US financial institutions reported an increase in Level 3 assets in Q3 to $610 billion (see Financial Times article). This amounted to an increase of 15.5 percent from Q2 as low liquidity has made it difficult to sell MBS and CDO assets. Classifying assets to Level 3 also gives the banks more control over how valuations are modeled and set. As banks begin reporting Q4 results, many analysts expect the number of writedowns of these assets to increase, especially given the recent announcement that the Treasury plans to use TARP money for capital injections directly into financial companies, as opposed to the original purchase of illiquid assets.
There is an interesting article in the WSJ about Bill Miller, and the fall of his once lauded Legg Mason Value Trust fund. After continuing to dip into the value market, buying many beaten down financial companies, the fund has fallen from $4.3 billion AUM from over $16.5 billion just a year ago. The fund that was consistently one of the top performers over the years is now among the worse for one-, three-, five-, and ten-year periods based on Morningstar's rankings.
The IEA is forecasting a contraction in world oil demand, the first in 25 years (see WSJ article). Spare production capacity is at a six year high among OPEC members. Specifically for the US, consumption is expected to fall off 6.3% this year, and another 1.4% in 2009. China is expected to fall 3.5% in 2009 after increasing oil consumption 5.3% in 2008.
Charge-off rates among credit-card issuers are expected to rise more than expected in Q4, after rising more than 6% in Q3 (see WSJ article). Roll rates, which indicate that customers will go from late to not paying, was up 20%. The roll rate for American Express increased to 47% in Q3 from 35% during the same time last year. Capital One increased to 34% from 28% over the last year. Given that unemployment is a leading indicator of credit card defaults, the numbers are not all that surprising.
Defensive stock Proctor and Gamble lowered its sales outlook for the current quarter, stating that organic sales growth will fall short of the previous 4-6% growth targets given just a few months ago (see WSJ article). The stock is down nearly 20% for the year, but still fairing better than the broader market.
A number of firms are beginning to become more active in using clawback provisions (see WSJ article). The clawback rules are being put in place to allow firms to take back money paid to traders and others whose trading positions blow-up at a later time. Such provisions are believe to help keep employees from entering into positions or strategies that may be too risky, but which may provide a large initial return and subsequent nice bonus. The worry of course is that such rules may cause some traders to become too careful, essentially shying away from necessary and manageable risk. There is also a worry that good traders may move on to other firms with less restrictive provisions.
What is probably most unnerving about such provisions is that it implies that the companies utilizing such a provision really have no idea what their risk levels are, or how to go about managing such risk. With risk management policies in place, especially those that elevate risk management functions within a firm and properly reward both traders and risk managers that at least attempt to manage and price such risk, a company should be able to better understand the risk they are taking and prevent traders from entering positions with excessive risk. If a properly analyzed trade later blows-up because of unforeseen events, then it could be argued that it is just the cost of doing business. Sure, if traders circumvent risk management procedures put in place at the firms, or are negligent in obtaining the necessary data or developing the best possible model, then by all means penalize them, regardless of whether the trade worked out or not. But as long as the traders and risk analysts accessed the risk based on the available data and models, and have their work approved by the risk managers, then it seems counterproductive to penalize traders for events outside their control. Sure, you will recover some bonuses, but you will lose much more in terms of talent, reputation, and lost capital. Recovering a rogue traders bonus may be too little too late and of little value, other than helping to pay the bankruptcy lawyers.
Even hedge funds that are doing well are seeing withdraws (see Reuters article). Why sell a good fund? As it turns out, the main sellers could be those that operate fund-of-funds. As a result of other funds (holdings) being down, redemption request at FoF are causing selling across the board, dragging down performing funds as well.
There is an interesting article from Cam Hui at SeekingAlpha discussing the need for hedge funds to return to basics, and for investors to rethink their expectations. Of interest from the article is the quote: "Hedge fund investors found out what they had wasn’t a contract with a hedge fund manager, but a call option on a management contract. When the incentive fees dried up, the manager packed up and went away." This gives me an idea. How about selling an option on ......, never mind.
Rumors of a Goldman / Citi merger have changed to a Goldman / Morgan Stanley merger (see Here Is The City News article). Still waiting for the Goldman / Yahoo / Microsoft rumor to surface.
