Hedge Fund Performance (5 years to end-March 2012)

In this research presentation, FPM Advisers serve to evaluate and share findings about hedge fund performance for the five years to end-March 2012. Investors believe it is a significant window to assess medium-term performance of hedge funds through this unique business cycle. Further we suggest that the significance of the last 5 years is in its forecasting ability for the next medium-term outlook.

From studies of business and market cycles after a housing and financial bubble, the current cycle which ensued in 2007 as a de-leveraging turning point is expected to have enduring effects, perhaps into 2017 (See Reinhart and Rogoff reference in FPM’s last blog: Head- and Tail-Winds in 2012) .

Briefly, some fundamentals suggest more de-leveraging and economic pain is necessary. Not least from over-grown national debt burdens in some developed nations, where debt to GDP is near or over the 90% unsustainable level. A level identified by the above cited economists Reinhart and Rogoff. FPM’s long-memory serves to remind us that in-vogue Spain entered the credit crisis with 40% debt to GDP, while now it is greater than 60%. Also confounding, is that the UK entered the crisis with debts at 94% of GDP! FPM understands the other forces at play, such as the question of fiscal and monetary integration in the European Union…

FPM Hedge Fund Risk-Performance Analysis

We present the risk-performance analysis of all 32 HFRI Hedge Fund Indices and the S&P 500 market proxy, during the past 5 years. Our last comprehensive analysis of all HFRI hedge fund indices was for the four years to June 2011 – see Hedge Fund Performance Since July 2007.

The colour highlights in Table 1 below displays the outliers and median statistics comparing all hedge fund and market benchmarks. The colours highlight the best, worst and median performances for a given metric (green, yellow and cyan respectively). This graphic visual helps to select from the mix of strategies and their corresponding statistics. This tool towards fund portfolio management we call “FPM Performance Comparison Tool” or “FPM PCT”.

 Table 1 Click on Image to View in Full Screen

The hedge fund indices presented in the table are sorted in descending order of Sharpe ratio performance. Top of the table is a Sharpe ratio performance of 1.47 (highlighted green) from Relative Value – Fixed Income Asset Backed strategies. (In September 2011 FPM investigated and introduced this stellar performance strategy in its research entitled Credit Markets @ Workout Inflexion Point.) At the bottom of the table is the FOF - Conservative Index, producing a negative Sharpe of -0.43, highlighted yellow. 

While the allocation decision is a complex one our FPM tools certainly makes it a simpler. Given an investor’s risk-reward preference, the rear-view mirror of performance can suggest performance expectations of strategies in given market conditions, ceteris paribus. Or else the FPM table is used to compare a customised portfolio’s performance over the same horizon.

Conservative Portfolio Allocation Considerations

A hedge fund allocator running a conservative portfolio for a treasury or chief investment office, may select low volatility investment strategies aiming to preserve capital – and by implication selecting funds exhibiting such characteristics.

Over the past 5-years an Event Driven - Merger Arbitrage strategy produced the lowest annual volatility of only 3.5%, with the median annualised volatility being 8.3%. A ‘median vol’ investment fund with diversification benefits can be sourced from the Fund of Funds – Strategic class. Similar median low risk returns were demonstrated over the 5 years by Event Driven - Distressed/Restructuring and Relative Value - Fixed Income-Corporate buckets. So a positive selection based on volatility alone suggests 5 different sub-strategies of hedge funds to choose from. Ignoring aggregated indices, the top 5 least risky sub-strategies are shown below:

Top 5 Low Volatility Hedge Fund  Strategies (over Apr’07 to Mar’12)

Hedge Fund Sub-Strategy	Annualised  Volatility
ED: Merger Arbitrage Index	3.5%
EH: Equity Market Neutral Index	3.5%
RV: Fixed Income-Asset Backed	4.1%
FOF: Conservative Index	5.6%
ED: Private Issue/Regulation D Index	5.9%

Also, perhaps there are other strategies to avoid or de-select in aiming to minimise volatility: such as Emerging Markets - Total strategies, which exhibited a high 14.7% annualised volatility over the said period. This is almost as twice as much as a median volatility strategy such as ED - Distressed/Restructuring, RV - Fixed Income-Corporate Index or FOF - Strategic Index.

We suggested ‘perhaps’ avoid Emerging Markets strategies because in fact adding the appropriate marginal weighting of a sub-strategy could be marginally incremental to absolute returns than additional risk for the said conservative portfolio. For instance, including an Emerging Markets - Asia ex-Japan strategy, with a positive Sharpe ratio of 0.13, would be a net risk-return benefit. Over the past 5 years, 0.14 is the median Sharpe ratio of all hedge funds performance.

Other strategies unsuitable for the CIO / Treasury portfolio may be the Equity Hedge - Sector (Energy/Basic Materials) Index, exhibiting 18% annualised volatility, the third riskiest sub-strategy in a mean-variance framework.

Attention Reader: Please understand that analysing indices is a similar process to evaluating the underlying or representative funds, i.e. unifying top-down and bottom-up analysis in hedge fund allocation decisions.

Important to recognise that analysing benchmarks is in effect studying averages. So imagine the complexity of the risk-return variations in the underlying hedge funds, in spite of the caveats of mean-variance framework.

* An updated version of FPM Hedge Fund Risk-Performance table using the third and final revision from HFR databases is available upon request when HFR Research Inc publishes final revision for March on May 1^st, 2012.

Macro Strategy Focus

In this paradigm of fundamental shifts in macro variables of global economies, our first and foremost recommendation for inclusion in a fund portfolio is a global macro hedge fund strategy. Chart 1 below shows the ‘stalwart performance’ persistence of the macro benchmark during this fundamental economic shift paradigm.  

                                Chart 1: Click on Image to View in Full Screen

FPM’s lead series of hedge fund managers who typically employ a global macro strategy, known as the “Commodities Corporation Offspring”, are Tudor Investment Corp (Paul Tudor Jones), Moore Capital (Louis Bacon) and  Caxton Associates (Bruce Kovner).

Despite the unspectacular 2011 performance of these three managers, as reported via Reuters in Most Global Macro Hedge Funds Suffer, Brevan Howard Thrives, we believe in the swings-and-roundabout performance of these leading lights. Of the top London-based global macro managers, there is at quick-pick Brevan Howard (Alan Howard) and Balestra Capital (James Melcher).

Of the two main styles global macro trading, discretionary and systematic, both styles had a difficult year in 2011. Witness Tudor, Caxton and Moore who tend towards discretionary. FPM Excel level screen dump below shows that the systematic style had the ‘Worst Drawdown % (& Period)’ of -6% between May and June of 2011.

                               Screen Dump 1: Click on Image to View in Full Screen

 

To the author this is somewhat revealing and indicative that the systematic models and algorithms which endured the peak of the credit crisis crash produced the worst drawdown in its aftermath! Since these global macro traders digest fundamental and technical data, the difficulty in generating performance suggest there’s likely to be a prolonged and incongruous flux between economic and market conditions.  Or as Simon Kerr, an independent investment consultant succinctly considers this dichotomy in his recent blog: “…If the fundamentals are still in gear with the original trade idea, and the outcomes are being driven for the reasons looked for then the trader will concentrate on the technical position”.

