How Sowood Went Bust

The WSJ this weekend came out with its post

mortem of Sowood Capital, the hedge fund started by former Harvard high-flyer

Jeffrey Larson which imploded spectacularly in July. There’s nothing particularly

surprising in the story (too much leverage, not enough capital), but I did get

an email from a reader asking about this passage:

By the beginning of this year, Mr. Larson was worried about many kinds of

riskier debt investments, according to people familiar with the situation.

To protect himself and take advantage of those risks, he bought senior debt

securities and sold short, or bet against, a range of investments generally

viewed as more risky, such as junior debt securities and various stocks.

Mr. Larson’s strategy depended heavily on using borrowed money, or leverage.

Because he was betting on small movements — such as whether a company’s senior

debt would go up more than its junior debt went down — he borrowed as much

as six times the firm’s capital to generate respectable returns when his bets

were right.

My reader asks, sensibly enough:

The first paragraph seems to be referring to senior and junior debt of different

issuers. However the second paragraph seems to be talking about senior and

junior debt of the SAME company. Under what circumstances would a company’s

senior and junior debt move in opposite directions?

It’s a good question. And the simple answer is that markets are unpredictable,

and that just about anything can happen, often for no good reason at


But there is actually a reason why the Sowood trade went sour, and

it centers on the whole phenomenon of highly-rated debt. Many investors are

very risk-averse, and buy only debt with high credit ratings; they often restrict

themselves to AAA-rated securities. Indeed, the demand for AAA-rated paper is

so high that an entire securitization industry has essentially sprung up in

order to create enough supply of such stuff, which always trades at tighter

spreads than capital-structure theory would imply.

Or always used to, anyway.

In July, a lot of market participants lost faith in the credit ratings in general,

and in their AAA ratings in particular. Suddenly, it came to light that some

(not all) AAA-rated securities were much riskier than the markets had previously

thought. People had understood the risk inherent in the lower-rated tranches,

and so they paid lower prices for them, or demanded higher coupons. So to a

certain extent the risk was priced in, with those. But because AAA-rated securities

were erroneously considered risk-free by some of their buyers, they often traded

with no credit-risk premium embedded. And to make matters worse, many of those

securities were also extremely illiquid.

What’s more, risky securities are generally held by investors with some non-zero

risk appetite. If they go down, they go down: that’s a known risk. But AAA-rated

securities are often held by investors with very, very little risk appetite.

If they go down, those investors are liable to want to sell, and sell quickly.

And then comes the icing on the cake: the fact that in most securitization

structures, there are many, many more AAA-rated bonds than there are bonds lower

down the ratings scale. If some small percentage of the holders of BBB-rated

bonds, for instance, decided to sell, the impact would be relatively low, because

the total value of the sale would be small, and some dealer somewhere would

probably happily make a market in that security. But if a similar percentage

of the holders of AAA-rated bonds decides to sell, then all hell can break loose,

because now we’re talking large sums of money.

Oh, and did I mention that AAA-rated bonds had recently become flavor of the

month among highly-levered hedge funds like Sowood? Leverage, of course, always

increases risk.

Put all that together, and it’s easy to understand why highly-rated debt might

crater overnight, even as lower-rated securities emerged relatively unscathed.

But in any case in order for Sowood to lose a lot of money it wasn’t necessary

for an issuer’s low-rated debt to move up while its high-rated debt

fell. This was just a relative-value trade, and so all that was needed was for

the spread between the low-rated and high-rated debt to narrow, rather

than widen. So long as the high-rated debt fell more than the low-rated

debt, Sowood was in trouble.

Of course, I doubt that the WSJ reporters know exactly what kind of trades

Larson was putting on when his fund blew up: Larson refused to talk to them,

and it could be that they got some of the specifics wrong. But the big losses

this summer were generally suffered by funds which went short risky securities

(small-cap equities, low-rated bonds) and long securities which were perceived

to be safer, like large-cap equities and high-rated bonds. So what the WSJ reported

rings true to me.

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