Friday, June 10, 2005


MDL losses reveal deeper, broader fund problems

The reporting on the revelations of the $215 million losses racked up by MDL for BWC have been an eye-opener for a lot of folks, but there is much more - outside of the political shenanigans that seem to be behind some of this - to this than meets the eye.

First, some of the reporting on MDL has been a little flawed. Specifially, we think it may be wrong to call MDL or what it created a "hedge fund."

Hedging 101
Hedge funds, at least in their normal business usage, are like a mutual fund that tend to be concentrated in derivative investments. In brief, derivatives - like equities - are based on some underlying asset, but are really based on either a component of the asset or based on a bet that the asset is going to move in a certain direction. Derivative markets were created to allow businesses to "hedge" their business bets. Stock "options" are a form of a derivative. So are "short" positions, "futures" and "forward" contracts. There are many, many types of derivatives and more are being invented each year, and many are termed "exotic" because the can be complicated and difficult to follow.

Why would someone want to hedge a business bet? Good question. Take Southwest Airlines for example. Long term, it plans on suceeding in business by being the best-run, best-managed airlines. Part of it's management plan is to try to eliminate economic effects that it can't control, e.g. jet fuel prices. So, unlike some airlines, Southwest purchases jet fuel futures contracts as a form of insurance that it won't be put out of business by a sudden spike in fuel costs. Thus, if Southwest loses money because fuel prices go up, the value of it's future contracts should go up by an equal amount. The two offset each other. Southwest buys just enough future contracts to cover possible fuel increases. As in this case, most derivatives are invented as some form of insurance for a business.

Finally, it should be noted that many derivatives often have the characteristic of reacting more dramatically to economic changes than the underlying asset, itself. For example, if someone is holding a short position on a stock when it soars, the losses could be enormous and virtually unlimited.

Hedge funds, then, are supposed to be a collection of various derivatives. In fact, however, a lot of so-called hedge funds are far from pure and may even have equity holdings.

MDL, on the other hand, appears to have been a strickly pure "hedge." We don't know all the details, but from the press reports it appears that MDL was purely invested in bonds. It also appears that MDL and Terry Gasper, the CFO for BWC, hatched a plan:
But in September, 2003, the bureau agreed to a suggestion from MDL to create an “active duration fund,” which would act like a hedge fund. Mr. Gasper reallocated $100 million from the long-bond fund into the ADF fund. Later, another $125 million was moved into the hedge fund for a total of $225 million.
This requires some translation, and clearly the business writers for the Blade and the Dispatch still don't exactly understand what was going on.

We think we do, and we'll try to keep it simple in order to keep it short. We think that Gasper understood that the BWC investments, as a whole, were suffering because of higher interest rates. One relatively easy way to hedge the effects of higher interest rates is through the bond market.

Bonds values react inversely to interest rates. If interest rates go up, the value of bonds that you hold go down. If the quote above is accurate, MDL/BWC was originally "long" in bonds, ie, it owned bonds and believed they would grow in value. But, because the Federal Reserve for the last two years has been raising interest rates, conventional wisdom was that being long on bonds was not a good thing. So, apparently MDL/BWC sold their bonds and used the money to buy short positions on bonds.

But an unusual problem occurred. From the Blade:
The Federal Reserve and Chairman Alan Greenspan raised short-term interest rates 2 percent over the last two years. If markets behaved as they have in the past, longer-term interest rates would have followed.

But that didn't happen. Instead, long-term interest rates fell. Speaking this week on the subject, Mr. Greenspan said the development is "without precedent."
So, MDL/BWC had gambled that interest rates would climb and make bonds drop in values. Then, their short positions would allow them to make money. But, instead, the opposite happened. Bond values increased, and MDL/BWC was forced to pay the difference.

Now, as noted above, short positions can be extremely dangerous. In order for individuals to engage in that kind of trading through our Ameritrade (or whatever) accounts, brokerage houses require that one sign off on a huge number of releases, waivers, etc., that serve to both notify the investors of the extreme danger they could face and to hold the brokerage harmless.

Short selling is extremely dangerous and risky even when done by the pros. Clearly, the ability to engage in short selling would require an explicit policy approved at the Oversight Committee level. We have not seen any reports that indicate that BWC had such a policy in place. And, if there was a policy, it is unimaginable that the policy would not require and spell out in detail the responsibility and supervison that would be required.

We think that's part of what Tina Kielmeyer, the interim adminstrator, means when she says that “it’s questionable” whether the investment fit into the parameters of the bureau’s investment policy.

But, we suspect that only part of what she means. We think there must have been something even riskier going on.

To explain, there is a difference between the dangers of short selling with bonds than with stocks. That's because equity prices could suddenly jump if, for example, a drug company suddenly announces a new discovery. Stock prices could conceivable double or triple in value in a matter of a day.

However, not so for bonds. Interest rates don't move that fast or in large jumps. So, the likelihood of the magnitude of MDL/BWC losses just don't make sense if they were holding simple short positions.

There have been a couple of references to MDL/BWC engaging in improper leveraging, with no details. Assuming that's true, what we think MDL/BWC did is a little mind-boggling and essentially took a gambit that was risky to begin with and than multiplied that risk with some clever financing.

For those interested, we think that what MDL/BWC did is the exact inverse of the infamous 1994 Orange County, California debacle where the county treasurer gambled on bond prices - gambled wrongly, that is - and suddenly lost $1.6 billion, enough to cause the county to go bankrupt.

Bob Citron, the Orange County treasurer, thought interest rates were going to drop. So, he bought bonds. Then he used the bonds as collateral to get a loan to buy more bonds. Then he used those bonds as collateral to buy more bonds. And so on, and so on. By creating this investment pyramid, he took a relatively modest investment and magnified its effects by several factors.

Besides increasing the size of his investment, there was another purpose to Citron's actions that gets very difficult to explain to lay people. This has to do with the term "duration." We don't want to go into the messy details of explaining the concept of duration, but regarding duration:
Citron's main purpose was to increase current income by exploiting the fact that medium-term maturities had higher yields than short-term investments. On December 1993, for instance, short-term yields were less than 3%, while 5-year yields were around 5.2%.
Back to MDL/BWC, we strongly suspect that Mark Lay and Terry Gasper built a pyramid of short bond positions using the first purchases as collateral to buy additional ones. Like Citron, we believe that they thought they were being clever by manipulating the differences between "duration" and yields of short-term and long-term bond maturities.


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