As FPM noted at the beginning of this note, about ‘this unique business cycle’, we believe their predictive powers encapsulated in the last 60 months of hedge fund strategy performance. Further that the regulatory and Fed-watching for policies, whether real or rhetoric dressing, and their outcome is crucial to economic and market comprehension by traders and investors. As if on cue for this article, just as much as double-dip was augured, and as FPM like to say “Stop Press!”: UK economy in double-dip recession!”

 

...Something More About Head- and Tail-Winds

Presented here are more provocative and sufficiently joined-up thoughts about market forces from the editor of FPM. Originally written before Christmas, but now posted with editorial screening. Also tempering health warning on the blog: this article published for highlighting prescient factors in the economy as much as for coherency or depth of argumentative analysis. 

While foreseeable indications point to more headwinds for the capital markets and economies in 2012 (as considered below), then by implication potential upside surprises is also augured. As someone who also doesn't like talking in absolutes I hope that makes 'hedged sense'. The below prescient comments makes up the body of the series on investment climate. Commentary continuing from Headwinds and Tailwinds: An Opening Salvo... ,which endorses FPM's wish to see Ron Paul nominated as Republican presidential candidate, and perhaps even President by the general elections.

Markets, Plays and Players

Market bears and shorts are in full parade now, projecting their managed-down realistic expectations about the corporate and economic climate outlook. At the same time globally concerted and unilateral policies are continually being hatched by politicians to restore confidence. Confidence is still fragile after the downturn from housing- and credit bubbles which started four years ago.  Amid the deleveraging cycle, it’s not inconceivable to witness a sudden turnaround in sentiment and subsequent upside extending towards pre-Lehman highs. This low probability optimism stems from belief that policy makers may produce a bold panacea to quicken deleveraging, such as addressing structural issues by say introducing inflation and consequent debt destruction. At FPM, we believe the benchmark S&P 500 moving down to 1,076 is the next support level more likely to be tested on the downside, more so than the 1,255 resistances on the upside. The latter resistance level is evidently the pre-Lehman high set on 15^th September 2008.

With such uncertainty capital market investors staying on the sidelines seems prudent. FPM believes there are select asset classes which are recession-proof. In circumstances where the cornerstones of investment performance, being asset allocation and timing trends, becomes trickier than avoiding awkward dating moments, then FPM recommends a select alternative funds exposure (‘SAFE’). Alternative Investment (AI) funds represent an array of multi-assets and myriad strategies, such as actively managed hedged equity strategies and macro funds allocating and timing between assets. Strategies which not only invest in plain vanilla equities and bonds as long-only investments, but potentially extending to commodities, real estate, and private equity and using leverage, derivatives and ability to short. FPM is supported in our general thesis of recommending select alternative funds for the foreseeable investment landscape by a master of hedge fund investing, Julian Robertson. In a recent CNBC interview he stated that the: “the [hedge fund] industry has a lot of legs because it is the best way to run money, the easy times are over."

                                                                                         

In light of global banks and other traditional lenders having been choked-off by new reserve capital requirements of Basel III and against a sovereign debt crisis, the shadow banking sector still has firepower and liquidity.By shadow banking system I refer to financial firms that practice global banking activities, which includes hedge funds, private equities, insurance companies, regional banks etcetera. Google plight of American insurance giant AIG, and Spanish & German regional banks in the financial crisis to understand their roles in the new financial services structure. So established asset managers and start-up ones as successful asset gatherers are increasingly taking up the capital-void left by investment banks. For example, hedge funds which are traditionally organised as proprietary trading desks are also making private equity and bank style loans. Remember hedge fund personnel often wear their investment bank experience as a badge of honour, highlighting the offshoot nature between global banks and shadow banking protagonists. See also FT's op-ed on 28th December:"Traditional lenders shiver as shadow banking grows"

FPM believes this defragmentation in the source of investment capital is an important development; a trend multiplied at the turn of the new Millennium.  No longer a core of ‘bulge bracket banks’ and other investment banks bear the risks they raise with lending and investing activities. Notwithstanding the influence of colossal players like Fidelity, Vanguard and Pimco as real cash investors. Risk being raised, sliced and disseminated too widely is at the heart of the financial crisis. The ability to break-down and transfer credit risks in debt / loan transactions via structured products, such as ABS and CDO products, DID MITIGATE WHOLSESALE DAMAGE to the banking system in the current credit crisis. That is, the whole global banking system was brought to its knees due to counterparty solvency and collateral quality concerns like that of Lehman and ABS, respectively. Hence the governments of Europe and US were opening up special liquidity financing window via EFSF and TARP etcetera. Instead of wearing the credit risk intermediaries raised, they were able to spread it via CDOs and the like in the fragmented shadow banking world and causing wider systemic consequences.

Head-winds:

 Sovereign Liquidity and Solvency: National debt restructuring speculation is expected to continue to be a fundamental driver in credit markets, and therefore by its significant size and threat of credit event the wider capital markets.

End-November 2011 European sovereign debt auctions reflected severe liquidity strains: Italian and Belgium 10-Year Yields Hit Euro-Era Highs. The sovereign debt burden of the Eurozone is not the only negative newsflow hampering the markets. US woes about Congress and Senate passing bills to extend and manage the national debt ceiling, currently above its constitutionally designated $15 trillion, is also major weighing heavy on investor sentiment. Most investors believe the reserve currency status of the US Dollar will ensure “at-any-cost” policies being enacted, despite the partisan politics and drama in negations.

e.g. Lithuania’s fifth largest bank, Snoras, was nationalised as Lithuanian authorities shut down the bank after it observed irregularities in the bank’s operations.

“…Hungary could become central Europe’s first casualty of euro zone crisis. Growth is poor, debt is high and a credit ratings downgrade to junk is likely. Disquiet over government policy is a problem and risks of deleveraging by Western banks are large. Hungary needs IMF funds.”

“…Cypres  acceded to the Eurozone in 2008, but it's already in a heap of trouble. A recent loan agreement with Russia of €2.5 billion will keep it afloat for a few months into 2012.” [Another Eurozone Country Bites the Dust]

The EU And IMF Watch In Horror As Everything Goes To Hell In Hungary [Dec 30, 2011]

Corporate defaults:  The global corporate default rate is expected  to increase to 2.4% from current 1.8% in 2012, with U.S. media and advertising and European business services companies worst affected, according to Moody’s Investors Service in a December 2011 report. There was a “considerable rise” in defaults in November, with 10 issuers rated by Moody’s missing debt payments. So far, 31 companies have defaulted this year compared with 55 during the same period last year.

Notably, these are not just small start-up failures. For example, MF Global was a $41 bn US broker-dealer who filed for bankruptcy on 31^st October 2011, becoming the 8^th largest bankruptcy in US history.

Stop Press: Saab declares bankruptcy as GM blocks Chinese deal. FPM is again on the money, focusing on the pertinent issues without blinkered parochial view!
Why does the market concentrate on one story at time?

