The Imperfect Science Of Hedging

The WSJ has an interesting article that describes a situation of how even the best intentions for hedging risk do not always work out exactly how you had hoped. In an effort to stem the tide of losses resulting from bad real estate and leveraged loans, many firms on Wall Street began shorting vehicles that would allow them to profit as these markets collapsed. Unfortunately, tracking error raised its ugly head, and now many are finding that not only were they not getting close to 1-1 back ($1 loss in assets followed by a $1 gain in the hedge - often unrealistic, but a high goal nonetheless), many are getting much less, with a 70% efficiency being a relatively good recovery. To add insult to injury, some are finding that their assets are continuing to fall in price, even as the tracking index they shorted against has been rallying - causing a double loss on both the falling long asset and the rising short index.

It looks like the company with the worst hedges in place is Lehman Brothers, which is expected have write-downs on BOTH assets and ineffective hedges somewhere in the range of $1.5-2 billion. Morgan Stanley will have about half this amount of losses, with both Goldman Sachs and Merrill Lynch being less effected, so far - Goldman in particular has less real estate, but more leveraged loans than its competitors, and may eventually post some losses from these hedges.

As highlighted in the article, it looks like Wall Street has a long way to go in the area of risk management.