a tale of two hedge funds

A Tale of Two Hedge Funds:

Magnetar and Peloton

Financial Crisis

Lowest Interest rate in forty years

Loose Lending Practices

Home loans were sold to major investment banks

Investment banks – Securitized into CDO’s and sold to investors.

Collateralized Debt Obligation

Securities backed by a pool of fixed income assets

Consists of CLO’s, CBO’s and RMBS

Provide liquidity as traded daily on secondary market

Pay slightly higher interest rate than corporate bonds

CDO is complex and costly process

Enables a bank to design loans to homeowners to make more loans as bank can sell

loan to third party

Bank can originate more loans and fees

Many CDO’s became liquid due to size, investor breadth and rating agency coverage

LBO (Leveraged Buyout) The acquisition of another company using a significant amount of borrowed

money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company

The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital

Rating Agencies

Help bringing liquidity to CDO market as per following reasons :

Analyzed each tranche of a CDO and assign ratings accordingly

Used historical models to predict risk

Limited Manpower

Had to allocate risk to appropriate tranche and understand correlation of loans

Correlation

Uncorrelated Loans

Defaults occur evenly over time and asset diversification solves problem.

AAA-rated senior tranche should be safe and interest should be equal to AAA – rated corp. bond or US

Treasuries.

Diversify geographically to stable returns.

Magnetar Founded in 2005

Magnetar Capital-Return 25% in 2007

Considered its return as one brilliant strategy

Strategy-certain tranches of CDO( collaterlized debt obligations) were unsystematically mispriced

Unaffected with the subprime market held up or collapsed

Magnetar Structured Finance Arbitrage Trade

Made profit –By equity tranche of CDO’s and derivative CDO instrument relatively mispriced

Bought less risky CDO equity and credit default swaps(CDS) protection on tranches

Performed its own calculation of Risk for each tranche and compared that with the return that the tranche offered

Results showed –Two classes of securities had very similar risks but significantly different yields

Bought CDS on mezzanine tranche and long position on Equity

Peloton Founded in 2005

Top performer in hedge funds in 2007

Became bankrupt after one month of getting two prestigious awards-at Black tie euro hedge ceremony

Peloton Fall Strategy Shorted the US housing market before subprime crisis and was profited

Misunderstood the subprime crisis Went long for AAA-rated securities backed by Alt-A mortgage loans UBS downgraded its Alt-A backed securities Market went down leading to margin calls No support from investors and banks due to conflicts in views

Leveraged Profit The investors purchased the senior tranche of CDO yielding LIBOR +50 bps

By leveraging by 25x earned a return commensurate with equity tranche or LIBOR +1250bps.

Bank Debt & Cov-lite Loans Fueled by leveraged buyout boom

Corporate bank debt allowed companies to operate with no maintained or interest coverage ratio

LBO firms demanded loose terms

Lenders passed on the weak cov-lite loans

Investors analyzed at summary level

Bank Debt & Cov-lite Loans Rating agencies gave false sense of security

Bank loan and leveraged securities prices fell

Investors believed that the default rates would hit higher level that in 1930s and would stay there till maturity

Covenant - lite Loans The current cov-lite loans were traded heavily

Was thought to have limited near term default as companies ran until cashless

The Cov-Lite were traded heavily as compared to Cov-heavy loans

The nominal coupons were less on cov-lite as compared to cov-heavy loans

Arbitrage – Bank loans and Bonds Yield on secured cov-lit bank loans and compare it with unsecured bonds of same company

If yields are close, trading opportunity exist

More risk the company wider spread gets

Difference of recovery rate on various securities

Default rates were identical because issued by same company

Bank debt had pressure of selling as held in large by investors. Whereas, bonds did not

Thank You

Amrita Das

Ankit Chokhani

Shreyansh Jain

Vivek S Nath