Currency Wars: The manager of the world’s largest currency hedge fund FX Concepts believes the Euro currency is in “death struggle”. FPM cites this as one of many fundamental macro trends to identify and exploit in this dynamic global economic milieu. The long-term downward trajectory of the US dollar, mitigated by its reserve currency status, is another such trend. Also, the mean-reversion and fundamental re-rating plays in the Euro is inevitable (in its current form or re-structured form). Currently, the Euro at $1.34 is trading above its life-time average of $1.2044 because of debt purchases by the European Central Bank and European financial institutions repatriating funds.

Baltic states and other emerging countries re-aligning their exchange rates to reflect stronger and growing economies is of course another trend.

Radical Fundamentalism Wanted from US Presidential Elections: Unless real political and economic reforms are delivered to address US sovereign debt, yet another painful and steep deleverging cycle is anticipated. Another economic downturn precipitated by destabilising events, such as an unexpected Eurozone sovereign debt defaults / restructure, especially debts of the largest Eurozone sovereign borrower Italy, whose credit-risk premium may peak to unsustainable 7-8% levels.  See FPM’s take on the November 2012 general elections via a look at the Republican presidential nomination candidates, "The man we’re backing for president". With updated headline-value reinforcing demand for new era politics from those most concerned about their futures: Ron Paul Just Nabbed Iowa's Biggest Youth Endorsement

US Recovery Was Made in Washington: It has been hailed that the equity market and economic recovery from the 2007-09 recession was “Made in Washington”; through various quantitative easing and liquidity financing. QEI- and QEII–type liquidity pumping has helped to stabilise capital markets from a state of catharsis. The Fed purchased $2.3 trillion in housing and government debt in two rounds from December 2008 to June 2011. FPM without being cynical asserts that ‘policy smoke and mirrors’ were used repeatedly to support S&P 500 plunging by 20% from highs pumping liquidity to stimulate economic activity thus averting prolonged or double-dip recession (defined technically as a bear market); and by. In the UK recessions are generally defined as two successive quarters of negative growth.

In not precisely addressing the real issues of a major housing slump, financial crisis and now unfolding sovereign insolvency, the Volker-crafted Greenspan-era fixes are only as sustainable as national debt levels are manageable. FPM asserts more decisive ‘real pain policies’ are needed to counteract corporate and consumer profligacy and revolving government administrations passing the buck, in recent business cycles. The buck stops here!

Promptly raising interest rates should encourage profitable lending on the money supply side, and credible borrowing on the demand side by both consumers and corporations. Leading to high-yield seeking capital investment projects, and greater propensity for consumer savings generating much needed capital on the supply-side. Cheap money only means lower investment hurdles characterising prolonged Japan-style deflation and stagnation.

Current economic policy of providing low-cost re-financing via public finances is only assisting those corporate and individual entrepreneurs who borrowed and lent irresponsibly if not greedily. Their irresponsibility is being propped-up. Creditors should eventually be forced to write-down their investment interests in what is materially at the end of the day only inflated paper-money valuations i.e. trillions of currency in aggregated computer systems (data centres) or accounting book entries referencing real / absolute and synthetic / abstract investment returns. Which as the saying goes is not worth the paper its written on! De-leveraging is supposed to result in lower valuations. A cycle that can unfold over an agonisingly long-time like the Great Depression to clear itself, only if dynamic creative-destruction is held-up by status quo preservation. 

Instead of slow implementation of Dodd-Frank measures to give time and relief to debt-burdened entities, those watch-dogs and their over-sight policies with real teeth should be enacted immediately.  At the moment the weak corporations and sovereign countries are being picked-off by vulture-enterprise, bond vigilantes etcetera. If not directly causing a default or restructuring, these shorts-and-bear investors are certainly heightening anxieties among real cash investors. The latter of whom are therefore left perplexed and scratching their heads, at least according to the editor of this article on his meetings with the investment crowd.

P.S. Yet another sign of stalling recovery is that US domestic profits of non-financial corporations increased only $17.4 bn in the 3Q11, compared with an increase of $80.8 bn in the second quarter. Stark!

People Revolution Against Crony Capitalism: In times of national economic strife inter-government politics and indeed between debtors and creditors, and other cosy good-times fostered relationships become fraught.  Mis-allocation of resources from ingenuous economic enterprise should not be financially supported by national governments at the expense of its future generation tax burden. Voters in 2018 can expect to be a heavy taxpaying citizenry. A democracy run by government promotes individual freedom for its citizenry; otherwise rulers and society are organised and designed towards wealth creation for a minority of corporations and its core owners. This evidently is a plutocracy – not really a characteristic of a true and just democratic social organisation of people! This has also resulted in great inequalities in wealth distribution, in many nations and NOT FORGETTING that in a wider global historical perspective too. Witness the recent world-over civilian unrest, especially at the heart of modern capitalism through the nexus of Occupy Wall Street and we are the 99% protest movement. Even in London, United Kingdom, where human tolerance, social welfare and relative socioeconomic-geopolitical are stable there were looting and rioting in major city streets during August.

Wilting Confidence / Sentiment: We all know the importance of confidence and sentiment in economic decisions, and especially for propping up a house of cards. For instance, the Euro crisis causes continuing drop in confidence. Eurozone economic sentiment declined for a ninth month in November 2011 to hit a 2-year low, as heightened sovereign debt crisis coupled with weak global growth took its toll on confidence. The economic sentiment index fell to 93.7 from 94.8 in October, a monthly survey conducted by the European Commission showed. The reading stayed below the expected 93.9 level. There was a broad-based deterioration in sentiment across the sectors.

Caution Over Dotcom-Era Type Hype IPOs: In a light issuance environment for raising equity capital, the supply of issues could be expected to be of high quality and successful. Zynga and Groupon offerings demonstrate renewed difficult business climate following rebound in IPOs in 2010, and company-specific risks in e-commerce business models. For example, in November the three-year old website broker Groupon made headlines after raising $700 mn from its IPO, which valued the company at $12.6 bn. Following a dramatic first day boost (November 4^th), to above $31, the stock price at writing is $22.25 (December 12^th close). IPO price was $20.

  

Housing Recession is the Elephant in the Room: Since house prices peaked in mid-2007 the US housing-led credit boom and bust continues to be a drag on its economy, and by implication elsewhere too. A picture speaks a thousand words, as below: 

By understanding how much further residential house prices have to fall for the market to clear itself, FPM seeks to gauge  any turnaround possibilities in the world’s largest economy and its related US$ 11 trillion bond market, that of US mortgage securities. While there are many versions of HPI*** data, and analysis about house price inflation fuelled by reckless lending to facilitate demand from yield hungry mortgage security investors.

Currently there is a slow clearing process in the US housing markets thats about delinquencies and foreclosure practices, while mortgage resets have taken a backseat. The price of housing loans will be relevant in 2012. As unemployment situation and further house price correction takes its toll on mortgages and their securitised products. For example, delinquencies in securitised Alt-A mortgages were seen rising sharply, with Credit Suisse forecasting US$2.4 trillion of Alt-A mortgages in existence at the beginning of 2010. Also that most of these were due for rates reset in 2012. ***An FPM Monitor Situation*** 

Since foreclosure crisis is is expected to shift from subprime mortgages to outside of the housing sector, losses are also expected in the largest US$3.5 trillion commercial real estate.

