Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street
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Ron Beller and Geoff Grant, another former Goldman Sachs partner, ran Peloton Partners, named after the vee-like bird formation adopted by endurance bicycle riders that lead the pack by taking advantage of drafting to reduce wind friction. In January 2008, Peloton Partners LLP was riding high. It had two funds, the $1.6 billion Peloton Multi-strategy fund, and the $2 billion Peloton ABS fund.4 The latter fund won Eurohedge’s best new fixed-income fund of the year award, after reporting a stunning net return of 87.6 percent for 2007.When the fund’s returns were announced, some of the attendees at the awards ceremony “gasped.”5 Shock and awe. Beller and Grant were lauded as “hedgie heroes.”6 Within two months of receiving these accolades, Peloton’s $2 billion ABS fund collapsed, and Peloton put its offices up for sale.
Beller told potential investors that his strategy was to make bets on a variety of assets to make money from global economic trends. He made leveraged bets on these trends, and for that to work, he had to be on the right side of the trend.
Initially, the ABS Peloton fund took short positions in subprime mortgage backed securities making huge bets against the U.S. housing market as John Paulson had done very successfully. Since the prices of those securities plummeted in 2007, the short position had huge gains. But what would Peloton do for an encore? There had to be another big trade. If only Peloton Partners could pedal to where there was luck—there must be more money! After all, spread relationships for AAA and AA rated products looked out of line with historical relationships. The spread curve should revert back to historical levels, according to the market timer’s nursery rhyme. So the fund also bet that the “highly rated” mortgage securities trading at more than 90 cents on the dollar would be protected by subordinated investors eventually paying back all of the principal, and he went long these assets. Like market timers before them, Peloton Partners ended up with speculator’s results. A fundamental analysis of the type Graham had advocated suggested that those “highly rated” products were overpriced and overrated. The prices were not going to revert back to “historical” levels; the prices would drop to reflect a lower fair value based on imperfect (but highly negative) loan performance data combined with the illiquidity that uncertainty about one’s imperfect data brings. This is a market timer’s worst-case scenario. Peloton Partners lost $17 billion in “a matter of days.”7
The Peloton ABS fund used credit derivatives (it sold protection) to go long $6 billion of exposure to two ABX indexes (the 2006 AAA and 2006 AA rated ABX indexes). In all, it was long $15 billion on various mortgage-backed assets and only partially hedged with short positions. Peloton was said to have leveraged up four or five times, “normal for a credit fund.”8 Leverage “averages” are misleading when the assets themselves are inherently very risky (mispriced in the opposite direction to your trade). When the price of the “highly rated” 2006 ABX indexes continued to drop, Peloton’s 14 lenders, including UBS, Goldman and Lehman, asked the fund to come up with more money to top up its cash cushion. Peloton’s ABX positions headed around Dead Man’s Curve and the fund skidded off the edge of the cliff.
Since Peloton liked bicycle analogies, this simplified one may help explain its problem with leverage. Suppose Peloton’s assets consist of a fleet of uninsured bikes originally worth $1 million purchased with $200,000 of its investors’ money and $800,000 of money borrowed from an investment bank. The investment bank says that at all times, Peloton must keep a balance of pledged assets—any assets—against the $800 million loan of $1 million in value. The extra $200,000 is margin collateral for the loan, a cushion for the investment bank making it unlikely that the investment bank will lose money. Initially, Peloton pledges the entire $1 million fleet of bikes as collateral for the $800,000 loan with the investment bank. If Peloton damaged 5 percent of its bikes due to rough riding, the assets would only be worth $950,000, and the bank would ask Peloton for another $50,000 in collateral to maintain the cushion. This is known as a margin call. If Peloton has enough cash on hand there is no problem. But if Peloton does not have enough cash (or liquidity) to meet the investment bank’s demand, it will have to liquidate the assets—sell the bicycles and unwind the position—to pay back the bank. Since the bikes are worth $950,000, the bank is paid its $800,000 in full, but the original investment of $200,000 is now only worth $150,000 for a 25 percent loss on the investors’ original capital.That’s the downside of leverage on fixed assets.
