Risks to Monitor in Structured Finance

Investors of CDOs must note the risks involved in such instruments.  Many were brought to light during the credit crisis in 2008.  They are:

• Default risk of the underlying collateral - This is greater for the equity tranches.
• Financial engineering risk - In 2008, the subprime mortgages, which were the underlying assets of the CDOs, began to default.  This caused most of the CDO tranches to suffer a drawdown.
• Downgrade risk - The credit raters, Standard & Poor's, Moody's and Fitch's may reduce the rating of the CDO tranches.
• CDO default rates - In a one year period in 2008, more than 4,000 CDO securities worth $351 billion were downgraded or defaulted.
• Differences in periodicity - The frequency of interest payments from the collateral may not match the payments on the CDO securities.
• Difference in payment dates - The interest payment schedule from the collateral may not match the payment schedule on the CDO securities.
• Basis risk - The risk when interest payments are calculated on the underlying assets of the CDO based on a different index than the payments on the CDO securities.
• Spread compression - When credit spreads become lower and result in reduced interest payments from the underlying collateral.
• Yield curve risk - Any yield curve shifts or changes in steepness affect CDOs if their underlying assets have different maturity dates.

Investors Staying with Hedge Funds Despite Down Year

According to the HFRI Fund Weighted Composite, hedge funds are down 1.22% year to date.  Equity hedge funds are doing worse, down 3.42% year to date.  Despite the less than stellar performance, assets under management (AUM) for the hedge fund industry are over $2 trillion - their high water mark.  Asian hedge funds have been leading the growth over the last decade; going from $14 billion in AUM in 2000 to $134 billion in AUM in June of 2011.  Chris Greer, global head of capital introductions at Citi, says that Asia is a hot market now but investor interest is cyclical.

The source for this article can be accessed here.

Some Smaller Hedge Funds Are Closing to New Investors

The credit crisis of 2008 has taught hedge fund managers that growing assets under management too quickly can hurt their performance.  Some small and mid-sized funds are closing to new investors.  They include Lakewood Capital Management, Route One Partners, Lobos Capital, Brenner West Capital Advisors, Jericho Capital and Redmile Group.  Small funds can get in and out of positions quickly and concentrate on their best ideas.  With too much assets under management, managers have to find investments.  At times, there may not be enough great ones so managers invest in "fair" ideas.  This lowers their returns.

To attract investors, smaller funds have to use top tier firms for their prime broker, fund administrator, legal and accountant/auditor.  Institutional investors are using seeding funds to invest in the smaller hedge funds.  They exchange capital for a portion of the hedge fund's business.  Some firms that do this are Blackstone, Goldman Sachs and Reservoir Capital.

The source for this article can be accessed here.

Another Private Equity Shop Wants an IPO: Carlyle Group

Following in the footsteps of Blackstone and Apollo Management, the private equity company Carlyle Group has filed an IPO with the SEC.  It should be closed in the first half of 2012 and raise $100 million.  Carlyle had first attempted to go public before the credit crisis of 2008.  The other private equity firms' stock prices have been failures, to say the least.  Blackstone went from $31 to $12.50 and Apollo's stock is down 33% since the IPO.  John Duffy of Keefe Bruyette & Woods had predicted this outcome.  He said, "If guy like Schwarzman are selling, I don't know if you want to be on the other end of the trade."

Sources for this article can be accessed at Crains and Finalternatives.com.

Distressed Debt Funds Seeking Exit Strategies for Their Investments

Distressed debt hedge funds took control of many companies that filed for bankruptcy during the credit crisis in 2009.  They are now seeking the traditional avenues for their exit such as an IPO or selling the business.  They include Cooper Standard (Silver Point Capital and Oak Hill Advisors), Delphi Corporation (Silver Point Capital and Elliott Management), Dura Automotive (Patriarch Partners) and Lear Corporation (Goldman Sachs) in the auto sector.  In the media sector, companies include Vertis Holdings (GE and Avenue Capital), Source Interlink (JP Morgan Chase) and Charter Communications (Apollo Management).  While in bankruptcy re-organization, the companies managed to close unprofitable divisions, reduce expenses and resolve issues with unions.

The source for this post can be accessed here.

An Investment Outlook on China

I was alerted to an article by Albourne Village written last month for a blog called hedged.biz.  The topic was Asian Economies and Investment Outlook.  The writer is forecasting several trends based on Asia:

China will build its infrastructure until domestic consumption grows - In 2009, US consumption of Chinese goods fell off a cliff.  To replace this activity, China responded with a infrastructure stimulus plan with $2 trillion being in special purpose vehicles called Local Government Funding Vehicles.  Eventually, this government sponsored program will end.  At the time, the Asian consumer will replace the US consumer - hopefully.  In China, domestic consumption will grow when income inequality becomes less and when enough people move into the "middle class" and have discretionary income.

Domestic consumption is the best strategy in China - The investor should be prepared for volatility when investing in this theme in the short term.  In the long term, it should have great returns.  There are three ways to approach this:  Asia exporters to China, Chinese domestic companies and Indonesian and Australian natural resources.

Lawsuits Planned Against the Banks on Mortgage Securities

The Federal Housing Finance Agency (FHFA) will be filing lawsuits against the largest banks because they misled investors on the quality of AAA- rated mortgage securities that they sold to Fannie Mae and Freddie Mac during the credit bubble.  The suits will be against Bank of America, JP Morgan, Goldman Sachs and Deutsche Bank.  A suit was filed versus UBS in July to recover $900 million.  All in all, the suits will seek to recover the $33 billion ($14 billion for Fannie Mae and $19 billion for Freddie Mac) in losses.  Besides the FHFA, the banks are facing private investor and 50 state attorney general lawsuits. The latter are working on a $20 billion settlement with Bank of America, JP Morgan and Citigroup.  The settlement will help homeowners being foreclosed on.  Lastly, AIG is suing Bank of America for $10 billion.  To reserve against these possible charges, Bank of America has been raising capital by selling non-core businesses.

The banks believe that mortgage securities lost value because of a slow economy and downturn in the housing market.  AIG, Fannie Mae and Freddie Mac were sophisticated investors and knew the risks involved with the securities.

The source for this post can be accessed here.