More than following national price levels FPM Monitoring are watching data on job growth, mortgage purchase applications, housing starts, consumer sentiment and homebuyer traffic pointing to improvements in the housing correction. An asset bubble deflating is in fact the factor auguring protracted low growth economies. Despite the drawn-out and seemingly immense crisis in the Eurozone, this is only a side-show detracting from the US housing-led bubble.

> Data Point: The national foreclosure rate was 3.48% in September 2011 according to California-based business analytics provider CoreLogic



The Unemployment Drag: While official US unemployment exceeds 9%, notwithstanding higher unofficial estimates, policy makers have this aim of crucially reducing it, while juggling with set targets for inflation and keeping the lid on it.

Only Chicago Fed President Charles Evans has publicly supported the idea of allowing consumer-price increases faster than 2 percent annually as a way to lower unemployment. The interest-rate commitment should be contingent on joblessness falling to around 7 percent or 7.5 percent as long as inflation stays below 3 percent in the medium term, Evans said in September. Fed policy makers aim for long-run inflation of about 1.7 percent to 2 percent.

 Unemployment is also a stupendous problem in Eurozone countries, especially those that are at the core of the debt crisis. Spain’s jobless rate jumped to 22.8%. Among 16 to 24-year-olds, it’s a staggering 51.4%, up from 18% in 2008 when Spain’s crisis began with the collapse of its housing bubble. In Greece, youth unemployment reached 46.6%. In Portugal, it’s 30.7%, in Italy 30.1%.

Tail-winds:

Private sector credit workout moves unabated: Global credit management arm of Blackstone, GSO Capital acquired the   largest manager of leveraged loans in Europe in September 2011.

Orderly Mechanisms of Credit Default Swaps: While recent credit events have convened ISDA’s CDS determination committee there has however been orderly auctions and settlements, despite counterparty credit-risk concerns about contingency payouts.

Converging Traditional and Alternative Asset Management Practices: The expected trend in merging practices of traditional long-only investing firms such as Fidelity and Vanguards with savvy and flexible alternative asset managers, such as hedge funds and private equity is well underway. For example, lower management and performance fees for hedge fund investors, down from the heralded 2/20 fees, is a clear trend. This is inevitable as lower absolute returns of hedge funds, investing in severe market dislocations, makes 2/20 seem onerous. Also, 2/20 didn’t matter so much when annual returns were double-digit, and still irrelevant for hedge fund big-hitters delivering alpha performance, who will be entitled to charge premiums.   Together with other technical reasons like lower yields from low interest rate environment, and increasing supply of hedge funds, means annual performance expectations lowered. Consequently, “after years of poor hedge-fund performance, some pension managers are demanding better terms, including lower fees”.

Emerging Markets Emerge and Frontier Markets Come to the Fore:  Many expect the drivers of global growth to be from BRIC type economies, as consumer deleveraging and subsequent disincentive for corporate capital investment in developed economies stalls global economic recovery. FPM concurs with view that Brazil, Russia, India and China with other smaller emerging economies can continue to grow their undeveloped industries and markets. Even more optimistically, by 2015 i.e. 8 years from onset of crisis, FPM believes the mobilisation of consumer demand from these heavy populous countries will substitute for stymied western consumption.

FPM would also add another large population country to the BRIC acronym, conveniently coined by Goldman Sacs: Indonesia would enhance the acronym to ‘BRIIC’.

CDO / CLO & Other Structured Products: The accruing performance fee feature of ABS- and CDO-like structured products makes them still performing assets, with caveat about underlying asset quality. Not so toxic assets as initially labelled after the deluge of credit downgrades and subsequent fire-sale re-rating of valuations.  As witnessed by the amount of M&A transactions where cash-rich asset managers have been gobbling-up specialist structured credit managers .

Like vultures hovering to feed on the bounty of a large animal carcass, so it is with distressed asset managers circling European leverage loans and sovereign debt sell-off. The vulture analogy is not meant negatively but one to describe utmost practical functionality i.e. scavenging is useful in cleaning up decaying matter efficiently. Similarly, non-performing loans are acquired and serviced by investors in exchange for property or material rights the debt bestows. A vital creative-destruction process in capitalism, maybe an antithesis or corollary to private equity activity of build-and-harvest.

Regulatory Arbitrage From Reforms and Retribution: Incumbent politicians and their regulatory bodies are fighting to keep their nation state from sliding into debt difficulties. Governments have to do battle with creditors who desire to preserve their wealth by keeping debt paper values whole. At the same time alternative investors or shadow banking entities are speculating on the next hand that policy makers’ will play. Their speculation via CDS on bank and sovereign debts is evidently bringing governments and banks to their knees, at least in the theatres of the Eurozone and US credit banking. Witness yield spreads movement on sovereign debt following policy-maker news flow this year.

Citing wider negative consequences to public assets in the form of our pensions and other saving investments there is justifiable reluctance to allow creditors, mainly banks and money managers to go to the wall and voluntarily write-down or write-off sovereign debts or other entirely. Capitalism’s doomsday scenarios arise from systemic consequences of letting strategically important global banking swallow the pain of their irresponsible credit expansion. Notice the perpetual moral hazard and its irony i.e. of being caught between a rock and a hard place.

In today’s headline terms, mainstream media supplied by vocabulary-edited editors (who in turn are dictated to government agencies of propaganda) confusingly inform professionals and public about debt ‘haircuts’ and ‘orderly’ bankruptcies and ‘voluntary’ debt defaults. Language is power and it is wielded like the sword by those who can! We all remember how ABS structured products termed ‘toxic assets’ were euphemistically re-phrased ‘legacy assets’.

Authorities have no wish to see bond and other term financing markets seize-up (like the ABCP market at the onset of US Subprime collapse catalyst). So lead-debtor-nations (LDNs) within fiscal trading blocks or otherwise, and their watchdog multi-lateral agencies such as the EU, ECB, EBA, FED, IMF, World Bank etcetera keep the banking system afloat at the behest of Ben Bernanke by "printing" bank credit. From the same revealing Henry Blodget of BusinessInsider.com article citing Mark Dow of Pharo Management:

“All that printing has made banks' "excess reserves" explode, which means [banks] have a ton of lending capacity if they want it… because the banks themselves need to deleverage: They need to build up their capital levels relative to their asset (loan) levels. And making new loans won't help them do that… In other words, most of the money Ben Bernanke is printing is sitting in bank accounts at the Fed, not finding its way into the economy. And because it's not finding its way into the economy, it's not destroying the value of the dollars that are already in circulation…”.


At FPM we have identified dealer pricing / marks in bond markets as an indicative of banking liquidity, in light of Basel III, Dodd-Frank and Euro-woes. (See video below with Troy Gayeski, senior portfolio manager at SkyBridge Capital).

FPM therefore argues that in the long-run banks cannot be supported by LDNs printing bank credits. As this will lead to and / or exacerbate structural deficits in debtor countries. Structural deficits ARE NOT advocated by Keynesian economists, only that “deficit spending is desirable and necessary as part of countercyclical fiscal policy”.

