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Making a Bubble


Convertible bond hedge funds were the darlings, the magical strategy that produced great returns with little volatility for several years.

It all began in the last cycle major cycle after the wash-out of 1998. The LTCM failure was thought at the time as possibly causing the demise of the hedge fund. Nothing could have been further from what happened. Wall Street's spin machine went into overdrive and convinced investors that it was just their strategy. Look at convertible bond hedge funds "they" said. They provided good returns before August of 1998, took some losses during the rest of the year, but then recovered nicely.

This was all because convertible bonds in general were fairly cheap. They provided value and thus could sustain volatile times. It wasn't magic, it was just value and there were good managers who managed risk through some tough times.

So hedge fund money gravitated to these types of hedge funds. The new money coming in was put to work and naturally drove prices (the basis where the value was) higher. Profits were made as value went down. As profits were made more and more money came into the product, driving value over time down further and further.

But no one saw the value erode; they just saw profits being made. And more money came in. New managers with less ability entered the market and rode the wave, new managers with less sense of risk, managers that were primarily focused on returns. The following illustrates the return profile of convertible bond hedge funds in general:

1997 14.5% 2001 14.6%
1998 - 4.4% 2002 4.1%
1999 16.0% 2003 12.9%
2000 25.6% 2004 2.0%

2004 began with record amounts invested in convertible bond hedge funds and no value left in the asset class itself. In our opinion the general market in 2004 was 4-6 % overvalued as all these managers had to either put their money to work or lose it to the next manager down the street. Guess what they did.

Investors in these hedge funds were just as complicit, but maybe not consciously so. They were complicit in the fact that they didn't do their due diligence to understand what drove profits and what the risks really were.

By the end of 2004 some of the larger and more sophisticated investors in these funds began to realize the state of the market. We helped them. Several large potential investors in our fund when they came to talk to us in the fall of 2004 were more interested in talking about the state of the convertible market than in talking about our fund. I and my partners spent hours talking about the vagaries and nuances of bonds, going over specific examples of valuation. We explained that the only convertible bonds that we were trading were new issues that came to market fairly cheaply and quickly gravitated to an over-valued state commensurate with the rest of the market, at which time we sold them. We explained to them the nature of markets and how asset prices are simply driven by money bidding them up. They realized that they were exposed.

In January 2005 several of these sophisticated investors redeemed their money from convertible bond hedge funds. This set off a chain reaction: to meet these redemptions managers first raised leverage so that they did not have to sell positions. This left investors that had not redeemed more exposed: they consequently took over the exposure of the investors that had redeemed since the capital supporting the positions was less. As redemptions increased managers could not raise leverage anymore and were forced to sell positions in order to meet redemptions.

This leads us to the state of the convertible bond market today. The basis has gotten fairly cheap, but losses continue to mount to the tune of around 15% for the year for investors that are left. The market is in disarray with few bids as levered managers and broker dealers long inventory are being forced to sell. People are losing jobs, a natural consequence of this process.

So an asset bubble has been popped and people are wary of the product. But it isn't the product that is the problem; it was the valuation and the management of risk. There is more selling to be done, but for those that managed risk appropriately it becomes a buying opportunity over time to build positions of value.

The cycle is long and the selling is not finished. It could take a year for this process to play itself out.

For those looking for signs of stress in the system here is one. Don't blame it on the assets, of which there are many kinds who are in or near bubble states. Blame it on valuation and the process that creates bubbles: easy fiat credit that forces investors into riskier and riskier assets to generate returns.

It takes significant discipline and financial acumen to avoid making these mistakes. In order to keep the train going, this is something policy makers hope you do not have.
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