Thursday, May 12, 2005

Who Will Shout “Fire”?

The theater is full, everyone’s in their seats with a bucket of popcorn in their laps and a soft drink in the holder, and the lights are down.

The movie is about to start.

Ominously, though, the emergency exit signs are on the fritz, and while most of the crowd is oblivious, a few of the more perceptive movie-goers are squirming in their seats, looking for the fastest way out in case somebody shouts “fire.”

That’s the way the convertible arb hedge fund business feels to me, after listening to a Merrill Lynch conference call on the state of that business and talking to friends who would know.

Yes, the rumors have been flying around the Street for a couple of weeks about one or another hedge fund being in trouble, and some big funds are having rough years—even though it’s nothing like Long Term Capital’s infamous collapse.

After all, the Dow Jones Convertible Arbitrage index is down only 7.5% this year (although I did hear of one small outlier down a cool 90%)—hardly enough to cause a hedge fund to turn off the lights.

But these are funds designed to limit volatility by hedging against interest rate risk and market risk and all kinds of other risk—and the fund-of-funds managers that were tossing dollars into these so-called market-neutral pools of money are not used to watching the pool evaporate, even slowly. Especially when there doesn’t seem to be a very good excuse. No collapse in the Thai Baht, no Russian default…not even an Argentina currency crisis.

So they are getting anxious.

That’s how it sounded on yesterday’s Merrill Lynch conference call—even though I didn’t understand more than three sentences in the Merrill analysts’ presentation or in the question and answer session that followed. Being an old-fashioned equity guy, I don’t measure alpha or beta or theta, or even the covariance of the delta. So I don’t have a clue when it comes to this black-box stuff.

But what I did understand is that the questions all had a single underlying theme: where are the exit doors?

What it all smelled like to me was a lot of people trying to figure out how to get out of their positions, or worrying about what other people are going to do to get out of their positions.


I heard a lot of answers from the Merrill convertible rocket scientists that seemed to begin, “well, what they can do is sell the third deviant tranche into the fourth derivative market through a hedged put sub-convertible relaxed-fit jean…” or something like that.

Whatever it was they were saying, it all sounded to me like one question: how to get out.

The basics are this: the convertible arb guys, who had it so good for so long buying converts and shorting the underlying equities with various ratios and various hedges, attracted enough capital to make the business unattractive.

Consequently, volatility compressed so that managers had to put on more leverage to get the returns they’d been accustomed to getting. Plus, as the hedge funds grew in size, they began trading more with each other rather than with the funds that actually own convertible bonds for a living.


End result: nobody left to buy.

Now, a few people are looking for their money back. And the question becomes where to sell this paper to raise the money to give back to the investor, now that the inflows into the pool have reversed flow.

These situations are not fun. They are not fun for the guys stuck with the paper; they are not fun for the investors stuck in the fund; they are not fun for the brokers stuck with relationships that are starting to come apart; they are not fun for innocent bystanders caught in markets that start to come apart when everyone rushes for the exit at the same time.

But they seem to happen with some regularity, and nobody seems to learn the previous lesson. 1980, when the Hunt Brothers got nailed trying to corner the silver market; 1987 when nearly everybody, including the smartest investors in the world, got caught long the Friday before the crash; 1989, when everybody was going to get rich doing LBO’s…and the United Airlines LBO fell apart; and of course, Long Term Capital Management in 1998, and the dot-coms in 2000.

Does the convertible arb bubble (ironic, isn’t it?: everybody, including me, is screaming about a housing bubble while all the while this huge convertible arb balloon has been slowly inflating right over our heads) have to end badly?


No, it doesn’t. But it probably will.

Right now, the fund-of-funds are watching this pool evaporate slowly and reading the articles and re-thinking their commitment…and probably submitting their notices of withdrawal for the end of this quarter, right now, as I write this.

And the funds themselves are looking at the calendar and evaluating their positions, trying to figure out what they can sell in order to meet the redemptions they know they will have to meet in a month and a half.

And the legit convertible funds and the market makers are watching the whole drama, and waiting. They see a lot of sellers and not a lot of buyers…and they know the opportunity to make money is not now.

It’s when the exits are clogged and people are trying to get out…price be damned.


Jeff Matthews
I Am Not Making This Up


P.S. For those of you following Grandma’s quest to nail down the truth behind the technology “decrapitation” at Overstock.com, and other credibility issues she has with the company…Grandma is hard at work and will report back when she finds out what happened.



The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

3 comments:

cdub said...

It's surprising that we don't here more about this in the mainstream media. Granted, it's probably difficult to explain to Grandma, but still.

The real question is...if we know its coming, what do the rest of us do to profit from it?

gvtucker said...

Just to add a number to this, approximately 80% of the convertible bonds out there are owned by hedge funds.

That doesn't leave too much capital out there as a source of liquidity if the hedge funds need an out.

hedged said...

converts were a great strategy in the 90s. they were perpetually issued cheap on a theoretical basis. realized volatility was consistently higher than implied. credit spreads in your typical convert name were generally wide and provided some decent carry.

then the strategy was bled dry. too many funds did the same thing. the bonds were no longer cheap on a theo basis...frequently even rich. credit spreads in general contracted, removing another source of convert bond return. realized volatility consistently underperformed implied volatily, again crunching return. additionally, the collapse of the tech bubble removed a very common source of newly issued converts: cash starved tech companies who were too risky to borrow using straight debt and too afraid of dilution to directly issue equity.

convertible arbitrage will be a good strategy again. just not now.