A sovereign credit default / event like Greece would be a catalyst equivalent to the sequence of events that led to the ABCP markets freezing-up as rating downgrades of structured subprime mortgage securities unfolded in 2007. The obvious difference is the scale of events; which would be a greater seismic event, as opposed to a tremor caused in ABCP short-term funding market, in earthquake parlance.

Whilst threatening liquidity financing problems via interbank 

S.E.C. Sues 6 Former Top Fannie and Freddie Executives

Attorney General Expect to Reach Settlement Before Christmas
FDIC Announces Settlement With Washington Mutual Directors and Officers

Headwinds and Tailwinds: An Opening Salvo...

On the date of posting this initial comment of a series of collective thoughts about the investment climate ahead, the US equity markets closing headline from Bloomberg is 'Dow Jumps Most Since 2009 as Central Banks Take Action on Crisis'. The investor cheer was largely to do with announcement of concerted central banks action to pump more liquidity in the financial system. An engine doesn't run without oil. 

As a contrarian to such ill-warranted and purely short-term speculative enthusiasm by market practioners, FPM is prescribing  for the discerning investors a  dose of economic reality-check from the man who doesn't 'talk in absolutes'. Yes we mean Texas Republican and Rebublican nomination candidate  for  the 2012  presidential elections Ron Paul. This article and CNBC interview with Ron Paul from TheStreet.com about today's world wide quantitative easing announced by prominent central banks, is the on-the-money dissection of existing financial policy measures (as pioneered and practised to death by the Chicago Business School professors and alumnus during the Reagan era and onwards to present day).

The man we’re backing for president: FPM supports Ron Paul as the GOP / Republican candidate for President in 2012 general elections. He is a credible, strong and self-willed politician with real reform plans to address the disastrous economic global highway "the western hegemony" is heading down. United Kingdom had such a bold leader in Prime Minister Margaret Thatcher in the 1980s. She was making hard decisions towards much-needed economic reforms (that also admittedly introduced the unfortunate runaway capitalism of today, and blindly unchecked by her vote-pandering weaker successors).

The other front-running Republican candidate Mitt Romney is backed by  powerful hedge funds and other heavyweights. Mr Romney only has plaster-fixes for the economy which  most hedgies, such as John Paulson (of sub-prime fame), knows preserves status quo of financially exploitable opportunities i.e. creative-destruction. Radical reforms of Ron Paul's manifesto would undermine the cosy crony capitalism, and represent an uncertain upheaval in policy direction of the past 30 years or so.

 Pointedly, remember that Mitt Romney was a founding partner of global private equity behemoth Bain Capital in 1984.A shadow-banking partnership which now manages $66 bn in assets (as at end 2011),  across its various platforms. Platforms that also include multi-billion dollar hedge funds Brookside Capital, Sankaty Advisors and Absolute Return Capital. These financial affiliates pull strings in economic affairs as campaign sponsors and financiers of lobby groups. Such financially entrenched organisations and their leaders can only openly predicate a economic setup for the wealthy i.e. a socio-eco-politcal establishment organised for the benefit of the 1% of world population. Where does that leave the man on the street or the 99%ers?


In full-picture FPM style we briefly introduce the other main candidate for the  Republican nomination . Newt Gingrich is a mixed bag electioneer with persistent political pedigree with many successes and a few skeletons in the proverbial closet. 



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Addendum 02 Feb 2012: In joined-up thinking FPM have incorporated two current headlines and a glue. The glue being an idea from a pertinent short-story by Charlotte Perkins Gilman, written 100 years ago and entitled "When I Was a Witch". A feminist writer who in this story imagines how she would deal with some of the 'wrongs' of her day.
So on my seeing a list of mainly capitalist financiers backing Mitt Romney for US Presidential candidate (see Federal Election Commission of USA full list), and then seeing "Texas Fund Eaten Alive By Hedge Fees May Curb Costs By Hiring In-House", I had a premonition. What if all the contributors to Romney's campaign had all their proceeds 'eaten-up' in massive promotional campaigns that came to no fruition. That is, their man was not elected for Republican presidential candidate, and instead business reformer Ron Paul was eventually elected President. This would be an ironic lesson to hedgies et al who take maximum performance fees when luck is in and then continue to collect minimum management fees when markets are against them and their investors lose out. The voting US public still have power over this premonition.They can squarely stymie the swagger of the mover-shakers protecting status quo.

The Search for Alpha: Soros of the Euro?

We know hedge fund managers are out there but are they "really out there", say with with a macro play to break-up the Eurozone's common currency the Euro? Like the one George Soros spearheaded causing the exit of the British Sterling from the European Exchanage Rate Mechanism in 1992? 

It's pertinent question for all money managers following the 3-pronged EU deal this week to address the uncertainties about the Euro debt / currency crisis:

1) Leverage the European Finance Stability Facility (from Euro 440 bn to Euro 1 trillion+).

2) Recapitalise the Banks to withstand provisions for debt losses.

3)  Debt relief for Greece of 50% from private sector debt holders.

The macro play is also pertinently linked to concerns about the the validity of alpha creation and generation in the hedge fund and wider alternatives space. That is, do managers herd around common  trades, or do they go out on a limb with research or applying other edge? 

George Soros, the billionaire hedge fund investor, renowned for his macro trade of betting against the British Sterling is well documented. What may now be mere detail and packaged neatly into the recess of memory as "Black Wednesday" should have resonance as an important lesson for today. The interpretation that the British pound was  deigned as overvalued in its entry into the ERM, from macro fundamentals research, was something that eventually undid the Bank of England. Earning Mr Soros the title of "the Man Who Broke the Bank of England", for making the astute judgement and wager, which reportedly earned him $1 billion dollars.

Similarly, Greece's entry into Eurozone was under false premise about its fiscal deficit, which was understated by as much as half of Greece's actual debt. Whether Greece’s entry was politically and discretely made expedient is for the regulators and other investigators. This malfeasance with Greek ascendancy to Eurozone membership did come to light and the 'truth outted', plunging Europe  into ongoing exacerbated currency and debt difficulties. Not to mention the spectacle provided for the public and media by the Germans and Greeks to exonerate any suspicion of misdemeanours (see picture below).

From even basic / preliminary research and insight, FPM understand there are strong possibilities for Euro restructuring i.e. of countries exiting and entering the status quo 17 member common currency union within the next 1-2 years (yes the art of forecasting is to indeed tell both the date and event not just either / or!). And over a longer horizon, that an eventual complete break-up of disparate countries making up the European Union is a probability. FPM is of the summary view that EU has once again kicked the real issues of Euro currency and debt into the long grass, through its latest bail-out plans. The 3-pronged response of the EU (listed above) awaits a few days’ market reaction before setting-in-stone the announcement at the G20 summit in Cannes on November 4, 2011. The market reaction was not good, as few days after the Greece-fix, Italy’s borrowing costs hit record highs. The next target for bond vigilantes since Greece debt default is seemingly shored-up – a pyrrhic victory.

