08.07.07

A Humbled High-Flier

Posted in Finance at 11:46 am by Valentine

Many details and facts borrowed from Steven Syre’s article in the Boston Globe. I commend it to your attention.

In tumultuous financial times, there always seem to be a few rats that get shaken loose from the ship. The latest to suffer this fate is Jeffrey Larson, founder and principal of the Sowood Capital Management hedge fund. Once a key manager of the Harvard University endowment, Larson is an accomplished professional with years of experience in the capital markets. His fund promised “to generate superior risk-adjusted returns for clients by applying our collective skills and experience rather than relying on market conditions” (taken from the Google cache of the now-defunct Sowood front page). Larson thought he had a sure thing. He hedged every bet. Yet he lost an estimated $1.5 billion of his clients’ money, including roughly $350 million for his former employer and another $30 million for the Massachusetts State Pension.

Like many hedge funds, Sowood took advantage of easy credit to invest in higher-yielding debt securities. Larson’s investments were focused in “senior debt securities of high-quality companies with strong collateral”, however I do not think he is talking about bonds with AAA ratings (since the activity in that segment of the market should not have resulted in a collapse). His investments would have promised higher return, if with somewhat greater risk of default. To mitigate this risk, Larson shorted more junior debt of the same companies. (Since the senior debt is redeemed first in a bankruptcy, the junior debt can be expected to lose at least as much when a company’s credit rating suffers.) When betting against junior debt was not possible, he sometimes bet against the stock itself.

So what went wrong? Spooked by the rising defaults in subprime mortgages (that directly led to the evaporation of two Bear Stearns hedge funds), investors suddenly demanded a higher risk premium for all debt securities. The spread between (zero-risk) Treasury yields and (moderate-risk) corporate yields had been at an all-time low (see this article), so a market correction should not have surprised anybody. What came as a shock was the rapidity of the collapse. The credit markets are often described as a “spigot” that dispenses cash to power the economy. By all reports, the spigot shut down almost overnight in July. Nobody was buying. At times, nobody was even willing to make a market in these securities.

A well-capitalized investment bank hoping to float a new offering will simply shrug and delay the issue for a couple months, suffering greater inconvenience than actual loss. An investor caught up in this situation would be well-advised to follow suit. Unfortunately, Larson was investing on margin. His lenders responded to the turmoil by marking down the value of his holdings, triggering the dreaded margin call. Without an active market in these securities it was impossible for Larson to liquidate sufficient positions to meet these calls. Ultimately he was forced into a private sale of assets to Citadel Investment Group at heavily discounted prices.

Furthermore, the behavior of the markets rendered his hedging strategy ineffective. While we can only guess at the details, I suspect that the market turmoil made it impossible for him to get full value for his short positions. Buyers may simultaneously be unwilling to buy a security yet unwilling to bet against a rebound in the coming weeks. Larson was presumably forced to meet the margin calls before the execution date for his options.

Adding insult to injury, the broader economic conditions remained positive. Remember, Larson was shorting stocks as a hedge against a decline in bonds. A recession would be expected to trigger a greater decline in stock prices than in bond prices, validating Larson’s strategy. Unfortunately this collapse was limited to the credit markets. The stock market surged in July, and surely none of his stock options finished in the money.

Jeffrey Larson is disgraced. “You entrusted us with the management of your money, and we lost a lot of it, to say the least,” Larson said. “No apology is sufficient.” I can imagine him sitting in his luxury penthouse apartment, staring at the ceiling, and wondering, “Where did I go wrong?” In my mind, he made three mistakes:

1. He bought into a bubble market. Fusion physicists know that exploding bubbles can generate massive concentrations of energy. Larson surely understood that the risk premium on corporate debt was historically low, yet he bought into the market anyways believing that his hedging strategy would protect him. When the bubble burst, his hedges were overwhelmed by the market forces released. Safer to buy into markets that should respond favorably than into markets that are already clearly overpriced.
2. He placed too much trust in his model. I’m willing to believe that July 2007 is the only month in Larson’s lifetime that would have caused his strategy to collapse. We should certainly strive to learn from history, as it has a way of repeating itself, but each repetition is subtly different from those that came before. Never fall into the trap of believing that you’ve seen every possible permutation.
3. He left himself too little margin for error. The capital markets have suffered, with corporate bonds losing maybe ten or fifteen percent of their value. Yet the risk of default on “high-quality securities” remains low. A wise investor will simply hold these securities and wait out the rebound. Larson’s heavily leveraged strategy left him vulnerable to margin calls on even a modest decline, ultimately leading to a “fire sale”.

In the end, Larson was too smart for his own good. He knew that he had a thorough understanding of the markets. He knew he could turn an easy profit by investing borrowed money. He knew so much — but he neglected to consider the possibility that he had missed something. Thus he skated too close to the edge, and the modest market tremor (otherwise known as an “unprecedented event” in market-speak) tossed him over the cliff. Larson’s hubris led to his downfall.

Permalink