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The Tick, Tick of GM in Hedge Fund Derivatives: Mark Gilbert

The Tick, Tick of GM in Hedge Fund Derivatives: Mark Gilbert

May 13 (Bloomberg) -- The aftershocks from the drop to junk by General Motors Corp. and Ford Motor Co. are rippling through the credit markets, testing the theory that derivatives redistribute rather than exacerbate risk.

Standard & Poor's removed investment-grade credit ratings from both automakers on May 5. This week, S&P started chopping its assessment of derivatives backed by Ford and GM debt. Meantime, research reports are full of tales about so-called correlation trades blowing up, fueling concern that some hedge funds may go to the wall as disgruntled investors tire of their inability to make money and withdraw funds.

A feature of financial markets is that everyone agrees there's no such thing as a free lunch, until they sniff their own plateful of fail-safe profit. In recent weeks, hedge funds thought they had found an alchemical strategy for making money out of the woes engulfing General Motors.

The trade involved buying GM debt and shorting its stock, or selling shares you don't own. You made money provided bond prices rallied while the shares declined; stocks and bonds don't typically move in tandem, while yields as high as 11 percent on the bonds were supposed to cushion your returns even if the trade didn't work out exactly as planned.

Squeezed on Both Sides

Then two things happened to blow that game plan out of the water. On May 4, Kirk Kerkorian disclosed his intention to build an 8.8 percent stake in General Motors, boosting the shares by 18 percent. The following day, S&P's rating change knocked about 5 points off GM bond values.

``Those who were short of the equity and long of the debt found themselves squeezed on both sides,'' wrote independent market analyst Dennis Gartman in his daily newsletter on May 11. ``This is the perfect storm to implode some hedge funds.''

Another popular trade involved derivatives called collateralized-debt obligations, which bundle together securities such as bonds or default swaps. By owning the riskiest slice of a CDO, known as the equity tranche, and selling the next-riskiest portion, the mezzanine section, investors hoped to profit, whether the underlying market gained or not.

``The trade is supposed to make money if spreads move either wider or tighter in a parallel fashion,'' wrote analysts at Merrill Lynch & Co. in a May 10 research note. Yet the rating cuts for General Motors and Ford ``caused spreads to move in a non- parallel fashion and these trades to underperform significantly,'' Merrill said. ``We expect a rush to the door to be painful.''

Declining Asset Values

Hedge funds don't have to detail their buying and selling anywhere, so it's tough to know for sure what's going on and whether trades are being unwound. Still, they do publish monthly figures for their asset values. Hedge funds declined 1.75 percent last month, their worst performance since September 2002, according to figures published earlier this week by New York-based Hennessee Group LLC, a consulting firm that compiles returns.

You can also see some of the waves crashing into the market by checking on the value of credit-derivatives indexes. The Dow Jones North American Investment-Grade Index, which measures the average cost of insuring the debt of 125 companies against default, climbed as high as 75 basis points this week, up from as low as 37 basis points on March 9.

That means the annual cost of insuring $10 million of debt for five years has doubled to $75,000 in a couple of months. In Europe, the iBoxx index of BBB rated debt yields about 128 basis points more than government bonds, double where it was at the start of March and its highest in almost two years.

Collateralized Debt Deteriorates

S&P, which rated about $90 billion of collateralized debt in Europe last year, cut its assessment of 19 CDOs on May 9, and put 25 more on review for a reduction. On May 10, it lowered the ratings of six classes of CDOs arranged by Deutsche Bank AG, and a day later it cut three notes managed by BNP Paribas SA.

Clemens Boersig, chief financial officer of Deutsche Bank, departed from his prepared slides at a presentation in New York earlier this week to reassure investors that Germany's biggest bank ``has no cash lending exposure to hedge funds,'' and has collateral to protect it against any potential losses in its dealings with hedge funds.

``We can only describe the reaction in the market to the possibility of large losses and the like at several hedge funds as being over-hyped,'' said Suki Mann, head of credit strategy at Societe Generale SA in London. ``Keep in mind that the number of active CDO players within the hedge-fund community is still relatively limited.''

Long-Term Capital Management LP and its ``can't fail'' arbitrage strategies, trashed when Russia's 1998 default destroyed 90 percent of the company's $4 billion fund, still cast a fetid shadow. If hedge funds and derivatives players can successfully navigate a path through current difficulties, they will go a long way toward erasing those painful memories.


To contact the writer of this column:
Mark Gilbert in London at [e-mail].


LINK: http://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_gilbert&sid=aOteOmAo8ad0