Now suppose that 25 percent of Peloton’s bikes round Dead Man’s Curve and skid off a steep cliff. One quarter, or $250,000, of the value of the fleet disappears. Peloton loses the investors’ entire original $200,000. More than that, if the bank repossesses the fleet and sells it—known as unwinding the position—it will not get back the full amount of the $800,000 since the $200,000 cash cushion the investors provided has been used up.The bank loses $50,000 and only gets back $750,000 of its original $800,000 loan. The investors lose 100 percent of their initial equity; the investors are wiped out. But the investment bank, the creditor, loses 6.25 percent of the original principal on its loan.
Bear Stearns’s shareholders and creditors had Peloton’s demise fresh in their minds when, a couple of weeks later, a confluence of events raised questions about Bear Stearns’s solvency. If Peloton were an investment bank, shareholders would be wiped out, and only the bond-holders and other creditors would recover some (or all) of the original amount of the debt.That is the power of leverage.When things are going your way, everyone is euphoric and gasping with delight. When things do not go your way, shareholders can be wiped out. The results can be dramatic and swift, and instead of gasping with delight, shareholders are gasping for air.
Funds that leverage risky debt assets without sufficient liquidity are doomed to collapse. Yet, time and again, bankers extended credit lines to funds using fully priced tranches of collateralized debt obligations, turning a blind eye to the unwind potential.
When we first met, Warren explained that he evaluates the underlying collateral: its probability of default and its probable recovery value. He avoids leverage and looks for a risk premium payment to cover potential losses and more. Peloton was about as far away from Warren Buffett’s philosophy as one can get.
Peloton’s problem with making leveraged bets on fixed-income securities was that they had little or no upside, and the securities underlying the ABX index were overpriced when Peloton put on the trade even though they had already dropped from par to prices ranging from 90 to 95.The downward price swing was due to irreversible damage in the underlying collateral, and unlike a manufacturing company, there is no source of future earnings to make up for the lost cash.9
In January 2008, when Beller accepted his award, Peloton thought it had solid credit lines and thought its $750 million in cash was more than enough liquidity to meet margin calls. It was wrong. On February 25, 2008, the ABX index prices dropped and when Peloton tried to sell assets to meet margin calls, brokers wouldn’t bid. At one point Beller, like the rocking horse winner, “collapsed on a couch in distress.”10 On February 28, lenders seized the assets of the Peloton ABS fund.
Beller, Grant, and a third partner had around $117 million11 of their own money plus the previous year’s fees invested in the ABS fund; Beller’s individual loss is said to be $60 million. Beller may not have learned his lesson. He reportedly believes that the Peloton ABS fund failed because the prices were only temporarily depressed when his bankers made margin calls and pulled their credit lines. The reality is that the delinquencies of the loans backing the poorly structured assets in the home equity indexes ensure prices will not recover to the lofty levels at which Beller put on his trades. Peloton’s long positions were partially hedged with short positions in lower quality mortgages. 12 It seemed to me the damage to “higher rated” tranches had yet to be acknowledged by a market that was still in denial. Investors seemed to avoid fundamental analysis at the time Peloton put on its original trades. BlackRock Inc. and Man Group PLC among others also lost money on thei
r investment in the fund.
The $1.6 billion Peloton Multi-strategy fund had contributed $500 million in investor money to launch the Peloton ABS fund. Investors’ assets were frozen and Peloton Partners wound down the fund. It is estimated that within the month of February 2008, investors in the Multi-strategy fund lost half of their capital. Beller and Grant wrote a letter to investors during the last week of February 2008 bemoaning the fact that their creditors had “severely” tightened their terms “without regard to the creditworthiness or track record.”13 In early March, a week after the Peloton ABS fund collapsed, Peloton Partners put its offices in London’s Soho district on the market.