I was just kidding about the 10 million. I did not want a bonus afterall (see Clusterstock article). Merrill and/or Thain doing damage control.
Fleckenstein, a regular guest on Fast Money, is calling it quits, or at least closing his short-only portfolio (see FINalternatives article). He is planning to open a new fund (not a hedge fund) that would be available to retail investors (ie., everyone). In a blog post, Fleckenstein states "I now (sic) longer want to run a short-only hedge fund, as it is very stressful, nerve-wracking and generally not very much fund (sic)." Then again, the money was nice .........
There is an interesting New York Magazine article on Jim Chanos. Even though he seems to be on CNBC just about every time you turn around, the article provides a little more detail on his background, and provides some insight into his approach. Interesting read.
While hedge fund returns have been taking a beating lately, the talk of the demise of hedge funds is probably a little over done and premature. While there has been $72.5 billion in outflows, this represents less than 4 percent of the average mid-year industry volumes (see Wealth Bulletin article). Also, while the industry has seen a number of funds close up shop, the numbers have "only" decreased from 7,601 to 7,299. As discussed in this blog a number of weeks ago (see previous post), the fallout seems to be impacting smaller funds more that larger, more established funds. In fact, many of the larger funds - which are either more diversified or have a star manager - are seen as being able to take advantage of the shifting resources and capital.
Even with fewer funds failing than originally expected (yes, these are just preliminary numbers), funds that stay in business will still find that they cannot operate as usual. For starters, funds will need to better match redemption rules with strategy. Some funds are illiquid by design based on the strategy being used. While trying to lock up funds until returns are realized (as with private equity) is probably not feasible, funds will need to better insure that redemption request rules take strategy into consideration. The use of leverage will also no doubt be reduced for many funds, which will also affect returns going forward. Finally, the popular 2-20 fee structure will also come under assault. Not only does the existing compensation structure seem excessive given recent performance (and future lower returns in the wake of lower leverage), fee concessions will be necessary as an incentive for agreeing to longer lock-up periods. In the end, expectations on both sides may need to be scaled down a little.
Hedge Fund Research's Global Hedge Fund Index was down 3.04 percent in November, after a drop of 9.26 percent in October (see FIN Alternatives article). That brings the index down 22.3% YTD through November. Continued poor performance has increased redemption requests, causing an increasing number of hedge funds to block investors from redeeming shares (see NY Times article). The increased addition of illiquid investments over the years (such as real estate and private equity) has caused many funds to start considering a new model that would require longer lock-up times for lower fees. High-water marks, which would force some under-performing funds to earn back 25 percent or more before taking profit fees, will cause additional funds to close, although others insist they will take the high road and not close until they are profitable again.
As of the end of last week, approximately 100 hedge funds have placed restrictions on withdraws, in what is becoming a financial roach motel where investors can check in, but they cannot check out (see Bloomberg article). The increased use of gates has even spread to some of the previous stars of the industry, such as Fortress Investment Group, Tudor Investment Corp., and D.E. Shaw & Company (see WSJ article). Furthermore, the problems are even worse for those funds investing in emerging markets, which continue to under-perform and are down an additional 1.41% on average in November (see Bloomberg article).
Finally, even with new gating restrictions, some hedge funds are also being forced to renegotiate borrowing terms with their prime brokerage lenders as losses and redemption requests increase (see Financial Times article). Many prime brokers are also seeing this as an opportunity to drop clients or renegotiate terms that were originally in favor of the large hedge funds who previously had bargaining power. No doubt many large investors with liquidity will be able to throw their weight around in a similar way as they begin renegotiating lower fee structures in return for longer lockup periods.
Private equity investors are starting to ban together to renegotiate terms of previous commitments (see Financial Times article). In particular, endowments and foundations, which have recently increase exposure to alternative investments, are looking for ways to scale back commitments after losing money and finding it difficult to meet their operating budget without dipping too deep into existing endowment funds.
The Lehman bankruptcy has apparently went better in the US (see Financial Times article). The UK FSA is even traveling to New York to see why the US insolvency regime has worked better than in Britain in the wake of the collapse of Lehman Brothers. Problem have caused many hedge funds to move assets to the US to avoid similar problems, causing London to worry about it status as a major financial center.