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It was the hedges wot done it. Lehman Brothers, which has had another bad week, forcibly removed both its CFO and COO yesterday, less than a week after declaring substantial losses following ineffective hedges on its mortgage securities and other ‘hard-to-trade and hard-to-value securities’ – ie, securities which are marked-to-model.

Why hedge?

Back to basics, what is a hedge? And why is it needed?

A hedge to a security is created to mimic the characteristics of the security so that price movements (volatility) and direction of movement (correlation) between the two are maximised.

The hedge can then be used to offset the risk of the underlying asset. Hedges are usually needed because the underlying security is illquid or you have too much risk on and are trying to protect against a step function move (as a result of default or fat-tailed market events). The best hedge is to reduce the size of your underlying security.

The theory is relatively simple. However, the challenge for traders and risk management is determining which subjective parameters to use for measuring volatility and correlation.

Naive geeks

Volatility and correlation are time variant and dynamic entities. As such, calculating them only has value to the extent that it’s forward looking and captures potential dislocations or ‘regime shifts’. Measuring the forward structure of volatilities and correlations is challenging, and is the most important tool in the arsenal of risk takers and managers. It requires experience, forward thinking and independent analysis.

This is where hedging went wrong. In the last few years, the creation of a myriad of derivatives to capitalise on the low yield, low volatility, stable correlation environment gave birth to a generation of geeks (politely called ‘correlation traders’). They were combined with naïve and willing risk managers, investors, regulators and a need to juice up returns regardless of risk, given the asymmetric risk culture of the shadow banking system.

On the flawed and dangerous assumption of extrapolating past low volatilities and correlations, securities and structures, portfolios and trading desks were set up to deliver high yields with obscene levels of leverage.

Lip service was given to the warnings of risk managers, and the trader was king.

Correlations collapse

When the system began to unravel last August, we had a seismic shift in the underlying premises on which these hedges were set up.

Volatilities spiked up to previously unseen levels, and correlations between the hedges and underlying securities began to break down. Many firms still refused to acknowledge that the businesses they were running were flawed and dangerous. These managers compounded previous errors by either increasing risk on the assumption that the new prices were an aberration, or increased their hedges deluding themselves into an illusory sense of security.

With liquidity fast drying up, the previously highly liquid ‘marked-to model’ securities and their so-called hedges became anything but correlated, in effect two separate and distinct iliiquid risky assets, thus compounding the risk and leverage to an institution.

Lies, spin and more lies

In March we were told Lehman and others would borrow from the Fed’s ‘Begging Bowl Window’ not because they needed it, but to remove the stigma associated with it.

Rather than the truth, lies and spin and deception about the true nature of the balance sheets of the shadow banking world were employed. By ‘parking’ worthless collateral securites with the Fed and thus removing the need to mark-to-market them, the correlation (what was left of it) of the hedges to the untraded underlying securites further diverged as markets became further disjointed.

Erin Callan, Lehman’s chief financial officer, blamed a “divergence between the cash and derivatives market” for “ineffective hedges this quarter”.

With poor risk management and forward thinking the exception rather than the rule in the shadow banking world, and with the Fed and the ECB starting to talk hawkishly about interest rates, it is fair to say that the problems of failed hedges have just begun and will not be confined to Lehman alone.

Dr Dread is a risk professional who has occupied senior positions in investment banks and hedge funds. He now manages his own money.