Anatomy of a meltdown

If this is at all accurate -- specifically about their taking short positions in subordinated credit to offset losses in senior debt, and only investing in entities with strong balance sheets -- then, Citadel will probably make a killing in the long run, having bought out their positions. It sounds like Sowood called the general direction of the credit market correctly (overall deterioration and widening of spreads), but the detailed correlations behind their trades were not realized.

I understand Harvard Management Corp lost hundreds of millions on their Sowood investment.

Note to self: remember that markets can be indiscriminate and irrational for long periods of time :-/

Transcript of Remarks By Jeff Larson, Managing Partner

Sowood Capital Management LP

Investor Conference Call

August 3, 2007

2pm Eastern Standard Time

INTRODUCTION

Good afternoon. This is Jeff. This call is extremely difficult. You entrusted us...

WHAT HAPPENED
How did we get here?

In the twelve month period ending this June, our returns were roughly 16%, a very substantial portion of those returns were in credit related positions, mostly credit vs. equity. In pursuing this strategy earlier this year, we began to build positions in companies whose senior or bankdebt was well cushioned with subordinated debt and backed by strong collateral, and with projected healthy recovery rates even in a default scenario. In many cases we hedged these positions by shorting subordinated debt, equity or both, in the belief that if credit spreads widened for senior or secured debt, they would widen much more for the subordinated debt and/or be accompanied by a decline in the company's share price.

We believed this strategy positioned us to benefit from a deterioration in subordinated credit relative to senior credit and justified the increased leverage it entailed. As we examined each investment and individual corporation, we saw relatively strong balance sheets, little to no chance of loss even in default, no near term liquidity pressures, and no fundamental reason to expect extraordinary widening in those corporate credit spreads. As we looked at these opportunities, in select cases where we were particularly confident in our analysis, we built some concentrated positions.

[credit spreads widened ... blah blah... positions deteriorated...]

In response to these developments, we took measures to further reduce our net credit risk, to cut positions were we could, and to create liquidity by both unwinding capital intensive credit positions and trimming our risk arb book. Unfortunately, these measures were not enough to withstand the events of the following week, beginning July 23. The deterioration in corporate credit accelerated even more sharply during the week of July 23. Each day brought greater and greater losses. As those losses increased during the week, we continued our efforts to reduce exposures and raise cash to meet anticipated margin calls...