Hedge FundsBy:

Praful Anchaliya

Rohit Seth

Sameer Kalra

Shally Rathi

Vidur Arora

Vijay Sangtani

2007-2008 financial crisis

• Lowest Interest rate in forty years

• Many home loans were sold to major investment banks

• Investment banks – Securitized into CDO’s and sold to investors.

Instruments involved

CDO• Securities backed by a pool of fixed income assets

• Consists of CLO’s, CBO’s and RMBS

• Provide liquidity as traded daily on secondary market

• Pay slightly higher interest rate than corporate bonds

• CDO is complex and costly process

• Enables a bank to design loans to homeowners to make more loans as bank can sell loan to third party

• Bank can originate more loans and fees

• Many CDO’s became liquid due to size, investor breadth and rating agency coverage

Reason of holding CDO’s

Securitization process took

time

Trading divisions made markets in the

security

Kept a small

holdback amount

Waterfall Portfolio of 300 mn

(BBB)

Annual Cash flow of 12.7 mn @ 4.25

After deduction of expenses & hedging cost

240 mn of AAA, paying

LIBOR +54bp {5.7 mn}

26 mn of AA, paying LIBOR

+79 bp{1 mn}

20 mn of BBB, paying LIBOR +275 bp {0.6 mn}

14 mn tranche of equity {return of

40%}

7.3 mn

5.4 mn 2.4 mn

In case of 3 mn loss

Reserve AccountIf reinvested

If not Equity holders

LBO (Leveraged Buyout)• The acquisition of another company using a

significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company

• The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital

Junk Bond• A bond rated 'BB' or lower because of its high

default risk.

• These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues.

Factors

Rating AgenciesHelp bringing liquidity to CDO market as per following

reasons :• Analyzed each tranche of a CDO and assign ratings

accordingly

• Used historical models to predict risk

• Limited Manpower

• Had to allocate risk to appropriate tranche and understand correlation of loans

Correlation

Uncorrelated Loans

Defaults occur evenly over time and asset diversification solves problem.

AAA-rated senior tranche should be safe and interest should be equal to AAA – rated corp.

bond or US Treasuries.

Diversify geographically to stable returns.

Hedge Funds ~ fall & rise

Magnetar• Founded in 2005

• Magnetar Capital-Return 25% in 2007

• Considered its return as one brilliant strategy

• Strategy-certain tranches of CDO(collaterlized debt obligations) were unsystematically mispriced

• Unaffected with the subprime market held up or collapsed

Magnetar Structured Finance Arbitrage Trade

• Made profit –By equity tranche of CDO’s and derivative CDO instrument relatively mispriced

• Bought less risky CDO equity and credit default swaps(CDS) protection on tranches

• Performed its own calculation of Risk for each tranche and compared that with the return that the tranche offered

• Results showed –Two classes of securities had very similar risks but significantly different yields

• Bought CDS on mezzanine tranche and long position on Equity

Magnetar Structured Finance Arbitrage Trade

Peloton• Founded in 2005

• Top performer in hedge funds in 2007

• Became bankrupt after one month of getting two prestigious awards-at Black tie euro hedge ceremony

Peloton Fall Strategy– Shorted the US housing market before subprime

crisis and was profited

– Misunderstood the subprime crisis• Went long for AAA-rated securities backed by

Alt-A mortgage loans• UBS downgraded its Alt-A backed securities• Market went down leading to margin calls• No support from investors and banks due to

conflicts in views

Market Evolution

Leveraged Profit• The investors purchased the senior tranche of CDO

yielding LIBOR +50 bps

• By leveraging by 25x earned a return commensurate with equity tranche or LIBOR +1250bps.

Bank Debt & Cov-lite Loans• Fueled by leveraged buyout boom

• Corporate bank debt allowed companies to operate with no maintained or interest coverage ratio

• LBO firms demanded loose terms

• Lenders passed on the weak cov-lite loans

• Investors analyzed at summary level

Bank Debt & Cov-lite Loans• Rating agencies gave false sense of security

• Bank loan and leveraged securities prices fell

• Investors believed that the default rates would hit higher level that in 1930s and would stay there till maturity

Covenant - lite Loans• The current cov-lite loans were traded heavily

• Was thought to have limited near term default as companies ran until cashless

• The Cov-Lite were traded heavily as compared to Cov-heavy loans

• The nominal coupons were less on cov-lite as compared to cov-heavy loans

Default Rate and Recovery Rate Discount Rate to justify Cov-Lite Valuations

  Annual Default Rate    

Difference in Recovery Rate 3% 4% 5% 6% 7% 8%

-5% 244 264 283 303 323 343

-10% 303 343 383 423 463 503

-15% 363 423 483 543 663 663

-20% 423 503 583 663 822 822

-25% 483 583 683 783 982 982

-30% 543 663 783 902 1142 1142

-35% 603 743 882 1022 1302 1302

-40% 663 822 982 1142 1461 1461

-45% 723 902 1082 1262 1621 1621

-50% 783 982 1182 1382 1781 1781

Arbitrage – Bank loans and Bonds• Yield on secured cov-lit bank loans and compare it

with unsecured bonds of same company

• If yields are close, trading opportunity exist

• More risk the company wider spread gets

Arbitrage – Bank loans and Bonds• Difference of recovery rate on various securities

• Default rates were identical because issued by same company

• Bank debt had pressure of selling as held in large by investors. Whereas, bonds did not

RR and DR

Thank You