As Benjamin Graham observed, the market is not there to instruct you. The market isn’t trying to teach you something when prices rise or fall (or when spreads widen or narrow) relative to where they were historically. You can stuff all of that information into a model (or your head) if you want to, but manipulating market numbers—if that is all you are doing—will not tell you anything about value. It is up to you to analyze the fundamental value and compare it with the market. Peloton Partners was not alone in skimping on fundamental analysis, but Peloton was not as well connected as the Carlyle Group, which had a fund of its own rounding Dead Man’s Curve.
Washington-based Carlyle Group is the world’s second largest private equity firm, and the most well-connected. As of March 13, 2008, it managed $81 billion in 60 venture capital funds.14 Louis V. Gerstner Jr., former CEO of IBM, chairs the group founded by Dan D’Aniello, William E. Conway, also chairman of United Defense Industries; and David Rubenstein, former policy advisor to former President Jimmy Carter. The Carlyle Group’s employees past and present include former President George H. W. Bush; his former Secretary of State James Baker (also President Ronald Reagan’s Chief of Staff and later his Secretary of the Treasury); former Carlyle head (until 2003) Frank Carlucci, President Reagan’s CIA director and defense secretary; former British Prime Minister John Major, Ken Kresa; former CEO of defense contractor Northrup Grumann; and Louis Giuliano, former CEO to military and oil electronics supplier ITT Industries. One of Carlyle’s investors is Shafig bin Laden, one of Osama’s many brothers. Shafig was one of the honored guests at a Washington-held Carlyle conference on September 11, 2001, the day his brother’s Al Qaeda terrorists hijacked U.S. passenger airliners and piloted them into the Pentagon and the World Trade Center.1516
Carlyle Capital Corporation Ltd. (Carlyle Capital), one of the funds managed by the Carlyle Group, was troubled since July 2007, the day it launched its initial public offering.The fund was registered in the island of Guernsey in the United Kingdom, run out of New York, and its IPO listed and traded on the Amsterdam Stock Exchange.The IPO was scaled down and delayed due to a nervous market. It ultimately raised $345.5 million, $54.5 million under its initial target of $400 million. Carlyle Capital Corporation ominously chose CCC as its stock ticker. 17 Within two months the market would ask whether CCC stood for its stock ticker or a near-default credit rating.
Like the doomed hedge funds managed by BSAM, Carlyle Capital financed its asset purchases with repurchase agreements. It had around $940 million in investor capital backing $22.7 billion in leveraged borrowings. CCC was around 24 times leveraged, meaning that if the price of its assets dropped 4 percent, the initial investment of its investors would be wiped out if it were forced to liquidate assets.18 If the price dropped more than that, its creditors, including a number of U.S. investment banks, would also lose money. Given that there were questions about the quality of the mortgage loans backing AAA rated securities, and given the low prices revealed when the BSAM’s bid lists circulated, a price drop of more than 4 percent was very likely.
By August 2007, the month the Fed indirectly bailed out Countrywide’s asset-backed commercial paper, the Carlyle Group provided CCC with a $100 million unsecured revolving credit facility to help meet margin calls. The value of CCC’s investments in AAA U.S. government agency residential mortgage-backed securities, declined in value. At the end of February 2008, the Carlyle Group increased its credit line from $100 million to $150 million.19 Carlyle Capital reported a net profit for 2007 of $16.8 million while downward price pressure on its assets persisted. In early March 2008, CCC received a notice of default for failing to meet a margin call, and it announced that since August it had sold around $1 billion in assets in an attempt to decrease leverage and increase liquidity. On March 7, 2008, after CCC could not meet additional margin calls, trading in CCC shares was suspended.20
