A(nother) Cautionary Tale: Or, if it’s too good to be true, it isn’t

The Story of Peloton Partners

A London based hedge fund, Peloton Partners was hailed for its success in 2007 when its fund investing in subprime securities hauled in a spectacular 87% return. Two months later in 2008 it blew up. All $2 billion in its fund was gone in less than a month.

The “what” of their spectacular fall is interesting to follow. The “why” is more difficult to understand.

Ron Beller and Geoffrey Grant formed Peloton in 2005 after they left Goldman Sachs as star traders. Grant, now 47, was a 15 year Goldman veteran who, when he left, was the head of Goldman’s global foreign exchange and co-head of the proprietary trading group in London. Beller, 45, had led Goldman’s fixed-income currency and commodity sales group in London.

They set up offices for their staff of 60 in the fashionable Ingeni building in London’s Soho with Turkish-style meeting rooms “in bright colors furnished with low sofas.” They hired “a whole floor of risk managers and administration staff to provide investment bank-style back-up for the traders.”[1] They also hired “Dr. Evil,” Spiros Skourdos, one of the traders who cost Citigroup $25 million in fines for bond trades in 2004.[2]

These stars quickly raised a lot of capital. Their multi-strategy fund invested in interest rates, foreign exchange, bonds, bank loans and structured credit, and shares in banks and companies in the financial sector. Their first year results were a modest 4.6%, well below the average of 8% for similar hedge funds. Investors started to bolt.

According to the Financial Times, “Mr. Beller say the year was ‘somewhat painful’ and withdrawals by investors were ‘frustrating’ . . . In December 2006, in spite of some investor scepticism, Peloton launched its ABS fund to focus on asset-backed securities, subprime in particular. . . ‘Redemptions were frustrating but it didn’t change our conviction in the trade,’ Mr Beller says.”[3] The new fund attracted $2 billion from investors.

2007 was a good year for Peloton. Their multi-strategy fund earned about 26% and the subprime fund made a spectacular 87% return on capital. It made Beller and Grant a lot of money.

They felt good about their strategy. They followed a long-short strategy which went long on less risky AAA tranche subprime securities and went short on the riskier BBB grade certificates. (For an explanation of how these securities work, please see Peeling Back the Onion, below.) The short position worked wonderfully.

“’With hindsight we were way too smart last year,’ Mr Beller says. ‘We could have just closed our eyes and shorted the index and made a lot more money but now credit differentiation is important again.’ . . . But Mr Beller predicts that the credit crisis will worsen – and contends that Peloton is ready. . . .’These are terrific trading markets,’ he says. ‘There’s a lot of volatility and uncertainty and these are the conditions where we find good trading opportunities.’”[4] He said this in February, 2007. They were so confident that Beller and Grant had $117 million of their own money invested in the subprime fund. They were even contemplating raising another $500 million.

In one month the fund was broke.

Peloton had changed their strategy. They bet that the AAA tranche, on which they had gone long, had fallen purely due to technical factors and would rise. They were buying “undervalued” AAA certificates. Because of their margin leverage of about 4–5%, they had a long portfolio of $8–$9 billion of AAA tranche assets.[5]

They market didn’t cooperate and kept dropping. In February their holding dropped 10% to 15% and the margin calls started coming in. At first they thought they could sell the portfolio and recover something. In the end their creditors, Goldman included, seized their assets and their subprime fund was wiped out. Also their multi-strategy fund had about 40% of its assets invested in the subprime fund.

“’I just can’t come up with the words to express our regret adequately,’ Mr Beller said, according to investors.’”[6]

According to the same Financial Times article, Beller had told investors there were seven reasons for the collapse.

“’. . . [B]anks‘ own losses on their home loan portfolios, the lack of interest from long-only funds in AAA mortgage assets, the collapse of several smaller funds and rising “haircuts”, or margins, from banks.’

“’In some cases,’ he said, ‘margin requirements doubled or tripled the cash required to be put up to buy loans – moves that also threaten other leveraged investors.’

“’This was not and is not a Peloton-specific issue,’ Mr Beller said.

“’Counterparts made clear to us they were increasing haircuts across the board and our efforts to get an exception for Peloton in the face of the increases were largely rejected.’

“’We believed we were positioned to weather this storm. In the event the cumulative impact of these and other events proved devastating,’ he said.”

Wow! In February they were on top of their game. In March they were wiped out.

They bet wrong: shades of Long Term Capital Management.

I don’t mean to unnecessarily pick on Peloton or Messrs. Beller and Grant, but they bet the farm on something they didn’t see coming and didn’t plan for the worst case. What were all those risk managers doing? They weren’t reading the same articles I saw. You can’t criticize them for being insincere since they had their own sizable assets invested. They believed whole-heartedly that they were right.

But how could Beller say in February that the credit crisis would worsen but that those were ideal trading conditions and then go long? It must have been those “technical factors.”

