Daniel Alpert of Westwood Capital and Jerry Webman of Oppenheimer Funds were recently on CNBC discussing the credit markets. Alpert mentioned that while the panic has left the market, and many banks are doing well due to widening credit spreads, the spreads are wide in-part since the assets on which many of the loans are made are still underwater. This gives room for some concern. Alpert also believes that while the recent funding for CIT was a positive, a bankruptcy at CIT is still about 50-50 given that their collateral will be difficult to collect upon. Alpert also still has some worry as to whether there will be enough capital available in the markets and banking system to absorb the level of losses that will still need to be taken.

Source: CNBC Video

Webman was a little more encouraging and believes that it is a positive that private funding was available for CIT. Nonetheless, credit spreads in the investment grade area are still pricing in defaults and poor recoveries at 4-5 times the historical averages, signaling that people are still cautious. Webman did mention one good trend that is showing up - people are breaking apart the "toxic" assets into their good and bad component parts, with the good assets being put back into less toxic and less complicated assets. This is good since banks are trying to become more capital transparent, which will allow them to make more loans of the type that CIT made. This makes a CIT-type of failure less difficult to deal with, and may explain the somewhat muted market reaction. Webman also believes that the latest earnings news is illustrating a gradual rebuilding of economic momentum, and strength in many parts of the financial world. With the current playing field, the big players will continue to be able to make money, even without the extreme levels of leveraged that were observed in the past.

In a recent Bloomberg article, it was mentioned by the Credit Suisse Group that the Federal Reserve could consider selling options to primary dealers in order to help them ease imbalances in derivative positions that are amplifying swings in interest rates (see Bloomberg article). This sounds interesting, given that a similar strategy was used in 2000 in the form of liquidity options to help head-off potential Y2K funding problems. In addition to options, investors could also use swaps, swaptions, and Treasuries to help hedge interest rate risk.

Of course, such a hedge position may not be possible for others if the new regulation being proposed by the Obama Administration is put in place (see the Washington Post article). One aspect of the new proposed regulatory framework would require firms to retain a stake in each securitized product that is developed. Furthermore,

"The plan also would prohibit firms from hedging that risk, meaning that they could not make an offsetting investment"

While I understand the reasons for proposing such a restriction - the hope that it will cause investment banks to develop less risky, less leveraged, and less opaque products, thereby preventing another 2008 credit meltdown - it seems this could be achieved in a less restrictive, yet more focused way. Forcing companies to keep a piece of the structured security (and subsequent risk) on their books appears counterproductive when it makes more sense to allow and encourage companies to hedge this risk, even if it means passing the risk onto another investor such as a hedge fund willing to take on the risk (and reward). Forcing companies to keep risk on their books will only repeat some of the same problems that various investment banks faced in 2008 when they were unable to sell and shed structured product risk once the credit crunch unfolded.

While forcing these companies to keep some of the structured securities on their books could make it more likely that they would offer less risky products, is this what we really want? One of the benefits of securitization is its ability to free-up capital for more productive uses. While this process certainly got out of control and was misused in some instances, placing a blanket restriction on what can be sold also places similar restrictions on risk reduction and the flow of capital into more productive hands - something we cannot afford to restrict, especially at this time. Here is hoping that the current proposal is just that, a proposal, and that any final legislation will consider the unintended consequences and be more focused on the specific problem that needs to be addressed - uncontrolled risk taking.

A recent paper (available here on SSRN) by Andrew Clare and Nick Motson, entitled "Locking in the gains or putting it all on black - An investigation into the risk-taking behaviour of hedge fund managers" explores the issue of whether or not hedge fund managers are adjusting the risk of their funds based on two factors - how the fund is performing compared to its peers, and whether or not the fund is currently above its high water mark, at which point the manager could capture performance fees (HT to a recent Hedge Fund Review article).

The authors find evidence that hedge fund managers do in fact adjust the risk profiles of their funds in response to their relative performance with peers: managers that are performing poorly will increase their risk profiles, while those doing well relative to their peers will do just the opposite and reduce the risk level of the fund. While in some ways this makes perfect sense, it does suggest that hedge funds on average are less worried about targeting absolute returns, the very reason some investors allocate capital to such funds.

The researchers also considered the implied "moneyness" of the manager's performance option to examine the behavior of managers when the fund is above its high water mark. In a sense, the compensation structure for hedge fund managers has option-like characteristics. As the fund performs above its high water mark, the performance option becomes in-the-money. Clare and Motson showed that managers with an incentive option well in-the-money will decrease the risk profile of their fund, possibly trying to lock-in value, especially towards the end of the calendar year. On the other hand, the managers of under-performing funds with options out-of-the-money do not seem to take on additional risk in an attempt to get the fund whole. The authors believe this behavior may be due more to a fear of liquidation from investors if the added risk ends up producing further losses. Preservation of capital (and the 2% fee on top of such capital) seems to be more of a driving factor than taking a shot at trying to capture performance fees. Given that many managers have a significant stake of their own wealth in the funds is also no doubt impacting any extra risk that the managers are willing to take.

So what does this imply for the markets? One could argue that during bullish years (or at least positive return periods), investors in both over- and under-performing funds may see the returns of their funds revert to the mean as we get closer to the end of the calendar year, with the under-performing funds possibly experiencing addition volatility as they try to chase the returns of their peers. On the other hand, when the market is down, both over- and under-performing funds, especially those with less of a likelihood of hitting their high water marks, are likely to maintain or scale-back risk in an effort to maintain capital during difficult downturns. Whether one can, or wants to trade on this behavior is another question.