Fri, 18/07/2008 - 07:00
As equity markets sag under the weight of bad economic news and the continuing problems of the global financial industry, short sellers are having a field day. Short bias funds shot the lights out in terms of performance in June even as the hedge fund industry as a whole slipped into negative territory for the first six months of the year. But managers need to look over their shoulders as regulators in the US and elsewhere hastily impose new controls on short selling and seek to pursue traders found to have illegitimately "talked down" their targets.
Activist hedge fund manager William Ackman has suggested a rescue plan to restructure Fannie Mae and Freddie Mac which, he claims, will reduce leverage at the two government-sponsored but stock market-listed mortgage lenders.
Ackman, who oversees USD6bn at hedge fund manager Pershing Square Capital Management, advocates a restructuring of Fannie and Freddie in which the common and preferred equity would be wiped out and the subordinated debt exchanged for equity warrants.
He proposes that for every dollar of senior unsecured debt held, a holder would receive 90 cents in new senior unsecured debt and 10 cents worth of new common equity. "That raises equity by USD75bn," Ackman says. "By eliminating subordinated debt of USD11bn, you are creating another USD11bn worth of equity."
Under the plan, made public in a presentation entitled How to Save Fannie and Freddie, holders of junior Fannie debt would get warrants, while common and preferred shareholders would get nothing.
The bleeding continued at both institutions on Tuesday, with the stocks of both mortgage giants down by as much as 30 per cent, suggesting that investors were not comforted by Treasury Secretary Henry Paulson's plan announced at the weekend to recapitalise the two companies.
But following Ackman's public intervention, Fannie Mae rebounded 13 per cent to USD8.02 on Wednesday morning in New York, while Freddie Mac climbed 15 per cent to USD6.03 - perhaps indicating that the market is more impressed by the hedge fund manager's proposal than by the Treasury plans.
"You'd think a statement from the Treasury secretary would have more credibility than from someone who's short the stock," says Richard Pzena, head of Pzena Investment Management. The times they are a-changin'.
Yesterday, a former Bear Stearns hedge fund manager opened her own firm with nearly USD1bn in assets. Melissa Ko, who generated annual returns of more than 25 per cent while running the Emerging Markets Macro Fund at Bear Stearns between 2005 and 2007, has now struck out on her own with New York-based firm Covepoint Capital.
Ko was part of the Bear Stearns Asset Management division that managed around USD27bn when the group was acquired by JPMorgan Chase after pessimistic market sentiment pushed it to the verge of a liquidity crisis.
She is just one of many members of the financial services industry who have seized the disruption unleashed by the credit crunch as an opportunity to quit salaried employment and take up the challenge of being their own boss.
Newcomers to the industry include many former bankers. Earlier this month, two former heads of fixed-income at Citigroup, Randy Barker and Geoff Coley, announced they were launching a hedge fund. Back in April, GLG's star emerging markets manager Greg Coffey decided to walk away from USD250m in share options and bonuses to start his own business when he quits the firm in October.
More than 45 traders, bankers, analysts and other executives have left investment banks this year to join hedge funds and private equity firms, according to Bloomberg. That's even before you include people starting their own companies, suggesting that reports of a slowdown in the alternative investment industry may be somewhat exaggerated.
Troubled times bring waves of rumours and speculation. But sometimes this goes too far, especially if it leads to something more serious, even illegal, like insider trading or wilful market manipulation.
The Securities and Exchange Commission announced on Sunday that it and other US securities regulators would begin examining rumour-spreading intended to manipulate market prices. The announcement, made before Monday's market opening in Asia, was designed to warn off broker-dealers, hedge funds and investment advisors from any deliberate rumour-mongering before the start of trading.
The turbulence in the markets last week, with rumours adding to public concerns about the fundamental soundness of some financial institutions and especially the US government-sponsored mortgage lenders, Fannie Mae and Freddie Mac, hastened the decision to begin the enquiry and to make it public.
"Traders know there is false information in the market," says Lori Richards, director of the SEC's Office of Compliance Inspections and Examinations. "It's important that firms be aware of their supervisory and compliance obligations to prevent violations of the securities law."
The probe will focus on what policies firms have in place to prevent the passing of false information and is aimed at stopping malicious rumours without hampering the natural exchange of information in the marketplace.
Short sellers such as hedge funds, who have been accused of spreading bad news about target companies in order to boost their gains, deny that they plant false information. The reason Wall Street is vulnerable, they say, is because financial services firms have failed to come clean about the extent of their losses on risky bets and fragile business models.
Bad times increase risks, and they are also prone to herald new waves of regulation and litigation. This week industry members may be somewhat more cautious about what they gossip about and with whom.
As the shares of US mortgage giants Fannie Mae and Freddie Mac went into freefall on Friday, plummeting to their lowest levels in more than 17 years, short sellers were counting their winnings. The slump was prompted by concern that a government bailout would be necessary for the largest providers of financing for US home loans.
Fannie Mae's shares were down 49 per cent to USD6.68 at one point on Friday morning before rebounding to USD10.25 by the close of trading - still a decline of more than 22 per cent.
Most short sellers are hedge funds. Many managers that have shorted Fannie Mae and Freddie Mac in the past say they would do so again.
According to former US Treasury Secretary John Snow, Fannie Mae and Freddie Mac have relied on leverage to fund their businesses in the same fashion as a hedge fund. Snow, now chairman of New York-based private equity firm Cerberus Capital Management, told Bloomberg that when in office, he suggested that "the business model they were using was really that of a hedge fund". Fannie and Freddie are dependent on continuous access to short-term credit markets in order to support their mountain of debt.
While shareholders are bemoaning the falling value of their investments in the mortgage giants, short sellers are probably sizing up new victims.
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