JPMorgan Chase vice chairman James Lee Jr., warned a Carlyle Group founder, David Rubenstein, that unless it could line up a huge capital injection, the funds’ collateral would be seized to satisfy its debts. The problem was that the only likely source of capital for the fund was the Carlyle Group itself. JPMorgan Chase was asking the Carlyle Group to bail out its hedge fund the way Bear Stearns had bailed out BSAM’s doomed funds. If the Carlyle Group bailed out its fund the way Bear Stearns had bailed out the funds managed by BSAM, it could lose some of its own principal, and losses would probably eclipse its $16.7 million in profits reported for 2007. On the other hand, investment banks seizing collateral would use up much needed liquidity. If investment banks were forced to immediately liquidate Carlyle’s billions in assets, they would take losses and drive market prices down even further. As of March 10, 2008, Carlyle Capital stared down the barrel of around $400 million in margin calls it couldn’t meet, and it asked its lenders for a standstill agreement.21
Bear Stearns had its own liquidity problems that week as the market speculated on its exposures. Even the breaking Governor Spitzer pay-to-play sex scandal could not upstage the March 10 Moody’s Investors Service’s downgrade of tranches of mortgage-backed debt issued by Bear Stearns Alt-A Trust. Bear Stearns was one of Carlyle Capital’s creditors and now this. Throughout the day of March 10, rumors circulated that Bear Stearns was sinking fast from lack of liquidity and possibly even insolvency. Bear Stearns officially denied it, saying there was “no truth to the rumors of liquidity problems.”22
In reaction to the market’s reaction, Moody’s clarified that its ratings actions did not affect Bear Stearns’ corporate ratings, which it viewed as stable. The rumors persisted. At the end of the day, Bear Stearns issued a press release quoting Alan Schwartz, then its president and CEO. “Bear Stearns’ balance sheet, liquidity and capital,” he said,“remain strong.”23
On March 11, 2008, Bloomberg News issued its article suggesting the rating agencies propped up AAA rated subprime residential home equity loan-backed bonds backing the ABX index. According to its analysis of S&P data, none of the assets backing the index merited an AAA rating and it took only a short step for readers to realize that 90 percent of the bonds in the AAA index were not even investment grade.24 “Peloton,” I told an investment banker, “was leveraged and long an ABX index, so the news suggests the depressed prices may not rebound and investment banks will take losses on those positions. Carlyle’s CCC is long AAA agency assets, and it cannot meet its margin calls. No wonder they want the Carlyle Group to put up more collateral (margin).”
The Carlyle Group was not alone. Anyone who was long would have to put up more collateral. Was John Paulson correct the previous summer when he hypothesized that, when Bear Stearns appealed to ISDA, it was trying to avoid making billions of dollars in payments on credit default swaps?25 If so, the Bloomberg article was devastating news. At a minimum, Bear Stearns would have to come up with more collateral to back those trades and it might eventually have to make payments to cover defaults.
The Federal Reserve Bank took unprecedented action that had the effect of being an indirect bailout for the Carlyle Group. It created a new Term Securities Lending Facility (TSLF). Instead of lending overnight it extended the term to 28 days to primary dealers and would accept “federal agency debt, federal agency residential mortgage-backed securities, and nonagency AAA and Aaa rated private label residential MBS.” The program would start thro
ugh weekly auctions beginning March 27, 2008, and the Fed would lend up to $200 billion of Treasury securities in exchange for the collateral.26 How soon can you stuff overrated AAA assets to the Fed so you don’t have to show a loss on your balance sheet?
Traditionally, the Fed freely provides liquidity to the U.S. banking system’s securities arms including: Banc of America Securities LLC, HSBC Securities (USA) Inc., and J. P. Morgan Securities Inc. But the Fed had never before opened securities lending to all primary dealers including some foreign banks, U.S. brokers and investment banks: BNP Paribas Securities Corp, Barclays Capital Inc. Bear, Stearns & Co., Inc., Cantor Fitzgerald & Co., Countrywide Securities Corporation, Credit Suisse Securities (USA) LLC, Daiwa Securities America Inc., Deutsche Bank Securities Inc. Dresdner Kleinwort Wasserstein Securities LLC., Goldman, Sachs & Co., Greenwich Capital Markets, Inc., Lehman Brothers Inc., Merrill Lynch Government Securities Inc., Mizuho Securities USA Inc., Morgan Stanley & Co. Incorporated, and UBS Securities LLC. Although the program would not begin until March 27 for primary dealers, banks should now be more willing to provide back-door financing for them in the meantime.