An Investment Banker's Take On Life: Margin Calls: Fearsome in a very edgy market

"Stay away from margin trading." That's the advice I remember clearly from a friend years ago when I first thought about wading into the stock market with some of my hard-earned savings. Well, he actually has good reasons for saying so. Whether you are new to the game or a pro, margin trading is still risky business because leverage, which is what you achieve when you trade on margin, is double-edged. Yes, it magnifies your gains. However, leverage also amplifies your losses, to the same extent.

These things came back to mind as I read MarketWatch's report yesterday on the market "mayhem" being caused by UBS AG's disclosure on Valentine's Day that it had a $26.6-billion exposure to securities backed by Alt-A mortgages. More specifically, UBS's revelation has triggered margin calls and forced selling among the players in the mortgage market.

Now, Alt-A mortgages usually involve borrowers which are more creditworthy than the subprime. The historical rate of default and foreclosures on Alt-A mortgages is not as high as that on subprime. As such, when Alt-A loans get securitized, they don't have the same built-in protection for investors as their subprime counterpart. With Alt-A delinquencies and foreclosures increasing since last year, however, market valuation on Alt-A securities have come under pressure.

Initial concerns that UBS might become a forced seller have indeed become self-fulfilling for the other players. Actually, that is the Catch-22 problem with disclosures in a very edgy market--damned with little or no disclosure, and damned even with an honest disclosure. The worst part is you can't predict which way the market will go with your disclosure. Didn't you notice the times when the market rebounded instead of getting shocked with the massive write-downs disclosed from banks in the recent past? That's how pleasantly surprising the market could sometimes be.

In this UBS case, however, we are presented with the market's uglier face. The UBS disclosure prompted Alt-A investors to immediately withdraw, sending market prices down 10% to 15% within days. The consequent marking-down of positions by holders of Alt-A securities triggered margin calls, because some of these positions were bought on margin. This has unwittingly set off a dangerous downward spiral--the margin calls push prices down, causing a marking-down, then with a resulting lower valuation another margin call is triggered and so on and so forth.

At least two have been reported to have been hit by these margin calls--Thornburg Mortgage and hedge fund firm Peloton Partners LLP. According to MarketWatch:

Since Valentine's Day, Thornburg has had to come up with $300 million to meet margin calls on a $2.9 billion portfolio of securities backed by Alt-A mortgages. The company warned that if it can't meet future margin calls, it may have to start selectively selling assets. The stock slumped more than 20% after the news.

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The Peloton ABS Fund, which invests in asset-backed securities including those backed by mortgages, has suspended investor redemptions and is looking to sell its portfolio after heavy losses recently, according to a letter Beller and Grant sent to investors on Thursday.

As we have seen in the above example, the thing we should be afraid of in a very edgy market like we have now is fear itself. I think that's what everyone from President George W. Bush down to Fed Chairman Ben Bernanke is trying very hard to address.

(Photo credit: www.sxc.hu)

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UPDATE-March 2, 2008

Here's the latest on Peloton from MarketWatch.com:

Some banks seizing Peloton assets: report

By Greg Morcroft

Banks owed money by London-based hedge fund Peloton have seized some of its assets after it liquidated one of its funds and disallowed redemptions at another, according to a news report Saturday.

The Wall Street Journal report cited "people familiar with the situation," and said that six banks have seized assets while three others are giving the fund time to try to find buyers.

The Peloton ABS Fund -- which invests in asset-backed securities, including those backed by mortgages -- has suspended investor redemptions and is looking to sell its portfolio after recent heavy losses, according to a letter to investors Thursday from Peloton managers Ron Beller and Geoffrey Grant, a copy of which was obtained by MarketWatch.

"Although there has not been any material deterioration in the credit quality of the Fund's assets, given the current liquidity situation in the asset-backed securities market, the Fund has experienced severe NAV [net asset value] declines," the managers wrote.

"In addition, because of their own well-publicized issues, credit providers have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls," Beller and Grant said.

Peloton has been working to find a solution to its problems, but decided the best way to protect the interests of investors and other stakeholders was to seek buyers for its portfolio, they said.

Peloton's bigger Multi-Strategy Fund has a very large position in the firm's ABS Fund, so it too has been hit hard by the problems. Because of this, investor redemptions from the Multi-Strategy Fund have also been suspended, the managers said.

"The problems for the Peloton ABS Fund have had a serious negative impact on the Multi-Strategy Fund, and we are currently assessing our options," they wrote in another letter to investors.

The Wall Street Journal said Peloton has been looking for a buyer for the fund, but that at least one rival firm, Citadel Investment Group, has turned the offer down.