2008 will be remembered as a watershed year, unless, of course, 2009 is worse. Along with the notable failure of banks, insurance companies, mortgage insurers, housing and the US consumer, we witnessed the annihilation of multiple investment strategies and asset classes. Over leveraging of risky assets led to much of the current economic malaise. The failure of tens-of-billions of dollars of macro hedge funds largely following the same strategy (no one had an original idea: buy commodities, sell financials names and borrow Yens at low interest rates for leverage) exacerbated the speed and magnitude of the decline. These funds operated off of the greater fool theory; each thought they could exit their positions before markets turned; they were grossly mistaken. Simultaneously, many other hedge fund strategies clung to risk models that ignored extreme illiquidity, volatility and contagion theory, especially as many of them simultaneously sought to unwind trades (i.e., ran for the exits). Concurrently, the freezing of credit markets even brought substantial losses to those who thought they were invested in safe short-term assets. The moral: people realize that sometimes return of investment is more important than return on investment.
Even closed-end funds (CEFs) were out-of-favor for much of the year; leverage was a big part of the reason why. CEFs’ continued use of leverage hurt their net asset values (NAVs) by magnifying losses. In addition, the cost of CEF leverage, as measured by penalty rates, briefly rose above long-term earning power, thus threatening dividend security. Net asset value performance, although dismal, was better than share price performance as discounts widened sharply.
2009 will be about the willingness and ability of the authorities to pursue policies that mitigate the worst side-effects of a world that needs to see colossal rebalancing and continued de-leveraging over the next few years. 2009 may also see the distinction between government risk and corporate credit risk blur; this should be good news for the investment grade bond market. However, the huge need for the US to continue to de-lever suggests that there is much macro pain to come. For credit it will still be a very bumpy path but in terms of big picture market timing, Q4 2008 marked the point where governments accelerated their socialization of financial and corporate sector credit risks by making direct investments into public companies.
Michael Ashley Schulman, CFA
Hollencrest Capital Management