Fun with hedge funds: Sowood edition

Those of you who follow financial markets have probably read about the collapse of Sowood, a hedge fund started by an experienced former member of the legenday Harvard endowment team.

What’s interesting is that the letter Sowood wrote to its investors is a particularly clear and lucid account of how these implosions happen. It’s almost a textbook description of what happens when these things blow up:

Today we made the painful and difficult decision to sell substantially all the funds’ portfolio [what was left of the portfolio — a little more than 40% of what they started the year with] to Citadel Investment Group [another hedge fund].

We took this step to protect your investment [they’re being honest in saying this; the alternative would have been worse].

Our actions over the weekend followed severe declines in the value of our credit positions [the market for many of our holdings became particularly illiquid, due to a lack of buyers, and prices dropped dramatically] and non-performance of offsetting hedges [everything went to hell at once].

Given what we were facing and our uncertain ability to meet margin calls [we were leveraged — we used debt to double down on our bets to juice returns, common for this class of hedge funds], we sought other buyers for some or all of the positions [all our peers on Wall Street smelled “blood in the water” and drove down market prices even further].

Citadel offered the only immediate and comprehensive solution [Citadel is probably being brilliant in buying this portfolio at basically 40-some cents on the dollar — but time will tell…].

The transaction enabled us to avoid anticipated forced sales at extreme prices that would have been made in order to satisfy obligations under our counterparty agreements [sure, we were already down more than 50%, but if we had actually sold in the open market, we maybe would have ended up down 80% or more].

After the transaction with Citadel, the Net Asset Value (NAV) of Sowood Alpha Fund Ltd. and Sowood Alpha Fund LP will have declined approximately 57% and 53% month to date respectively, and approximately 56% and 51% calendar year to date respectively. As a result, our NAV as of July 30 is approximately $1.5 billion. [We just vaporized more than $1.5 billion dollars of your money.]

We understand this is a very difficult moment for you [well, OK, that is an understatement]…

We are planning a listen-only conference call later this week at which time I will discuss the actions we took over this past weekend and next steps [you can scream at me but I won’t be able to hear you].

[More explanation follows:]

During the month of June, our portfolio experienced losses mostly as a result of sharply wider corporate credit spreads [the prices of the debt instruments that we held suddenly fell like a rock] unaccompanied by any concomitant move in equities and exacerbated by a marked decline in liquidity [lots of sellers, no buyers].

This occurred over a broad range of credit related instruments. In the first two weeks of July, spreads continued to widen, and we experienced a loss similar to June. The weakness in corporate credit – particularly focused on loans and loan credit default swaps – accelerated sharply during the week of July 23. Until the end of last week these developments, while reducing the value of our portfolio, were manageable. [Most likely true.] Our counterparties [the banks that loaned us the money we were using to buy more assets than we actually had investment capital to buy] had not severely marked down the value of the collateral that the funds had posted nor changed our margin terms, and immediate liquidity needs could be met. [Shorter version: the banks hadn’t yet called in any of our loans.]

However, towards the end of last week, given the extreme market volatility, our counterparties began to severely mark down the value of the collateral that had been posted by the funds. [Whoops, the banks just called in the loans.]

In addition, liquidity became extremely limited for the credit portion of our portfolio making it difficult to exit positions [c.f. “blood in the water”].

We are very sorry this has happened. We have always attempted to do the very best for our investors. A loss of this magnitude in such a short period is as devastating to us as it is to you. We are committed to acting in the best interests of the funds’ investors and to keeping investors informed of decisions made in furtherance of this objective. We sincerely appreciate your patience and understanding during this challenging period. [This is about as classy as it gets from someone who just lost you more than 50% of your money in three weeks.]

Somewhere, Nassim Taleb is sitting back, smiling, and saying “I told you so…”