The Sub-Prime Crisis and the Hedge Fund Collapse

Here as we approach the 20th anniversary of the crash of October 19th, 1987, the academic world is starting to read the entrails of the hedge fund crash of 2007 as it relates to the sub-prime crisis.

In August, the financial world trembled as hedge funds involved in CDO's, most notably two funds of Bear Stearns, collapsed. Even this week, news of potential equity investments by Buffett or perhaps others have led to speculation in Bear Stearns stock (BSC).

What is sometimes missed is how verklempt the financial world got in August. A wave of deleveraging of hedge funds ensued which resulted in some very strange occurrences, namely cheap stocks, or value stocks, got pummeled, and expensive stocks, or popularly shorted stocks, rose. This caused a lot of pain on the street, especially among quantitative hedge funds, or quants.

In an academic article "What Happened to the Quants in August 2007?" by Andrew Lo, an MIT prof and a quant hedge fund manager, as well as a letter to clients by Cliff Asness, another well-respected hedgie, the conclusions are pretty much the same:

Here is a quote from Lo in an article in the International Herald Tribune: "Now that we have so many boats in the harbor, you can't whiz by at 50 knots without rocking a few boats." He is referring to the proliferation of hedge funds in equity neutral or long/short equity which ten years ago totaled about $10 billion. Today, that's a $160 billion figure. "In the middle of the ocean, your wake has no impact, but in a crowded harbor, a fast exit can cause quite a disruption."

Asness describes a similar viewpoint, "I have said before that 'there is a new risk factor in our world,' but it would have been more accurate if I had said 'there is a new risk factor in our world and it is us.' In his view, the gulf between cheap versus expensive got way too narrow in August, but has now become wide again. The problem was that too many boats were heading for the same exit.

The most highly shorted stocks showed a big uptick in trading volume. Worse yet, they beat the least shorted stocks by about twelve percentage points through the middle of August.

In Lo's paper he suggests that:

"The losses to quant funds during the second week of August 2007 were initiated by the temporary price impact resulting from a large and rapid unwinding" of one or more quantitative equity market-neutral portfolios. The speed and magnitude of the price impact suggests that the unwind was likely the result of a sudden liquidation of a multi-strategy fund or proprietary-trading desk, perhaps in response to margin calls from a deteriorating credit portfolio, a decision to cut risk in light of current market conditions, or a discrete change in business lines."

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