Be your own hedge fund?

There was a small implosion on Wall Street on Tuesday, February 20th. It didn’t make the front page of most the finance and investing news websites. But there is a fascinating story around this implosion that I think is worth reviewing.
First though, a little background.

arbitrage \AR-buh-trahzh\, noun:
The nearly simultaneous purchase of a good or asset in one market where the price is low, and sale of the same good or asset in another market where the price is higher.

Hedge funds frequently make money by engaging in all kinds of arbitrage trades – mergers, convertibles, bonds, etc.
In order to cool an overheating economy the Fed began tightening the belt and raising interest rates a couple years ago. As a result an imbalance in interest rate markets occurred – one that retail investors, as opposed to hedge funds, were uniquely positioned to take advantage of. While interest rates rose Internet banks began offering high-yield FDIC insured savings accounts, offering rates of up to 5.5% in order to attract money to back mortgages. At the same time, credit card companies were offering up 0% balance transfer offers. These offers were designed to generate new customers who, presumably, would transfer balances away from other credit cards and after their promo rate expired would begin paying interest in the balances to the new company.
A funny thing happened though. The proliferation of both the 0% offers (and very loose lending standards) and the high-yield savings accounts created the opportunity for consumers to act like a hedge fund. And they have. Entire message boards are filled with people engaging in ‘App-o-Ramas’ where they apply for 10, 20, 30 different credit cards with 0% offers. Many people have been able to achieve aggregate credit lines of over $250,000. They then take the 0% money from the credit card company, drop it into a savings account and make ~5%. Simple, and relatively safe actually.
The story doesn’t end there though. People get greedy, which usually results in people getting stupid.
One enterprising guy decided that 5% wasn’t nearly enough return, and figured inflation would eat up all his profits. So, he decided that putting the money into the stock market was a better idea. And not just any stocks, but stocks with ultra high-yield dividends – Canadian Royalty Trusts. And when those stocks tanked due to tax of new regulations, he moved a lot of money into the sub-prime mortgage stocks.
And even dropping $200k of credit card money into the stocks wasn’t enough – he took out a loan, secured with the stock of the sub-prime mortgage company he was invested in, to buy more of the stock. Talk about being leveraged to the hilt.
Well, anyone that’s been reading the newspapers had to know that the sub-prime industry was in for a hit. And then, HSBC announced some bad news in early February related to the sub-prime portion of their business. At this point all signs were pointing to the exit. But money makes people stupid and a 30% dividend is hard for some people to pass up.
And then the bottom fell out. After market close on the 20th, Novastar Financial – a REIT structured sub-prime lender announced some bad news. Very bad news. In addition to having to buy back a lot of bad debt from banks, they didn’t expect to earn any taxable income until 2011 and are seriously looking at moving away from the REIT structure due to those reasons. A stock that had already fallen almost 50% since December dropped another 30% overnight.
Obviously, the gentleman in question took a big hit (I don’t believe he was 100% in Novastar, but had significant leveraged exposure). Novastar may recover eventually but he likely wont have the luxury of just waiting it out since his investment was so highly leveraged. Furthermore, he still has potential downside since he can’t afford to liquidate his full position as it’s backing the stock secured loan. Talk about a bad day.
The whole gory story plays out here – it gets interesting on page 8 of the thread.
If you want the real in-depth view on how it played out beginning to end the guy’s website is located here, where you can dig through the archives to see his thinking.
Moral to the story? Understand the difference between engaging in arbitrage and making highly leveraged high-risk investments, and definitely understand the value of a well diversified portfolio.
For a completely tangential connection – read on…

Continue reading Be your own hedge fund?

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