Before emerging markets’ currencies were forced to devalue often it was preceded by an IMF-prescribed attempt to restructure internal and external deficits while the country’s central bank defended its exchange rates. Extrapolating from such market behaviour, the Greece saga is a prelude to the single currency restructure, with ironically now stronger emerging markets countries such as China  invited to contribute to the improved EFSF!

Two op-eds in the Financial Times in February 2010 serve as an FPM research benchmark for its views. The first article is by Ottmar Issing, described as “one of the fathers of the euro”, entitled Europe cannot afford to rescue Greece and the other is by Mr Soros entitled The euro will face bigger tests than Greece.

Without concerning this FPM thought piece further about the multitude of factors surrounding the Euro's break-up or restructuring possibilities, the other point of this article, as hinted in the investment feasibility note, is indeed whether there are bona-fide hedge fund managers with a long-term fundamental alpha strategies? The Euro currency break-up would be great alpha play in the creative-destruction mode. FPM expected and understands the windfall short-term trading flows on Euro policy news. Demonstrating alpha capture or simply independent thinking, global debt problems was initially unravelled by the US-housing bubble bursting through subprime sector activism by John Paulson et al.

There have been many numerous researches about hedge fund managers not seeking or capturing real alpha, and that most hedge funds are really beta in alpha clothing, with simple crowding around particular themes and plays. This paradox even questions whether active management is indeed occurring, as opposed to “closet trackers”. Please refer to excellent truth-outting investigative journalism “Don’t believe the fund manager’s hype” by Alice Ross writing in a weekend FT Money supplement in the Serious Money section.

A caveat about the much touted link between hedge funds and alpha, is that traditional long-only portfolio managers may also seek alpha strategies, or simply lead or stand-out from the investment herds. Unashamedly Bill Gross, manager of the world’s largest bond fund ($242 bn FuM) for Pimco - a subsidiary of Allianz group of companies, was on record as wagering on a rise in US interest rates this year 2011. Though this contrarian view contributed to 10 months of poor performance and hardly representing alpha-type returns, such a leading bond investor can take an “out there” view – even if on this occasion a wrong-way bet. Since Operation Twist, of Federal Reserve policy of controlling long-money rates, Mr Gross is betting on falling interest rates.   

FPM draw parallels between the evolving hedge fund industry  and the investment era at the beginning of the current Millennium. At the turn of the centuary the investment bandwagon to ride was all things "dot.com" related. An example folly of this era was when Time Warner, a respectable giant media corporation, merged with the then new and highly valued e-commerce company Aol.com. The merged company changed its name even to AOL Time Warner (Editor's texting moniker: ROFL!). In a similar way there are many new and emerging asset managers jumping on the "hedge fund" bandwagon.  Considering negatives, these emerging managers may be mere “me-too” players. The positive potential in these emergent managers may be to discover a unique long-term trade and attribute their name to it.  Actually discovering a novel strategy in their investment process and generating alpha would set themselves up in the premier league of instutionalised hedge funds. As John Paulson did with Paulson & Co., betting on the subprime before this financial crisis.

As a final citation about the state of hedge funds and the character of the principals behind them and subsequent investment strategies, I defer to FPM’s select gurus of hedge funds, Ray Dalio of Bridgewater Associates. In his long presentation I refer to his comments from 3.20 minutes onwards about independent thinking and alpha.

Also, this article is not simply posing a rhetorical or hypothetical question but an actual one – please email FPM (fpm@talktalk.net) if you are, or know managers, with the Euro break-up as long-term macro strategy. Who’s really out there?

Implications of Operation Twist on Asset Allocation

While main stream media and popular press "bang on" about sovereign debt, economic slowdown and downgrades in unison head-scratching about mid-year market declines, the practical aspects of trading these volatilities in capital markets is the management expertise of leading investors.

Leading asset managers re inevitably embroiled with global policy makers to best ascertain future policy impetus and implications for asset allocation shifts. For every twist and turn of central bank and government policies market participants get their heads around it and react with asset allocation decisions. Such as the implications of August 2010 annual Jackson Hole speech by Federal Reserve head Ben Bernake, which paved the way for what became Quantitative Easing 2 (QE2).

Since the 2H 11 global economic headwinds reflect possibility of re-entry into recession if not a slowdown, Ben Bernake and company have this time introduced Operation Twist as the subtle tinkering tonic for the capital markets aiming to ultimately restore economic confidence. Operation Twist attempts to control long-term interest rates instead of the usual monetary tool to direct short-term interest rates.

FPM's read on the intended consequences of this policy impetus is that the debt maturities are being extended or cheap money is available with longer time to re-pay it. The policy implementation is via open market operations to sell short-dated treasuries and use the proceeds to issue long-term bonds. If this action were applied and compared to a corporate credit referenced by default swaps it would be deemed by the International Swaps and Derivatives Association, the trade body for the derivatives market ISDA as “credit restructuring event”. I am reminded of bond tender plans e.g.. by Anglo Irish Banks and ISDA's verdict.

FPM’s high conviction belief is that in the week beginning 19^th September and especially since Wednesday 21^st September’s FOMC statement at 2:30pm announcing Operation Twist, portfolio realignment is underway. A shift into accessing cheap long-dated credit is currently the modus operandi of select institutional investors. Equities, and even safe-haven gold and to some extent commodities have been sold off  in anticipation and reaction to the Fed’s “twist” on the policy of using its balance sheet to boost financial assets – QE3 became a no-go policy! FPM bases this market opinion on the liquidity cycle’s observation about the flow of money between asset classes.

Remember that QE2’s support for fundamental issues such as jobs growth and on wealth effects seem uncertain. The financial asset purchases created mini asset bubbles which peaked in late April for equities, as indicated by bellwether S&P 500 reaching 1363. Since July 22 the same benchmark has been down-trending.

Notwithstanding the distraction of the ongoing Greek tragedy, together with this week’s downgrading of Italy’s credit rating by S&P, and contemporaneous credit downgrades of bellwethers financial services Citigroup and Bank of America, a new uptrend in investment assets is in the offing, at least until there is a new twist from economy and markets.

Credit Markets @ Workout Inflexion Point

During the private equity leveraged-buyout boom and the housing bubbles in the US and other developed countries, and up to the height of the financial crisis, demand for leveraged- and mortgage  loans came mostly from structured finance offerings such as collateralized debt obligations (CDOs) and mortgage backed securities (MBS). Since the 2007 sub-prime driven unravelling of structured credit portfolios, with inherent flawed model assumptions, the subsequent clearing of debt markets has been incessantly underway. The ‘workout’ in identifying fair-value of these hard-to-value assets, which had been battered in the ensuing ratings downgrade and plummet in mark-to-market valuations, is showing dividends. 

As a turning point and until the sovereign debt turbulence of August 2011, there are both obscure and vivid examples of the clearing of credit market. Adjectives for loans, credit and debt have become prominent in recent financial vocabulary, with descriptions such as “delinquent”, “non-performing”, “in forbearance”, “distressed”, “credit quality” etcetera. The premise for FPM’s inflexion in credit assertion is based on interest rate and credit cycle and plethora of credit-related market activity.

