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The Buy Side Learns to Survive in the Post-Credit Crisis Environment

In the post-credit crisis markets, buy-side firms are learning how to manage new challenges, such as a lack of sell-side liquidity in fixed-income products and new concerns over counterparty risk.

Volatility Requires Investment Strategy Adjustments

Beyond rethinking with whom they trade in the wake of the credit crisis, buy-side firms also are adjusting what they trade. The lack of liquidity as well as distrust of the credit-rating agencies has played havoc with fixed-income investment strategies.

In the case of Concordia Advisors, "It has caused us to do a lot of deep thinking about the strategy mix," relates the firm's Williams. While the CEO declines to elaborate on how the hedge fund manager's strategies have changed since the credit crisis unfolded, he says, "Our strategies have played well throughout this period. That's not to say we haven't played a lot of defense — when the markets go through a period like this, you end up playing defense when you're used to playing offense."

While Williams reports that Concordia has seen investment flows come into its hedge funds recently, other hedge funds have not fared as well during the crisis. "The funds that made headlines [for huge losses] are those that applied a modest or high degree of leverage to securities that appeared to be highly rated that were proven to find no market as the ratings were brought into question," Williams explains.

Meanwhile, Sapient's Middleton points out, while some hedge funds have shut down as a result of insurmountable losses, others are doing exceptionally well. "There are polarized positions on this," the consultant says.

Even REX Capital, an arbitrageur and market maker whose hedge funds are diversified through a commodities index future — known as the Continuous Commodity Index, which represents the basket of 17 commodities — is not immune to the volatility. When prices of crude oil and other commodities soared this year, commodity fund managers like REX Capital reaped the gains. "Commodities still remain one of the shining spots of '08," asserts REX Capital's Kleisner.

With crude oil prices dropping in July, however, the commodity sector lost 20 percent of its recent gains. Still, "We've had almost six months of record performance," Kleisner says, adding that the firm had one fund that was up 34 percent on the year. "That would be great in any year when the S&P was down 15 percent."

One reason the commodity bubble is bursting could be that hedge funds are deleveraging — reducing the amount of money they borrow so they can lower their margin costs. "As far as leverage goes, long-short CTAs [commodity trading advisers] probably use a lot of leverage, and they definitely had to trim their models down in this new world of money constraints," Kleisner explains. "We're looking at money coming out of commodity markets last month [June] and not really going anywhere."

Unwinding Underperforming Positions

While diversified fund managers such as REX Capital are staying afloat, some asset managers are still searching for liquidity to unwind positions in CDOs and structured credit products at a time when broker-dealers can't take any more of these securities on their balance sheets. "The cash CDO market has pretty much died," says Tim Sangston, a consultant at Greenwich Associates. "You couldn't get a bid, and you couldn't trade."

More than 50 percent of the 1,300 institutions that participated in Greenwich's 2008 U.S. Fixed-Income Investors study said they plan to change their fixed-income strategies in the wake of the global credit crisis. Of that group, more than 60 percent say they are shifting their investments to higher-quality fixed-income securities, and nearly 55 percent say they are tightening risk management policies, according to the report. Of those institutions needing to unwind underperforming positions, about 30 percent are looking to unload asset-backed securities and/or investment-grade credit bonds, while a quarter are seeking to unwind positions in mortgage-backed securities (MBSs), said the report.

The balance sheet problems of the major broker-dealers, however, have acutely affected the sell side's ability to provide liquidity in certain fixed-income securities. "Secondary market trading in the corporate bond markets, in the municipal bond market at some points in time and even the government market had seized up as specific balance sheet requirements caused dealers to not want to take risk on," says Concordia's Williams.

Wall Street powerhouses such as Citi, Merrill Lynch and UBS, which reported almost $500 billion in write-downs from toxic assets such as CDOs, are not able to absorb any more of these assets on their balance sheets. In fact, many of these struggling firms had to raise capital from sovereign wealth funds in the Middle East and Asia to bolster their reserves.

With bulge-bracket dealers pulling back, institutions are looking to regional brokers and midsize dealers, which are playing a more important role in matching customer flows, say sources. "What is happening in a crisis like this is the balance sheets go down, liquidity dries up and [dealers] won't take on any additional risk. Therefore, you allow the regional dealer who doesn't have any capital to match flows between customers," says the head fixed-income trader at a large traditional asset manager who requested anonymity.

Meanwhile, buy-side firms are also looking for opportunities to buy distressed credit — if they are good assets available at a cheap price, according to Sangston. This may be a sign that buy-side firms are swapping roles with the sell side, in that the buy side is providing liquidity. Several sources cite the recent examples of private equity firms gobbling up distressed credit products as evidence of the trend.

For example, Dallas-based Lone Star purchased $30 billion worth of CDOs from Merrill Lynch in August for 22 cents on the dollar, and Blackstone Group bought high-yield bank loans from Citi. Meanwhile, last year Citadel bought mortgage-backed securities from E*Trade. In addition, there's also a shift in terms of the buy side hiring its own in-house credit analysts and investing in technology rather than relying on the rating agencies (see related sidebar: "Demand for Credit Analysts Rises on the Buy Side in Wake of Rating Agency Disasters").

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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