Dead Man’s Curve

Ron Beller first made big headlines in 2004 when Joyti De-Laurey, personal assistant at Goldman Sachs to his wife, Jennifer Moses, went on trial and was convicted of forging the Bellers’ and Moses’ signatures to filch funds from their personal accounts. Beller and his wife asked De-Laurey to work for them personally when they both left Goldman Sachs, but De-Laurey stayed to become the personal assistant of another Goldman Sachs partner, Scott Mead. She was also convicted of filching funds from him. De-Laurey reportedly took £4.4m (around $6.48m in today’s dollars) from the collective accounts of Scott Mead, Jennifer Moses (Beller’s wife) and Ron Beller. Neither of the Bellers noticed that De-Laurey had taken millions from their personal accounts for several months. Is it any wonder that during the trial De-Laurey referred to Mr. Beller as "an absolute diamond"? Yet, when Beller co-founded London-based Peloton in 2005, investors seemed eager to let him manage their money.

Ron Beller and Geoff Grant, another former Goldman Sachs partner, ran Peloton Partners, named after the vee-like bird formation adopted by endurance bicycle riders that lead the pack by taking advantage of drafting to reduce wind friction.

In January 2008, Peloton Partners LLP was riding strong. It had two funds, the $1.6bn Peloton Multi-strategy fund, and the $2bn Peloton ABS fund. The latter fund won Eurohedge’s best new fixed-income fund of the year award, after reporting a stunning net return of 87.6% for 2007. When the fund’s returns were announced, some of the attendees at the awards ceremony gasped in shock and awe. Beller and Grant were lauded as "hedgie heroes." But within two months of receiving these accolades, Peloton’s $2bn ABS fund collapsed, and Peloton put its offices up for sale.

Beller told potential investors that his strategy was to make bets on a variety of assets to make money from global economic trends. He made leveraged bets on these trends, and for that to work, he had to be on the right side of the trend.

Initially, the ABS Peloton fund took short positions in subprime mortgage-backed securities making huge bets against the US housing market as John Paulson had done very successfully. Since the prices of those securities plummeted in 2007, the short position had huge gains. But what would Peloton do for an encore? There had to be another big trade. After all, spread relationships for AAA- and AA-rated products looked out of line with historical relationships. The spread curve should revert back to historical levels, according to the market timer’s nursery rhyme. So the fund also bet that the "highly rated" mortgage securities trading at more than 90 cents on the dollar would be protected by subordinated investors eventually paying back all of the principal, and he went long these assets.

Like market timers before them, Peloton Partners ended up with speculator’s results. A fundamental analysis of the type Graham had advocated suggested that those "highly rated" products were overpriced and overrated. The prices were not going to revert back to "historical" levels; the prices would drop to reflect a lower fair value based on imperfect (but highly negative) loan performance data combined with the illiquidity that uncertainty about one’s imperfect data brings. This is a market timer’s worst case scenario. Peloton Partners lost $17bn in a matter of days.

The Peloton ABS fund used credit derivatives (it sold protection) to go long $6bn of exposure to two ABX indexes (the 2006 AAA- and 2006 AA-rated ABX indexes). In all it was long $15bn on various mortgage-backed assets and only partially hedged with short positions. Peloton was said to have leveraged up four or five times, "normal for a credit fund." Leverage "averages" are misleading when the assets themselves are inherently very risky (mispriced in the opposite direction to your trade). When the price of the "highly rated" 2006 ABX indexes continued to drop, Peloton’s 14 lenders, including UBS, Goldman and Lehman, asked the fund to come up with more money to top up its cash cushion. Peloton’s ABX positions headed around Dead Man’s Curve and the fund skidded off the edge of the cliff.

Since Peloton liked bicycle analogies, this simplified one may help explain its problem with leverage. Suppose Peloton’s assets consist of a fleet of uninsured bikes originally worth $1m purchased with $200,000 of its investors’ money and $800,000 of money borrowed from an investment bank. The investment bank says that at all times, Peloton must keep a balance of pledged assets—any assets—against the $800,000 loan of $1m in value. The extra $200,000 is margin collateral for the loan, a cushion for the investment bank making it unlikely that the investment bank will lose money. Initially, Peloton pledges the entire $1m fleet of bikes as collateral for the $800,000 loan with the investment bank. If Peloton damaged 5% of its bikes due to rough riding, the assets would only be worth $950,000, and the bank would ask Peloton for another $50,000 in collateral to maintain the cushion. This is known as a margin call. If Peloton has enough cash on hand there is no problem. But if Peloton does not have enough cash (or liquidity) to meet the investment bank’s demand, it will have to liquidate the assets—sell the bicycles and unwind the position—to pay back the bank. Since the bikes are worth $950,000, the bank is paid its $800,000 in full, but the original investment of $200,000 is now only worth $150,000 for a 25% loss on the investors’ original capital. That’s the downside of leverage on fixed assets.

Now suppose that 25% of Peloton’s bikes round Dead Man’s Curve and skid off a steep cliff. One quarter or $250,000 of the value of the fleet disappears. Peloton loses the investors’ entire original $200,000. More than that, if the bank repossesses the fleet and sells it—known as "unwinding the position"—it will not get back the full amount of the $800,000 since the $200,000 cash cushion the investors provided has been used up. The bank loses $50,000 and only gets back $750,000 of its original $900,000 loan. The investors lose 100% of their initial equity; the investors are wiped out. But the investment bank, the creditor, loses 6.25% of the original principal on its loan.

Bear Stearns’s shareholders and creditors had Peloton’s demise fresh in their minds when a couple of weeks later a confluence of events raised questions about Bear Stearns’s solvency. If Peloton were an investment bank, shareholders would be wiped out, and only the bondholders and other creditors would recover some (or all) of the original amount of the debt. That is the power of leverage. When things are going your way, everyone is euphoric and gasping with delight. When things do not go your way, shareholders can be wiped out. The results can be dramatic and swift, and instead of gasping with delight, shareholders are gasping for air.

As Benjamin Graham observed, the market is not there to instruct you. The market isn’t trying to teach you something when prices rise or fall (or when spreads widen or narrow) relative to where they were historically. You can stuff all of that information into a model (or your head) if you want to, but manipulating market numbers—if that is all you are doing—will not tell you anything about value. It is up to you to analyse the fundamental value and compare it with the market. Peloton Partners was not alone in skimping on fundamental analysis, but Peloton was not as well connected as the Carlyle Group, which had a fund of its own rounding Dead Man’s Curve.

Excerpted and adapted from 'Dear Mr. Buffett, What an Investor Learns 1,269 Miles from Wall Street' by Janet Tavakoli, Wiley 2009, ISBN # 9780470406786.