The hedge-fund industry is
reeling from its worst crisis in a decade as banks are now
demanding more money pledged to support outstanding loans even
when the investment is backed by the full faith and credit of
the United States.
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.
"If you have leverage,
you're stuffed," said Alex Allen, chief investment officer
of London-based Eddington Capital Management Ltd., which has
$195 million invested in hedge funds for clients. He likens the
crisis to a bank panic turned upside down with bankers, not
depositors, concerned they won't get their money back.
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."
'Mercy of Counterparties'
Ivan Ross, founder of Westport,
Connecticut-based hedge fund Tequesta Capital Advisors, received
a call from his bankers on Feb. 22 demanding he put up more
money or risk losing his loans. Ross was unable to meet the
margin call as the market for mortgage- backed debt seized up,
preventing him from selling securities to raise the cash. Four
days later, lenders liquidated his $150 million fund.
"Because it's impossible in
this environment to move among dealers, you're at the mercy of
counterparties," said the 45-year- old Ross, who has
managed hedge funds for 13 years, including a stint handling
mortgage-backed debt for billionaire George Soros. "To the
extent they want to shut you down, they can."
The demise of Tequesta revealed
the deathtrap for hedge funds caught in the credit maelstrom of
banks selling mortgage-backed bonds as fast as they can while
demanding more collateral from clients who use the securities to
back loans.
Carlyle Fund
On Feb. 24, London-based Peloton
Partners LLP gave up a "night and day" effort to stave
off demands from banks, including Goldman Sachs Group Inc. and
UBS AG, for as much as 25 percent collateral for securities that
once required 10 percent, according to investors in the fund.
Peloton, run by former Goldman partners Ron Beller and Geoff
Grant, liquidated the $1.8 billion ABS Fund, its largest.
The same day, about 5,000 miles
(7,770 kilometers) away in Santa Fe, New Mexico, JPMorgan Chase
& Co. told Thornburg Mortgage Inc. that it had defaulted on
a $320 million loan because it couldn't meet a $28 million
margin call, according to U.S. regulatory filings.
Thornburg, the home lender that
lost 93 percent of its market value in the past year, was near
collapse March 7 after it failed to meet $610 million of margin
calls. Chief Executive Officer Larry Goldstone said in a
statement the company fell victim to a "panic that has
gripped the mortgage financing industry."
Repo Agreements
Carlyle Capital Corp., the
debt-investment fund started by private-equity firm Carlyle
Group of Washington, was suspended from trading in Amsterdam on
March 7 after it couldn't meet margin calls, and its banks
seized and sold assets.
"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.
Collateral 'Haircuts'
Banks usually limit their risk on
repos by lending less than the value of the securities used as
collateral. Tequesta was able to borrow $95 on $100 worth of AAA
rated jumbo prime mortgages in early 2007, meaning the bank took
a $5, or 5 percent so-called haircut. By last month, the amount
required had risen to as much as 30 percent, Ross said. Jumbo
mortgages are loans of more than $417,000, typically used to
finance more expensive homes.
The losses started in mid-2007,
when prices of subprime loans, those to homeowners with bad
credit histories, started tumbling because of a surge in
delinquencies. The contagion spread to other credit markets,
including bonds backed by student loans and credit cards and now
mortgages backed by federal agencies, which have an implied
guarantee from the U.S. government.
Prices keep falling, with yields
on mortgage-backed debt issued by agencies such as Fannie Mae
rising last week to the highest level relative to U.S.
Treasuries since 1986. Costs to protect corporate bonds from
default are close to a record high.
Under such circumstances, lenders
have no choice but to ask clients to put up more cash. For AAA
rated residential mortgage backed securities, banks have raised
haircuts 10-fold in the past year to 20 percent, according to
estimates from Citigroup credit analyst Hans Peter Lorenzen in
London.
Treasury Swings
On AAA asset-backed securities,
banks are demanding a 15 percent haircut, up from 3 percent last
summer. Corporate bond haircuts have gone to 10 percent from 5
percent, bankers said.
At least one bank has raised
Treasury haircuts, which range from 0.25 percent to 3 percent,
depending on the length of the loan and the creditworthiness of
the borrower, said bankers, who declined to be identified. They
said they wouldn't be surprised if the practice becomes more
widespread, not because they expect the U.S. government to
default, but rather because there have been bigger price swings
in the Treasury market, which affects value.
Some banks may have been late to
raise haircuts for their biggest hedge funds because they are
lucrative clients, said Jochen Felsenheimer, head of credit
strategy at Milan-based UniCredit SpA, Italy's biggest bank.
"Until now, hedge funds have
been the big winners of the crisis and this could be as well due
to banks not having yet drawn down their margin,"
Felsenheimer said.
Survival of Fittest
Carlyle said in a March 6
statement that margin prices requested for securities weren't
"representative of the underlying recoverable value"
of its securities. Lenders started to liquidate its portfolio of
$22 billion of AAA rated mortgage debt issued by Fannie Mae and
Freddie Mac.
"It's not a question of
prime brokers deciding which firms live and which don't,"
said Odi Lahav, head of the European Alternate Investment Group
at Moody's Investors Service in London. "They're trying to
manage their own risk. There's a Darwinian aspect to
survivorship in this industry."
Some managers set themselves up
for a stumble by taking on too much leverage and not
anticipating that terms could change, said Christopher Cruden,
CEO of Lugano, Switzerland-based Insch Capital Management, which
oversees $150 million for clients.
"If you're going to dance
with the devil, there comes a time when your toes are going to
be stepped on," Cruden said. "Prime brokers are there
to do business, not be your friend."
