When Hedges Fail

Here's a gentle reminder for CFOs and risk officers at major international banks: If you hedge your position but you don't hedge it 100%, then you haven't fully hedged your position.

Last month, it was UBS (UBS), which made a decision based on "statistical analyses of historical price movements" that if it hedged its super-senior bonds against a price fall of somewhere between 2% and 4%, then those bonds were fully hedged. Now, it's Lehman Brothers (LEH):

Erin Callan, Lehman chief financial officer, has said publicly that Lehman's previously successful hedges, which included bets against indexes such as the CMBX, which tracks the performance of commercial mortgage backed securities, are no longer performing well...

Any second-quarter loss would be driven by both a reduction in the value of those holdings as well as the less effective hedging.

Many hedges are limited: They give you protection against some of the possible downside, but not all of it. That's clearly what's happening here - as the holdings continue to decline in value, the hedges have essentially been used up.

The worrying thing is that Lehman has some seriously enormous exposures here:

At the end of the first quarter, Lehman said it had exposure of $36.1bn to commercial mortgages and related securities and $31.8bn in exposure to residential mortgages and securities.

Add those two together and you get $67.9 billion, which is three times Lehman's market capitalization and (since the bank is trading on a price-to-book ratio of 1) three times its book value, too.

Maybe it's time to revisit Jesse Eisinger's column about Lehman's balance sheet.

Comments

[CreditTrader:]

Hey Felix, love your stuff (though think Walnut Creek/East Bay can be beautiful!) - wanted to get your opinion on the UBS/BX deal. Seems to me like they are doing nothing but the old super senior play. Pool up crappy loans, sell BX first-loss piece (at a discount), and then lend them the rest - nice bit of Basel II arbitrage (lowers capital coz first loss is gone) but the risk remains and the loan terms (we don thave them) must have been spectacular for BX to take this...also check out the Fed's lending activities in the last few days...and the US brokers are spiking in CDS land...keep up the great work.

2008 May 22 11:13 AM

[icandoitdon:]

a perfect hedge is not viable because it is not economical. the cost of a perfect hedge so bady dilutes the underlying position as to negate it's purpose.

to use an example, if the only perfect hedge in the stock market is to have offsetting short and long positions in the same security. what's the point?

the real issue is managing risk. i would submit that investment banks do it poorly because they use far too much leverage. the only reason the full effects of it have not been recognized is that the federal reserve has become their sugar daddy.

2008 May 22 02:17 PM

[master_trader:]

just need to realize that 1 in 1,000 year events occur every 4-5 years and then you can risk adjust properly without needing an uneconomical neutral hedge.

2008 May 22 04:45 PM

[notsosmart:]

all will be well as long as the printing presses in dc are working 24/7,you think?

2008 May 23 09:01 AM

[fingham:]

An offsetting hedge, even if it's expensive and imperfect, is still your best alternative if you're stuck holding a huge stinky diaper bag of CDOs. For the rest of us, it generally makes sense to manage risk by diversifying. If you believe, for example, that US stocks are too high, don't start trying to do a bunch of offsetting short trades - just move long stock money to the sidelines or into other asset classes. Diversification is still the only free lunch out there. Hedges are not free, and they often don't "work" as planned.

2008 May 23 01:52 PM

[vaduz:]

does it start again, as in march?

2008 May 23 03:06 PM