Lesson 4 of 25 · 7 min

A convergence fund, 1998: the sequence after August

Once the market could infer what a distressed holder had to sell, the exit price stopped being the quoted price.

The sequence is the lesson, so here it is in order. In mid-August 1998 a large sovereign default and debt moratorium triggered a general move into the most liquid government bonds. That move is the opposite of convergence: the expensive, liquid side got more expensive and the cheap, less liquid side got cheaper, across every spread at once.

Mark-to-market losses on the book produced collateral calls from the fund's financing counterparties, which were met in cash, which reduced the cash available to meet the next ones. Attempts to raise new capital ran through September. By then the size and direction of the positions were widely inferred in the market, and a holder whose required sales are known does not transact at the screen price.

In late September 1998 a recapitalisation was agreed: a group of the fund's financing counterparties, in a process organised by the relevant central bank, injected capital reported at around three and a half billion dollars in exchange for almost all of the equity. The positions were then wound down through 1999 rather than liquidated at once, which is the part of the episode most often left out.

Two mechanisms are worth separating. The first is mark-to-market loss, which is a number. The second is exit slippage, which is the extra cost of converting the position into cash on someone else's schedule. Slippage is invisible in every risk report and dominates the outcome. Track 7 lesson 9 develops the general form: the exit window, not the price, sets the discount.

A position the market can infer is no longer a position at a price. It is an announced future sale.

Key terms

Flight to quality: A general move of money into the most liquid, safest instruments. It widens nearly every relative-value spread at the same time.
Slippage: The gap between the price at which a position is marked and the price actually realised when it is sold in size.
Recapitalisation: An injection of new equity into a failing entity, typically in exchange for most of the ownership, so the positions can be unwound rather than dumped.

Worked example

The cost of selling into a market that knows

Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. $8,400,000 of par marked at 99.60, sold in three equal tranches of $2,800,000 as the bid falls.

Marked value of the book: $8,366,400
First tranche at 99.10: $2,774,800
Second tranche at 98.30: $2,752,400
Third tranche at 97.25: $2,723,000
Total realised: $8,250,200
Slippage against the mark: 1.39%

The mark was honest and the loss was still 1.39 percent larger than it said. At twenty-five times leverage, 1.39 percent of the assets is 34.7 percent of the capital.

Check yourself

You must raise cash from $4,000,000 of par marked at 99.20. You sell half at 98.40 and half at 96.90. How far short of the marked value do you come, in dollars and in percent?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.