The WSJ this weekend came out with its post
mortem of Sowood Capital, the hedge fund started by former Harvard high-flyer
Jeffrey Larson which imploded spectacularly in July. There’s nothing particularly
surprising in the story (too much leverage, not enough capital), but I did get
an email from a reader asking about this passage:
By the beginning of this year, Mr. Larson was worried about many kinds of
riskier debt investments, according to people familiar with the situation.
To protect himself and take advantage of those risks, he bought senior debt
securities and sold short, or bet against, a range of investments generally
viewed as more risky, such as junior debt securities and various stocks.
Mr. Larson’s strategy depended heavily on using borrowed money, or leverage.
Because he was betting on small movements — such as whether a company’s senior
debt would go up more than its junior debt went down — he borrowed as much
as six times the firm’s capital to generate respectable returns when his bets
were right.
My reader asks, sensibly enough:
The first paragraph seems to be referring to senior and junior debt of different
issuers. However the second paragraph seems to be talking about senior and
junior debt of the SAME company. Under what circumstances would a company’s
senior and junior debt move in opposite directions?
It’s a good question. And the simple answer is that markets are unpredictable,
and that just about anything can happen, often for no good reason at
all.
But there is actually a reason why the Sowood trade went sour, and
it centers on the whole phenomenon of highly-rated debt. Many investors are
very risk-averse, and buy only debt with high credit ratings; they often restrict
themselves to AAA-rated securities. Indeed, the demand for AAA-rated paper is
so high that an entire securitization industry has essentially sprung up in
order to create enough supply of such stuff, which always trades at tighter
spreads than capital-structure theory would imply.
Or always used to, anyway.
In July, a lot of market participants lost faith in the credit ratings in general,
and in their AAA ratings in particular. Suddenly, it came to light that some
(not all) AAA-rated securities were much riskier than the markets had previously
thought. People had understood the risk inherent in the lower-rated tranches,
and so they paid lower prices for them, or demanded higher coupons. So to a
certain extent the risk was priced in, with those. But because AAA-rated securities
were erroneously considered risk-free by some of their buyers, they often traded
with no credit-risk premium embedded. And to make matters worse, many of those
securities were also extremely illiquid.
What’s more, risky securities are generally held by investors with some non-zero
risk appetite. If they go down, they go down: that’s a known risk. But AAA-rated
securities are often held by investors with very, very little risk appetite.
If they go down, those investors are liable to want to sell, and sell quickly.
And then comes the icing on the cake: the fact that in most securitization
structures, there are many, many more AAA-rated bonds than there are bonds lower
down the ratings scale. If some small percentage of the holders of BBB-rated
bonds, for instance, decided to sell, the impact would be relatively low, because
the total value of the sale would be small, and some dealer somewhere would
probably happily make a market in that security. But if a similar percentage
of the holders of AAA-rated bonds decides to sell, then all hell can break loose,
because now we’re talking large sums of money.
Oh, and did I mention that AAA-rated bonds had recently become flavor of the
month among highly-levered hedge funds like Sowood? Leverage, of course, always
increases risk.
Put all that together, and it’s easy to understand why highly-rated debt might
crater overnight, even as lower-rated securities emerged relatively unscathed.
But in any case in order for Sowood to lose a lot of money it wasn’t necessary
for an issuer’s low-rated debt to move up while its high-rated debt
fell. This was just a relative-value trade, and so all that was needed was for
the spread between the low-rated and high-rated debt to narrow, rather
than widen. So long as the high-rated debt fell more than the low-rated
debt, Sowood was in trouble.
Of course, I doubt that the WSJ reporters know exactly what kind of trades
Larson was putting on when his fund blew up: Larson refused to talk to them,
and it could be that they got some of the specifics wrong. But the big losses
this summer were generally suffered by funds which went short risky securities
(small-cap equities, low-rated bonds) and long securities which were perceived
to be safer, like large-cap equities and high-rated bonds. So what the WSJ reported
rings true to me.