Sub-prime fallout

Behind the Times Select firewall, Gretchen Morgenson has explained nicely why the defaults on sub-prime mortgages are affecting all the financial markets.

What is amusing about it to me is that all the hot-shot hedge fund managers and their mathematicians and computers seemed to have forgotten the standard disclaimer that appears with any investment advertisement: past performance is no guarantee of future returns.

Excerpts:

Using what are known as market-neutral strategies designed by computer models, hedge fund traders have been blindsided by a correlation between bonds and stocks that they never expected would occur.

.....

For example, a computer might trace the relationship and trading characteristics of two similar assets, like shares of General Motors and Ford. The fund manager then makes trades, going both long and short, based on the way these shares generally trade. If Ford typically trades cheaper than General Motors, the manager would short Ford and buy G.M., capturing what might be small profits, but on a large volume.

.....

Seeing that such bets typically generated profits over long periods left traders believing that their stakes were conservative.

The only trouble is, financial markets do not always trade in a way that is typical or predictable. And when they deviate from the norm, all the wonderful and smart trades stop behaving according to plan.

ANALYSTS call it model misbehavior.

I had to emphasize that last line, it made me laugh out loud.

Fund managers experiencing losses in their fixed-income portfolios who were unable to sell their positions then tried to unwind the trades they could sell — that is, stocks. They cashed in the shares they had purchased and bought back the ones they had sold short.

The result was that stocks that had historically been weaker became stronger, and vice versa.

“It is not simply that model returns are flat (or not working),” Mr. Rothman wrote, “but specifically that the models (ours included) are behaving in the opposite way we would predict and have seen and tested for over very long time periods (45-plus years).”

As a result, “risk models are miscalibrated for the current market environment,” he wrote.

Another line that made me laugh out loud.

The article goes on to explain that many of these funds work with borrowed money, so have to resort to desperate measures as things start unravelling; and that since everyone relied on the same market behavior, they're making the same trades, thereby compounding the effect.

“They have their standard deviations, correlations, ‘stable value’ and ‘real return’ funds and nothing for what the normal human being would call risk at all,” said Frederick E. Rowe Jr., a money manager at Greenbrier Partners in Dallas. “They’ve taken the word ‘risk’ and hijacked it. The concept of risk — the permanent loss of capital — vanished in the minds of the people who speak the new language.”

Risk, and all that it should connote to investors, is back in the language now. Unfortunately, it has brought an awful lot of losses with it.