HCMI Client Letter - July 30th, 2007

Dear Clients and Friends,

Hedge funds come in many flavors and strategies, but the key distinction between hedge funds and traditional investment firms such as ours is the element of leverage.  A hedge fund can borrow funds to increase returns, but this borrowing leaves the hedge fund vulnerable to substantial losses.  For example, a hedge fund buys $100K of stock with $50K of a client’s money and $50K borrowed from their prime broker.  If the value of the stock portfolio goes up 50%, the client has a 100% gain (portfolio worth $150K, less the $50K loan, leaves $100K in equity, or a double.)  If the value of the stock portfolio falls 50%, then the client is wiped out.  Returns increase faster the higher the percentage of borrowing.  For example, if a client could buy stocks with 5% down and 95% borrowed, they could double their investment with just a 5% rise in the value of the stocks.  However, a mere 5% drop would wipe them out.  So retail brokerages generally limit the initial maximum loan (margin) to 50% and the maintenance margin to 70% (i.e. if the value of the stock portfolio falls to the point, about $71,500, where the loan equals 70% of the value of the portfolio, then either the client has to put up more cash or the brokerage will sell their stocks.)  At HCMI, we never use margin because we never want to be in the position of having to sell stocks whether we want to or not.

In recent years, hedge funds have made substantial investments in strategies which can be loosely called “credit spreads.”  The low risk rate on the 10 year treasury is currently 4.76%, and you can readily “borrow” at that rate by selling treasuries short (let’s say you sell short $1 million in the 10 year, for which the maintenance requirement is 98%, not 70% as in retail equity accounts.)  You would get $980,000 to play with, as long as you covered $23,800 in coupon interest every 6 months.)  If you invested that cash in a corporate bond yielding 6.5%, you would get a coupon of $31,850 every six months ($980K *0.065/2), on which you’d capture a gain of $8,050, or $16,100/year.  Since your equity is the $20K maintenance requirement on the Treasury bond, your annual return approaches 81%!

Sound like a pretty good deal right?  The deal has gotten even better in recent years as the credit spread between treasuries and other securities have narrowed.  As yields in corporates fall, the market value of the bond rises, so not only are you making money on the coupon spread but the value of your bond portfolio is also rising.  There are other ways to enhance returns.  For example, instead of “borrowing” money in the treasury market at 4.76%, you could go to Japan, borrow yen at the current fire sale price of 0.5%/year, convert the proceeds to dollars to buy corporates.  Now your coupon spread is 6% instead of 1.74%, so you’ve almost quadrupled your interest income.  Also, you could leave the realm of AAA rated corporates and go into junk corporate bonds, or even junk mortgage securities, pushing your coupon spread towards 10%.  Awesome, right?  Unfortunately, there’s no such thing as a risk-free 10% return.  In this example, the risk is that the value of the long position (the junk corporates or junk mortgage backeds) falls, while the value of the short position (the borrowed yen or the borrowed treasuries) rises, the capital loss could exceed the net interest income.  In the case of highly leveraged funds, several, including two at Bear Stearns who should know better, have “hit the wall” in the last 6 weeks.  As a result, banks and prime brokers which until recently have been eager to lend to hedge funds, are suddenly reviewing and, if necessary, cutting credit lines.  Portfolio managers therefore must rush to sell collateral, which exacerbates the problem and causes other problems.  Private equity firms, which borrow funds to take companies private, can’t finance deals because there’s no secondary market now to take that paper off the banks’ balance sheets.

Net, there’s a loss of liquidity in US and international credit markets.  Traders can’t sell what they want, so they’re selling what they can, which is most easily US treasuries, US large cap stocks and by shorting the S&P 500 futures.  So after hitting record levels in the S&P 500 and the DJIA on July 16^th, US stock markets fell 6.1% in the following two weeks – the worst performance for stocks since 2002.  

The obvious question is: are we back to that horrible period for stocks.  In brief, no.  In 2000-2002, stock prices were plummeting because corporate earnings were plummeting, the US economy was in recession and the S&P 500 had traded up to twice fair value.  At present, corporate earnings are doing just fine, with growth for Q2 2007 projected at 8.3% but running at 12.5% for the companies that have reported so far (about 39%).  The US economy is growing at potential - 3.4% as we saw in last Friday’s GDP report.  The S&P 500 remains at a 17% discount to fair value according to the Fed Model.  So while the stock market action of the last two weeks looks grim, we’re reminded of the last major hedge fund melt-down in 1998, when Long Term Capital Management and other hedge funds in the credit spread game got wiped out.  In 2007, the trigger is the collapse of the US sub-prime mortgage market; in 1998, the trigger was the collapse of the emerging countries bond market.  The stock market which had been up 22% YTD by mid-July, gave that all back over the next 6 weeks, but closed the year with a gain of 27%.

The long term trend of the stock market was unaffected the crisis, but short term things look pretty bad, and that’s exactly where we are now.

Strategy
Last month we wrote, “Our forecast for stock market gains in 2007 remains at 8-10%.  With the S&P 500 up 6.9% YTD, that doesn’t leave much room for further gains this year.”  By July 16^th, the S&P 500 was up 10%, and now is up 3.8% YTD.  Our forecast for year end remains unchanged at up 8-10%.  We’re certainly not selling stocks now, and as cash comes in, we’ll invest it pretty quickly.

As always, please don’t hesitate to call questions and concerns.