Wednesday, July 04, 2007

Hedge Fund Basics, No Handgun Needed

First of all there are no licenses needed or government regulations that regulate hedge funds so anybody can start one up. Startup capital of about 20 million should do, but 100 million would be more impressive. The least understood part about a Hedge Fund is that it is usually an LLC (Limited Liability Company). There is the primary investor who starts it up, and a bunch of secondary investors. The main investor gets 50% of profits off the top and the secondary investors get to split the rest of the pie. The limited liability part of the LLC means, once the money is gone; you can’t go sue the owners of the LLC for what you lost.

So starting with 20 million, this allows the LLC to shop around for a bank loan of 80 million. The total in the kitty after the bank loan is now 100 million. Current leverage is 5 to 1.

Suppose the Hedge Fund decided to invest in the S&P 500 basket of stocks. The E-mini S&P 500 futures contract goes for a 7% margin requirement. This would be a 14 to 1 multiplier on top of the 5 to 1 or 70 to 1. I don’t think any hedge fund would be that crazy to bite on just the S&P 500.

Then we go to the next level. Puts and calls. These are the most familiar forms of derivatives. They deal with stocks and bonds. 90% of them will expire worthless at expiration. They are insurance bets. Put buyers are betting the market will go down and Call buyers are betting that it will go up. The sellers of the options believe the reverse is true, or if they think you have a chance, the option will cost you a lot more. The seller’s goal is to price the option so the buyer will let it expire worthless.

A hedge fund, has a real money maker by writing puts and calls on stocks or the index options. I’m not really sure on the margin requirements for naked option writing. I would guess it’s less than 10% of the underlying stock value and would depend on how close it is to being in the money. As the house in this deal, the odds are better than owning a casino in Las Vegas, by a wide margin.

There is an undefined area where a hedge fund can operate, insuring financial assets like home loans, that have no put or call options in the stock market. I am not sure of how the mechanics work on this sort of option. I do know that you use to be able to create options that didn't exist for thinly traded stocks on the Philadelphia Exchange.

The lenders that bought coverage are now trying to recoup their losses from the hedge fund insurance. Now it seems that the risks warranted a higher premium. The trouble is, the hedge fund did not correctly gauge the dangers of a down market.

The real fun starts once the insurance redemptions pick up speed. The misery starts once you realize what an LLC is and isn't. As an abstract entity, it sounds solid. But when you examine the limited liability of the animal and the fact that there is no regulation of the way it is run, there seems to be a rather obvious problem. The problem is what makes it so neat, it can be anything it wants to be, its a real enigma. Its losses are limited and its rewards are not. Under normal circumstances this sort of operation would require a hand gun to be successful. Plus, there is no jail time if you mess up, its perfectly legal.


david said...

Perfectly legal, yet in no sensible way is this method hedging for historic risk. When the liquidity flood is slowed to a trickle as lenders are crushed by defaults, all these long leveraged positions will unravel like the snap of a wet towel in the face. Right?

Jim in San Marcos said...

Hi Dave

I think you are right, its kind of like lighting a match to see if there is any gasoline left in the container.

There is about a one minute pause before you realize that most of the hair on your face is gone.

This could be the pause phase ....

Anonymous said...

The option/insurance that you refer to on home loans is called a credit default swap and is sold on private exchanges. This market is the real overhang on all the markets. The size of it makes the US debt look small.The CDOs of today that everyone is talking about are constructed of these and are 100% synthetic.There are a lot of gray areas in this market. It is unregulated and there is no consensus on how it will function in a full blown crisis. If you look at the FED website at the experts they have working for them, you will not find one with "real" market experience in any market.

Jim in San Marcos said...

Hi Anon 9:57

The synthetic stuff is a real mind boggler. It's a little like smokeless gunpowder, just as much damage,but its real clean.

As for experts, I agree with you, there isn't much real experience, they are crawling out of the wood work.

Another thing that hasn't been tested is the computer programs that run our market. In a down market, a programing error could bring the system down. I remember when computers first came out, there was no concern for dates past 1999 so they only used the last two digits. Just declaring a field size in a program as three digits wide would be OK if the field never exceeded 999. If the value hit 1000, you step into something unexpected.

Any way you look at it, its a balancing act done without a net.