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Hedge funds: The albatross of debt exposes a few turkeys

By Paul Wallis     Mar 11, 2008 in Business
Exactly what was happening in the hedge fund sector was one of the imponderables of the subprime meltdown. The banks are now tightening the screws to support their big loans to hedge funds.
Large amounts of awfulness may well hit the fan.
Cultural note: Opinions of hedge funds vary. There are, or at least were, many who think they’re very sharp operators who get good returns on investments.
Then there’s people like me, who think that they should have kept evolving for a few more billion years before playing with other people’s money.
Bloomberg, perhaps less philosophically:
Since Feb. 15, at least six hedge funds, totaling more than $5.4 billion, have been forced to liquidate or sell holdings because their lenders -- staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market -- raised borrowing rates by as much as 10-fold with new claims for extra collateral.
While lenders are most unsettled by credit consisting of real estate and consumer debt, bankers are now attempting to raise the rates they charge on Treasuries, considered the world's safest securities, because of the price fluctuations in the bond market.
This means:
Banks are trying to get capital to write good business to heal the gaping holes created by the credit crunch, subprimes, and the economic and inflationary situations.
They do not need non-performing assets, particularly big loans that don’t do much in terms of profits. Bonds have been feeling the heat, and haven’t been too impressive as performers.
The hedge funds, for their part, had been borrowing big, and a lot of their assets have been shriveled in value by the meltdown.
The loans, like any normal loan, were backed by collateral. In the case of the hedge funds, that collateral included securities, which are their basic investments. A lot of those securities have evaporated, (things like subprimes are unsellable, and others have lost a lot of value) but the requirement for collateral on loans remains.
So the hedge funds have to ante up with collateral and/or higher rates, or be closed down by their creditors. A tenfold increase is no joke. What the banks lack in subtlety, they're making up for with lack of ambiguity.
There’s no doubt that the hedge funds have been caught out:
The lending crackdown is the worst to hit the $1.9 trillion hedge-fund industry since Russia's debt default in 1998 roiled global credit markets and required the U.S. Federal Reserve to pressure the securities industry to arrange a $3.6 billion bailout of Greenwich, Connecticut-based Long-Term Capital Management LP. Today, hedge funds are being forced to sell assets to meet banks' margin calls**, resulting in the dissolution of the funds.
``There has to be more in the next weeks,'' Allen said. ``There are people who have been hanging on by their fingernails who can't hold on much, much longer.
**Margin calls are demands for more money to cover losses where money isn't paid in full. Effectively it's coverage of outlay, and it's unavoidable for borrowers. Usually it refers to stockbrokers who pay for stock on behalf of a client, which loses value, and leaves the broker out of pocket. In this case it refers to the banks losing money on loans. The hedge funds are now generating a lot of margin calls.
That near- $2 trillion or so has an environmental problem, too. Because of the nature of hedge fund investments, which are spread across what are called “advanced” investment ranges, they’re also directly exposed to the credit disease at its most virulent, in the securities area.
In the finance sector, where people raise loans which become assets on the books to raise more loans, there’s a level of risk at every level. That’s what’s happening now
To cover loans, the hedge funds need to sell cash assets. That reduces their collateral asset base, and consumes cash they need for moving into less dangerous investments.
This is pretty much the investment pattern in full reverse.
So they sell stocks, bonds, whatever, hitting other markets. You can do a lot of damage with a $1.9 trillion dollar rock, if you throw it in a glasshouse full of fragile investors.
The rest of the article is an exhaustive study of things that can go wrong with hedge funds, like this very basic situation:
"Banks are reducing exposure anywhere they can and the shortest way to do that is to cut leverage,'' said John Godden, chief executive officer of London-based hedge-fund consultant IGS AIS LLP.
Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.
The managers that trade fixed-income securities generally borrow money through repurchase agreements, or repos. In a repo, the security itself is used as collateral, just as a homeowner puts up the house as collateral for a mortgage.
And just like a mortgage, when things go sour, they go really sour.
Nobody yet knows how exposed the hedge funds are. That $1.9 trillion will take a bit of pinning down.
If that sort of money, or anything like it, goes out of private pockets, we will definitely find out.
Well, if the entire financial sector turns to jelly, Bloomberg does have a future writing horror scripts.
They’ve had a lot of experience recently.
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