties (the people who made the agreement and paid the premium) are most likely large financial institutions who are hedging their long-term bets in favor of the market. So it may turn out to be a dumb bet for them, but they’re essentially purchasing insurance on what they have or will have in the market.
For Berkshire to lose money, a few things have to happen. To keep it simple, let’s just talk about the S&P 500, because we don’t know which foreign indices were used.
1. First, over the next 12 to 20 years, the market would have to have a negative cumulative return.
2. Second, that negative return would have to be large enough to overcome the premiums received.
How large? Once again, we don’t know the size of the options. But the premiums, which were $4.5 billion at the time they were written, will have compounded for more than 15 years by the time of expiration. If Buffett (or future Berkshire managers) can achieve 15% annual returns, the premium cash will have grown to over $36 billion. So the aggregate losses on the put options—the size of the options times the amount of negative returns—would have to exceed $36 billion for any profits to be erased.
Because of their long-term length, it mitigates the risk of a short-term Black Swan-type event affecting the options. A “Black Monday” one day anomaly would have little effect, other than a temporary quarterly adjustment. Something could still happen (i.e. a long depression, or a nuclear war, God forbid) that would cause losses. But this bet seems pretty favorable as long as the world economy does alright in the long run. Chalk one up for the Oracle of Omaha."
Brad Setser in his most current post indicates that almost 300 billion of Lehman Bonds…
No, $300 million. If it was billion, they would be really po’d!
“It would be amazing if the sage [Buffett] were brought low by the financial crisis, having employing AIG-like strategies in writing insurance on the stock indexes.” — dividedmind
It’s looking like a classic “race to the bottom” between Bernanke and Buffett.
At first glance, Bernanke would appear to be light years ahead in the race to liquidation or conservatorship, having trashed his balance sheet to the tune of hundreds of billions in just the last two weeks.
But Buffett, having made an enormous bet in favor of conventional thinking and the government-managed status quo, may yet come from behind and pip young Helo Ben in the stretch.
Godspeed, gentlemen! Just remember — it’s only paper money!
— Juan Falcone
I think Buffett is guessing we will inflate our way out of anything, and I would guess he is right. I recall an article he must have written late 70s about how he made a lot of money in nominal terms but due to inflation real term returns were much lower.
Check the BRK AR footnotes for the nominal size of the positions.
Thanks bob_in_ma: I haven’t seen the work Millions
in so long I just misread it as Billions.
“Stuck positions” was deliberate and I was aware of the double entendre.
The problem:
Mark-to-market accounting.
The solution:
Mark-to-Hank!
yves,
You can read the article by entering the link in google translate:
http://translate.google.com/translate_t#
Here is a link to the translated page:
http://translate.google.com/translate?u=http%3A%2F%2Fwww.ftd.de%2Funternehmen%2Ffinanzdienstleister%2F%3AFolgen-der-Finanzkrise-Hypo-Real-Estate-droht-Kollaps%2F419518.html&hl=en&ie=UTF-8&sl=de&tl=en
Chinese state banks have admitted to holding 300 million (not billion) of LEH bonds. SAFE likely has some as well, but the sum isn’t going to be that large —
bsetser
From the intro remarks of the call:
It requires us to take warrants at the Secretary’s discretion … in the direct case [i.e. a seizure of a failing institution] we will be very aggressive in taking warrants for the taxpayer benefit. … Companies that sell over $100 million dollars into this fund must give warrants.
The warrants we can set at whatever level we want to set, it’s not specified. We want to set that at a level so there is some upside for the taxpayers, but also encourages all firms to participate. This goes back to the spirit that we don’t want just failing institutions to participate but also healthy firms to participate. Having that discretion was very very important to us.
So, I guess, healthy firms can come in and take the taxpayer for $100 million with no downside for them and no upside for us. Likewise, while the Treasury will be very aggressive about taking stock options on failing institutions, when healthy institutions come for their checks, the Treasury will set the price of the warrant at whatever level is high enough to keep the firm at the trough.
Sounds like a real win-win to me!
Woops, how’d this end up in this thread.