Equities markets continue to take a beating as weakness initially stemming from failure in the subprime credit market takes hold throughout the economy. And despite Thursday’s late rally that eliminated a more than 300 point loss, the full affect of the fallout from the credit crisis has probably not yet been seen.
We discovered an interesting item in a letter from failed hedge fund Sowood Capital Management to its investors. Sowood dropped more than 50% in July and sold its remaining portfolio to Citadel Investment Group according to the letter. As their losses from their exposure to credit markets grew deeper in mid and late July, Sowood Managing Partner Jeff Larson noted that the collateral put up to back trading positions was being downgraded by counterparties. Larson wrote, “Our counterparties began to severely mark down the value of the collateral that had been posted by the funds.”
So they not only had exposure to credit markets in their positions but also the collateral used to establish those positions were subject to massive market adjustments.
We do not mean to spotlight Sowood here — judging from their response to investors and in that they are returning incentive fees earned the previous year—they appear to be more responsible than many other funds that have experienced severe losses. It just seems to explain how we have gotten to the point we are at.
Sowood didn’t deal directly in subprime loans but its losses were the result of that market’s meltdown. It appears that the problem is not so much high risk securities based on bundles of subprime loans—but high risk securities being dressed up as low risk securities in the form of investment grade securities.
Recent stories in the financial press have taken aim at rating agencies that appears to have given unduly favorable ratings to securities based on bundles of subprime loans. Those securities — the theory goes — made it easier for mortgage banks to make more marginal loans, which can then be bundled and sold as investment grade securities. It becomes a vicious circle. And hedge funds investing in high risk securities is not even the problem as much as using these high risk securities—dressed up as low risk investment grade products—as collateral for other investment activity. Hence, now that these securities begin to be priced appropriately, all the myriad of investments and positions taken, backed by these securities have to be unwound because the collateral that back them is no longer adequate.
That suggests a lot more selling after credit agencies take a second look at how they rate a lot of thes new fangled securities. There will be plenty more to learn when the post mortems on this particularly market crisis are complete. Additional rules and regulations will but put in place. But one has to question how a volatile investments can be used to back the trading of other volatile assets. It seems to be a recipe for trouble.
