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 opposite...
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.