Micro Workout Amid Macro Stability

The micro-economic aspects of asset bubble economies of 1998-2007 are and were being fixed amid macro-economic monetarist stimulus, introduced by the then chairman of the Federal Reserve, Alan Greenspan. Asset bubbles bursting, whether related to emerging markets-, technology / TMT, or sub-prime housing, inevitably leads to recession and recovery periods.  Recent stimulus included the massive re-capitalisation of banks to preserve their regulatory capital requirements from the effects of withering asset quality valuations in structured securities (and ‘ballooning’ notional CDS exposures – look out for “CDO vs CDS”, an FPM note to follow). The new paradigm of easy credit from central banks’ “pump and prime” such as low interest rates and government tax relief prevented asset bubble recessions spiralling into protracted deep ones while solvency issues were sorted at the micro level.

FPM has collated some evidences of active loan markets including the purchase, unbundling and selling of pooled loans, and higher recovery values. Also indicative of restoring economic order and confidence are the multiple legal cases surrounding mortgage securities mis-selling etcetera. Litigation and settlements may not seem a credit quality issue other than its confidence-restoration link to the structured securitization debacle. FPM’s insight suggests these litigation and resultant outcomes affect investors holding these mortgage debt or leveraged loan secuirities, at least their recovery values in situations of loss-making positions. Mortgage litigation losses remain a dark cloud looming over financial services. As is the impact of forebearance. The Bank of England warned in its semi-annual Financial Stability Report this year that it may explain the lower rates of arrears and repossession for homeowners in this recession than in the last (See FT article: Iceberg of soured loans hides true losses).

Mortgage Loss Litigation 

After the fire-fighting period post-Lehman 2008, the SEC started initial investigations into the mortgage-bond selling by suing Goldman Sachs in April 2010 over the Abacus 2007-AC1 deal. Then broad-based investigations and subpoenas ensued in the autumn / fall of 2010. The results of law suites, litigation and settlements are now unfolding in the 2H11; as are independent fresh cases such as the July 2011 lawsuit filed by China Development Industrial Bank. CDIB claims that Morgan Stanley "misrepresented the risks" of CDO called Stack 2006-1 Ltd.

Some of litigation workout examples augur mixed fortunes for indicted banks. In June 2011, it was reported that JPMorgan Chase agreed to pay $153.6 million to resolve US SEC charges that it misled investors in a mortgage-related CDO, named Squared CDO 2007-1, it constructed for Magnetar, an Illinois hedge fund. Similar settlement later that same month when Bank of America completed an agreement to pay $8.5 billion to settle claims related to subprime-mortgages securitization (via mortgaged backed securities). This last settlement represents one of the single biggest, related to 20 institutional investors including fund management behemoths BlackRock and Pimco. Clearly such steps, ‘clears the slate clean’ of the malfeasance in securitization and ensuing financial crisis. As caveat, this author’s optimism is tempered by headline risk of such reported settlements.

Stop Press: FPM told you so! As of 2^nd of September 2011, Federal Housing Finance Agency of the US is suing 17 banks for losses related to mortgage security mis-selling. Adding to the current on-going market jitters, the 17 listed global banks including securitised mortgage players such as GE and Countrywide Financial and First Horizon National, had their stock prices marked down between 2 and 8 percent on the news. These traded lower due to additional liability to banks’ capital stemming from the potential new litigation losses (up to $20 billion mentioned) related to the selling of some $120 billion of RMBS.

FPM long-memory research reminds us that banks churned out $1 trillion plus of CDOs and the like. These structured ABS with multiple ‘tranches’ led to some $2 trillion of writedowns and credit losses for global financial firms since the start of 2007.

Also, since 2000 the leveraged loan market grew significantly, and at the end of 2007, the market for leveraged loans was worth $1,061 billion, making it the largest corporate debt market.

As for the biggest asset-play market, US mortgages not held by Government Sponsored Entities (GSEs) but in private mortgage conduits accounted for nearly $3,000 billion at the end of 2007. These non-agency MBS in the US accounted for $1,800 billion at the end of 1Q2011, according to the Federal Reserve. Remember the total mortgage debt outstanding held by major financial institutions, Federal and related agencies and mortgage pools or trusts is $13,700 billion at end-March 2011 (similar in size to the entire US GDP).    

CLOs Transform into Mutual Fund Offerings

The institutionally-held investments in securitised debt, rashly generalised as ‘toxic assets’, are being repackaged into simpler mutual fund structures (both closed-end and open-ended varieties). These portfolios’ constituents are primarily private-equity leveraged loans and/or securitized home equity loans with short- to medium-term refinancing instruments.

Indicative of credit workout, noticeable that in March 2011 Apollo Global Management, a top 5 global private equity firm providing loan-financing; and a large exchange-traded fund (ETF) manager Invesco PowerShares, both launched portfolios where the underlying is ‘legacy’ loan paper.

Apollo’s closed-end fund (CEF), a long-only mutual fund with limited issuance of shares and traded on exchanges, constitutes floating rate notes or FRNs.

FPM’s new-trend-notice reflects that FRNs have become “attractive option for refinancing loans”, as confirmed by Paul Hatfield on Creditflux.com. The pre-financial crisis model of borrowing short-term through asset-backed commercial paper (ABCP) market, and lending / investing in longer-term higher yielding assets (such as CDOs andCLOs), is a model that broke down during the financial crisis, by its functional seizure.

Invesco Powershares’s offering became the first ETF for corporate bank loans. The ETF tracks the S&P/LSTA US Leveraged Loan 100 Index, a basket of the 100 largest and most liquidly traded loans.

Investors have allocated cash into mutual funds that buy such loans, increasing the assets managed to $37bn as at February 2011, according to Lipper the fund tracker.

AXA Investment Managers in Paris, with a division specialised in structured credit, were one of the early users of the CEF structure for ABS investments via its Volta Finance (ticker: VTA). Which invests in corporate credits, CDOs, ABS, leveraged loans, and infrastructure assets. Since the launch in October 2006 pre-crisis and the systemic crash in 2008 there is an up-trending price recovery (See Chart 1). Another Amsterdam listed CEF, Tetragon Financial Group (ticker: TFG), launched in 2007 also experienced similar price slump in the 2008 but has bounced back stronger (see Chart 2). Further primary fund analysis is required to understand the performance difference, whether due to better underlying loan picking or refinancing etcetera.    

  

Another notable structured products CEF vehicles is the Carador fund (ticker: CIF) managed by GSO Capital which is owned by the Blackstone Group.

FPM believe this repackaging of underlying credit is better suited to CEFs as opposed to open-end vehicles or the defunct and complex CDO model. With mutual funds the investor acquires only stock / equity in a regulated, pre-defined product life-cycle with access to the performance of underlying commingled loans. Unlike CDO structures there is no holding of subjectively rated tranche debt paper or “waterfall payment” of interest or principal related to seniority of bond-holding and correlation of loan defaults etcetera. All investors in mutual funds have equal economic interest as equity shareholders with income and capital growth expectations, ceteris paribus.