Let’s look at the US housing market in February, 2008. As we all know, the mortgages that were backing the securities Peloton bought were junk paper because the housing market collapsed and was continuing to deteriorate. Housing inventories were at their highest level since the bust of the 1990s, foreclosures were still climbing, and developers and their lenders were in trouble. For a more detailed explanation of this, see the article, below, Peeling Back the Onion. In was obvious that these subprime loans were really “junk” since you can’t spin BBB/BB/B paper into gold, no matter how the senior tranches are secured. If the market falls apart, junk is junk.
Why do hedge fund managers (who don’t really seem to hedge) think they are investing and not gambling? Even Vegas has odds. It’s as if they thought they were playing poker and didn’t realize they were actually playing Russian roulette.

For those who wish to avoid the following opinions and think Nassim Taleb’s books, Fooled by Randomness and Black Swan, are ivory tower intellectual exercises, you can tune out now.

I will give Messrs. Beller and Grant credit for being very bright and capable guys. I think they were honest and hard working. They enjoyed doing good works with their money. Maybe all the money around them made them “Masters of the Universe” and they got greedy. Maybe not. Look, Wall Street and the City are where people are supposed to be greedy. That’s what motivates traders.

I will suggest that the Peloton managers:

1. were blinded by their own success; and
2. they had no idea that they were gambling.

Success does something to people. It makes them think they’re smart, not lucky. You can’t blame them; that’s human nature. As Taleb points out, we humans have an urge to explain things in cause and effect terms. If you make a huge amount of money at a young age (or even in old age) you’re going to think you’re pretty damned smart.

If you’re pretty damned smart you’re going to think other people are not as smart as you or even that they’re pretty damned stupid. ”If you’re so smart, how come you’re not rich (as me)?” I’ve seen this so many times in almost every domain of human enterprise that it should seem pretty obvious.

What these people miss on the way up is that they’re pretty damned lucky. You’d have to read Taleb to fully understand luck and the randomness factor in investing. Let’s just say that if you made a scatter graph showing the investment results of all investment advisors, it would look just the same as a randomly generated pattern. Hmm. That means it’s tough to tell if you’re smart or lucky. According to the randomness pattern, some people are going to be luckier than others. Some are going to be really, really lucky, but not many. For purposes of surviving long term on Wall Street, it’s best to assume you’re lucky.

That gets to my point number 2. Taleb reveals in Black Swan that really risky events occur regularly but investors never see them coming. Especially the investment pros. They think they’ve got risk covered: the math works out just fine. But they always get creamed by some huge unforeseen event (which Taleb calls a black swan). These guys were so confident that they put their own money in and were going for another $500,000,000 from investors.

The Peloton managers assumed that the AAA tranche certificates would rise, not fall. They never hedged against the fall. They blanked out. They, like the Long Term Capital Management managers (which included a Nobel Prize winner) in 1998, assumed that they were playing poker. In poker you can calculate odds. In the real world you can’t. That’s because we humans don’t act according to Newtonian mechanistics; it’s difficult to plot future human action on a bell curve.

They were playing Russian roulette. Hindsight you say? No. The whole point is that black swan events occur regularly. Yet we’re always calculating risk analysis for the last black swan that happened. We never see the next one coming.

You would think, with the knowledge that black swans regularly occur, investment advisors would better hedge their risks. In Peloton’s case, why didn’t they hedge so that if the market for the AAA tranches went down in price, they would not lose everything.

These guys were victims, in a way, of their own humanity. We’re all wired about the same and we tend to make the same mistakes regardless of what history or the facts tell us. I believe that if they had read and understood Taleb’s books they wouldn’t have made as much money but they also wouldn’t have blown up and lost everything.

I actually don’t think the investment world will learn these lessons. I just read an article where one of the founders of Long Term Capital Management is having problems with his new bond fund.[1] This time he said he accounted for riskier markets by reducing leverage but he still was margined about 15:1. He’s down 28% and facing margin calls. It’s kind of depressing.

[1] Financial Times 2/3/2008
[2] Financial Times 7/3/2006
[3] Financial Times 2/3/2008; emphasis added.
[4] Ibid.
[5] Financial Times 2/29/2008; The Times 3/1/2008
[6] Financial Times 3/5/2008
[7] “A Decade Later, John Meriwether Must Scramble Again” WSJ 3/27/2008

Another Depressing Footnote:

Zwirn Mulls Launch of New Fund

By JENNY STRASBURG and GREGORY ZUCKERMAN April 2, 2008 1:30 p.m.
Daniel Zwirn, the hedge-fund manager who froze withdrawals on $4 billion in assets about a month ago after investors asked to pull more than half their money out, is already talking about starting a new fund.

Mr. Zwirn, 36 years old, has locked up clients of New York-based D.B. Zwirn & Co. for likely four years or longer as it winds down the loans, real-estate holdings and other investments in its D.B. Zwirn Special Opportunities funds. Even before he gave formal notice of that plan in February, Mr. Zwirn, a former senior investment manager of hedge-fund firm Highbridge Capital Management, was gauging interest in a new venture, according to people familiar with the conversations.