Financial Leverage and the Collapse of Sowood Capital

I've been reading some articles on Sowood Capital to better understand the reasons behind its collapse. The hedge fund was run by Jeffrey B. Larson, a former Harvard Investments manager and focused on a low-risk investment strategy. It actually wasn't the investment strategy that doomed the hedge fund, but rather the way that the Sowood raised capital to leverage its investments.

For those that don't know, leverage is a way investors get a higher return. It works much like a mortgage on your home. To buy a $400,000 home you might put in $50,000 of your money and borrow $350,000 from the bank. If the house increased in value by 10% you now have an asset that you can sell for $440,000 or $40,000 over what you paid. But remember, you only put in $50,000, so you have made a return of 80% on your investment. The $350,000 that you borrowed was financial leverage.

The same principle applies to Sowood capital. The company's core investment strategy was to purchase a company's bonds and other debt notes in the hopes that they would go up. They would then also short the company's stock, a position that would allow them to profit if the company ran into trouble. This way, they were covered in both directions. If the company did well, its bonds would increase in value and they would make money. If the company did poorly, the short position would kick-in and cover the losses.

The problem with Sowood was that when the sub-prime market began to melt down, bonds lost value faster than the stocks dropped and so the company's position was not fully covered. Lenders, alarmed by the drop in collateral began to call-in their loans. But Sowood hadn't set aside adequate money to pay the loans back. As the value of the collateral dropped, the company was caught in a death spiral, needing to sell more of its bonds, bonds that were dropping in value the more it tried to sell them.

Going back to the housing analogy, it's as if your house is declining in value and worried about this, the bank calls in your loan and the loans of all of your neighbors. But as all of your neighbors put their homes on the market, the value declines even more so that even if you sell, you can't repay the loan anymore, all of your equity has been wiped out. At that point, you have no choice but to walk away and give the bank your house.

Eventually, it became apparent that the company would not be able to meet its obligations and on July 30 Larson announced that he was closing down Sowood and selling its remaining assets to Citadel Investment Group.

Using leverage an investor can amplify returns and make big money. But in bad times, leverage can be an anchor around your ankles.