Ralph Cioffi’s Failed Liquidity Arbitrage

Veryan Allen has a neat riposte to anybody who claims that

the meltdown at Bear Stearns’ credit funds shows how dangerous hedge funds can

be: the Bear Stearns funds weren’t

hedge funds!

Allen has a classic ex post definition of what a hedge fund is. Real

hedge funds, he says, make money in up markets and in down markets. So if you

lose lots of money in a down market, you weren’t a hedge fund at all. It all

seems wonderfully sophistic, but Allen does have two very good points.

Firstly, a hedge fund should not be a "leveraged beta bundler" –

something which levers upside returns at the cost of levering downside returns

as well. And secondly, you can’t hedge the exposure you have to illiquid instruments

by buying a more liquid offsetting position.

Bear Stearns was leveraged long CDOs of illiquid securities and "hedged"

by shorting liquid ABX indices. As with similar problems in the past, BSC

was long illiquid, short liquid. If a fund is leveraged and can only sell

to a limited number of counterparties who KNOW it has a problem, getting out

becomes difficult…

There is nothing inherently wrong with investing in "untraded" assets

provided the risk-adjusted returns are sufficient to compensate. In bearish

credit conditions ideally you usually want to be long the liquid and short

the illiquid but weaker credit funds and less experienced managers do the


Just as with LTCM, being long the illiquid and short the liquid works well

until the market reverses and then years of consistently positive months get

given back in one massively negative month. Leverage, liquidity and valuation

risks are ONLY worth taking if you are compensated for those risks and plainly

this was not the case.

The irony here is that on this logic, which is unassailable, investors in synthetic

CDOs are actually much better off than investors in the "real thing".

A synthetic CDO is made up of liquid and unwindable credit derivatives, and

so long as the manager of the CDO has a halfways decent risk management system,

it shouldn’t find itself with sudden unexpected losses, since it’s relatively

easy to mark the contents of the CDO to market. On the other hand, a CDO filled

with untraded tranches of illiquid mortgage-backed securities might implode

quite suddenly.

Of course, all of these instruments, synthetic or not, are still much more

illiquid than even the illiquid securities that LTCM was investing in (Russian

GKOs, off-the-run Treasury bonds, that sort of thing). Liquidity is relative,

and the mortgage-backed CDS market has yet to be tested by a sustained bout

of bearishness. For the time being, however, I bet that Ralph Cioffi

is wishing he’d had more derivatives in his fund, not fewer.

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