Distinguishing between open-end and closed-end mutual fund structures investors are advised to consider CEFs as long-term investments. A secondary market in CEF fund sales-trading ensures possibility of liquidity. Where the bid-offer price for the underlying CDOs, inclusive of securities transaction cost, is perhaps referenced to a proxy benchmark, say Markit CDX North America Investment-Grade Index. Already analysts have expressed some concern at illiquidity in the underlying loan market.

Structured-Debt Hedge Funds

According to HFRI hedge fund indices and FPM analysis the top-performing investment strategy is the Relative Value Fixed Income Asset Backed.  This strategy’s benchmark produced 39.8% compound over 4 years ending June 2011 (or 8.7% annualised). FPM research recommend performance and diversification strengths of eight hedge fund managers with expertise in fixed income and particularly securitised ABS, either in mortgages and/or leverage loans (as listed below). For example, the mortgage funds’ securitised debt strategies may specialise in pre-payment sensitive mortgage-backed securities, which show little correlation to other markets. Leverage loan plays include Par structure CLOs.

Aladdin Capital	The Aladdin Opportunity Fund was launched in mid-2008 with the goal of profiting from knock-down value across asset-backed securities (ABS) markets.
Cairn Capital	European ABS and leveraged loan specialist launched its Cairn Capital Structured Credit Fund “to capitalize on current dislocations and opportunities across the spectrum of structured credit”
Cambridge Place Investment	Cambridge Place specialises in asset-backed debt and related instruments, including private investments and real estate.
Chenavari Financial Group	Toro Capital 1 has produced gains of 27.8% over the first six months of 2011 and 338.7% since inception in June 2009, and managed by 36 years old Frederic Couderc.
CQS (UK)	The CQS ABS fund has returned an annualised 35 percent since launch in October 2006 to date end-June 2011.
GSO Capital	The credit trading arm of Blackstone Group launched GSO Capital Opportunities Fund in 2008, and gained 13.5% net internal rate of return. They have launched a second fund in June 2011.
Structured Portfolio Management (SPM)	SPM's mortgage backed arbitrage fund Structured Service Holdings claimed top spot for 2010 in Bloomberg’s Top 100 Hedge Funds with gains of +49.5% (following the fund's 2009 returns of +134.6%)
Tetragon Financial Management (formerly Polygon Credit Management LP)	Senior secured bank loans (aka leveraged loans) constitute the main assets of Tetragon Financial Group.  TFG gains exposure to these assets through existing and new investments in the residual tranches of CLO and CDO products.

Table1: Source: FPM

Plethora of Credit-related Market Activity (See also Addendum below)

The unbundling of securitized debt and subsequent realization of value is the credit market propping mechanism or trend that FPM are highlighting in this note. Repackaging debt is in itself is not a new financial solution: remember the Brady bonds of the late 90s, where an emerging markets bubble and subsequent debt overhang from bank issuers, were resolved by the debt being wrapped with IMF guarantees and sold into the market.

The equity tranche or first loss tranche of structured ABS is even in some leveraged loan structured products showing value. The above mentioned Volta Finance fund managed by Axa Investments reported in June that its CLO residual holdings or CLO equity positions were being marked at 75% of par on average. CFlux’s secondary CLO index levels of Dollar denominated equity tranche shows 46 cents on the dollar as at end August 2011. This suggests an entry point in such plays. Arbitrage across the spectrum of structured credit certainly exists. CLO management agreement transfers is an active market due to nuances of terms contained in the structures and discounted prices of these assets with inherent time-value if not as yet intrinsic value. (Await forthcoming structured product “CDO vs CDS” FPM research).

Citi Capital Advisors, a unit of Citigroup, led firms taking over the management agreements of $4.5 billion of CLOs in the US in August alone. There are also plenty evidences of fund raising to get in on the action. CQS, a hedge fund mentioned above, announced in June that it is capping the CQS ABS fund, launched in 2006, after it has raised $2 billion. The fund then managed $1.6 billion. Other fund-raising efforts announced at similar times this year are by GSO Capital, planning to raise up to $3 billion, and Avenue Capital aiming to gather as much as $2 billion to focus on investing in the debt of US companies. Remember this secular trend started in early 2010 of the credit cycle, where Fortress Investment Group bought two businesses with a total of $13 billion in CDO assets. Carlyle Group acquired the collateral management contracts for 11 CLO funds managed by Stanfield Capital Partners. Carlyle also took a 55% stake in a long-short credit hedge fund Claren Road Asset Management.

Also indicative of credit comeback is the Rothschild Asset Management take over of credit manager Elgin Capital. Elgin’s other credit funds had closed during the credit crisis, with the remaining business being the management of four CLOs. Consolidation in the structured products by larger well-backed institutions capitalizes on fund-raising difficulties weaker rivals face. This trend is natural and expected in the credit cycle and FPM has highlighted its significance for investors.

An obscure but relevant statistics about the state of credit markets is the level of balance sheet write-downs or write-ups of credit assets. FPM noticed that US banks’ revenues from credit trading were lower in 1Q11 on quarter-to-quarter basis with 2010. Office of the Comptroller of the Currency reported in its 1Q11 Quarterly Report on Bank Trading and Derivatives Activities:

“…The relative absence of these write-ups in 2011, compared to both 2009 and 2010, explains the difference in trading revenues in these periods.”

   

FPM interpret this “relative absence of write-ups” on legacy credit assets as signal that fair-value in mark-to-market is now accomplished, and further that credit issuance and trading is set for revival. Less credit business explained the overall lower bank trading revenues, therefore means of growing credit revenues will be an imperative for banks.

However, FPM author feels that this may come from higher interest rate environment, but that not being a credible policy option now; other credit flows will need to be substituted. Possibly, increasing syndication and trading in sovereign debt, as witnessed in August and into September this year.  

FPM’s Contrarian Credit View

The corporate credit-boom, credit-crunch and subsequent workout in the financial services sector have been cyclically profitable – with entry points provided by uncertainty in economic fundamentals, such as current concerns about policy makers’ ability to deal with sovereign deficits and debts. A case-by-case analysis is certainly warranted rather than the broad-brush treatment. As this if to highlight this concern, Bank of America through its acquisition of Merrill Lynch and Countrywide Finance still faces a situation of dealing with $1 trillion of problem home mortgages.

The final positive note is that the credit comeback started in mid-2010. Singling out the largest corporate debt markets as an example – see Chart 3 below, FPM feel confident in confirming Credit Markets @Optimistic Workout Inflexion Point, despite August sovereign debt news-flow. This assertion is time-stamped using US Market screen-shot from Google finance page on 9^th September, 2011: alternative for FPM to being a contrarian cash investor (Chart 4). 

Chart 3

 

Chart 4

Addendum 

Lloyd Bank (UK) is accelerating its sale of bad commercial property loans. In 2010 it sold about £4 bn of real estate loans through "forcing an administration or encouraging and investor exit". In May Lloyds  marketed its first sale of a portfolio of distressed property assets, making £1.8 bn in 1H11 propety disposals.
The Bank still has about £23.7 bn of troubled real estate loans, while Savills estimate about £350 bn of outstanding debt in the UK commercial property market. The sale is expected to managed by  JPMorgan Cazenove and is currently in early stages.