A Tale of Two Hedge Funds: Magnetar and Peloton

A Tale of Two Hedge Funds: Magnetar and Peloton

Case summaryMagnetars successPelotons failureHousing boom & burst- Low interest rate, CDOs, rating agenciesCov-lite corporate bank debt

Financial CrisisLowest Interest rate in forty yearsLoose Lending PracticesHome loans were sold to major investment banks Investment banks Securitized into CDOs and sold to investors.

Collateralized Debt ObligationSecurities backed by a pool of fixed income assetsConsists of CLOs, CBOs and RMBSProvide liquidity as traded daily on secondary marketPay slightly higher interest rate than corporate bonds

CDO is complex and costly processEnables a bank to design loans to homeowners to make more loans as bank can sell loan to third party principle agent problemBank can originate more loans and feesMany CDOs 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 capitalPerformed its own calculation of Risk for each tranche and compared that with the return that the tranche offered

Role of credit rating agencies

Used historical data.Believed that a nationwide housing downturn was unprecedented CDOs were not present in significant numbers to scientifically analyse.This cycle was different from previous cycles therefore historical data could not be relied uponRating agencies allocated risk to different tranches based on collaterals correlation with each other.Uncorrelated- defaults will happen evenly asset diversification can solve the problemHigh correlation- non diversifiable risk reasonable likelihood of senior tranche impairment.

Magnetar strategyEquity and Mezzanine tranches of ABS CDOs had same risk but very different yieldsBoth were related. Either both get paid or both not.Magnetar capitalized on this by going long on Equity tranche and taking short positions in Mezzanine tranche. Trades were constructed in such a way that the cash inflow from long positions in equity tranche were much higher than the cash outflow due to short positions in Mezzanine tranche. At the same time in case of a high default, the principal balance on Mezzanine shorts would be much more than equity longs meaning high payoffs even if the underlying collateral went south.Their strategy would only lose money if the equity got wiped out while the Mezzanine tranche stayed intact, the probability of which was very less.

PelotonFounded 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 StrategyShorted the US housing market before subprime crisis and was profited

Misunderstood the subprime crisisWent long for AAA-rated securities backed by Alt-A mortgage loansUBS downgraded its Alt-A backed securitiesMarket went down leading to margin callsNo support from investors and banks due to conflicts in views

Leveraged ProfitThe 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 LoansFueled by leveraged buyout boom

Corporate bank debt allowed companies to operate with no maintained leverage 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 LoansRating 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 LoansThe 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 BondsYield 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 getsDifference 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 YouAmrita DasAnkit ChokhaniShreyansh JainVivek S Nath