Hedge funds, GM, Kerkorian

Gotta Love the Hedge Funds

16.05.2005

by Dan Denning

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Gotta love the hedge funds, making bets on events based on probabilities, or what seem like improbabilities. How about this bet…long GM bonds as a contrarian play (before the downgrade) and short GM stock to hedge (before the stock soared)? It probably looks foolproof in a statistical model. And then volatility happens. You get caught on the wrong side of the trade…both times.

First, investor Kirk Kerkorian, who already owns 3.9% of GM stock, offers to more than double his stake in GM and buy an additional 28 million shares at $31. The stock soars 18% in one day to close at $32.80. Not a good time to be short.

The very next day Standard and Poors downgrades GM bonds to junk status. Not a good time to be long. The rumour—and it’s just a rumour of course—is that at least one hedge fund, London-based GLG was long GM bonds and short GM stock prior to the events.

Anyone who is long GM bonds after the well-documented troubles at the automaker of the last year must be, in the words of Alan Greenspan, “desirous of losing money.” But I suppose when you can get credit easily from say, Deutsche Bank (one of GLG’s creditors)…easy come, easy go.

The real danger to markets in a situation like this is a loss of liquidity. Volatility itself is no bad thing. As Avinash Persaud writes in the introduction to his book “Liquidity Black Holes,” “Volatility is a normal and necessary function of markets. Markets should adjust quickly to new information and, if the information is shocking enough, the adjustment will be volatile.”

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Traders live for these kind of events. Fat tails…rare events…black swans. But sometimes they spiral quickly out of control. “Our concern…is where episodes of high volatility reflect not a market adjustment to a more stable position, but a market disruption: where price changes no longer help to clear a market, but help destabilise it,” Persaud continues. “A liquidity black hole is where price falls do not bring out more buyers, but generate even more sellers, who chase the market lower, bringing out yet more sellers.”

“Thus,” Persaud concludes “in portfolio and banking markets, the system seizes up. No one player is willing—or indeed able—to prevent the formation of a liquidity black hole once confidence has evaporated and a downward cycle has begun.”

Has it begun? Wait and see. And while you’re waiting, buy some gold.

Dan Denning