Hedge funds: the credit crunchs enigma

Date: Monday, May 26, 2008
Author: Eric Reguly, Globeandmail.com

ROME -- Breathe in. Breathe out. You can relax now.

The worst of the credit crunch, and the liquidity crisis it spawned, is over, we are told. It's getting slightly easier to borrow money.

True, the banks are still taking writedowns, but the pace is slowing.

Banks and insurers are replenishing their capital at a furious pace, as AIG did this week, when it raised a cool $20-billion (U.S.) rather than the $12.5-billion it had announced earlier. No other big securities firm seems on the verge of Bear Stearns status - that is, toast.

Whatever you do, do not - repeat, do not - think about the hedge funds. If you do, your breathing might become quicker. Your blood pressure might rise.

That's because the hedge funds are opaque. No one knows what's in them. They might be fine. But they could blow up too, the proverbial next shoe to drop in the credit crunch's (allegedly) waning days.

By now, we know the banks are not run by CEOs and their flunkies. They are run by accountants. The bean counters are just no fun any more, even when you fill them with spiked Shirley Temples. They insist that the financial instruments on the books - a futures contract, a share - be valued at what it's worth right now, not what it might be worth in nine months or on your aunt's birthday.

In today's markets, that means a string of writedowns even if the bank is convinced the asset in question might be worth five times as much once liquidity and confidence return.

Not so the hedge funds. Private and largely unregulated, the hedgies don't have a strict mark-to-market burden. Their valuation requirements are flexible.

If the instrument is, in effect, worthless because it doesn't trade, big deal. It will just be held at par until the price rises to the point that another truckload of management fees can be collected. That could happen in three days, three months or 12 months.

The luxury of time, it appears, has kept the hedgies off the front pages (only a few have blown up, like Peloton Partners' $2-billion ABS fund). But time can't stay on the hedgies' side forever.

At a certain point, a dud instrument or investment has to be written down or blown off the books, bank style. The credit crunch started nine months ago, in August. Might the moment of truth be coming for the hedgies?

The hedge funds' big potential danger, of course, is leverage, piled high and deep like cheap pasta. If they go, they could go with a great thundering crash, spreading destruction near and far. Leverage is used to amplify returns - you load up with debt to ramp up your return on equity. Bear Stearns's leverage rate was 26 in 2005, that is, the total assets were 26 times the value of the shareholders' equity. By last year, the figure had climbed to about 33. All you have to know is that leverage works both ways.

Leverage is one potential time bomb. The other is the monster credit default swap (CDS) market, whose notional value is estimated at more than $60-trillion. The swaps are a form of insurance. They are used by owners of debt to hedge, or insure, against defaults.

The hedge funds are obviously exposed to this market. How much isn't known. Remember, the hedgies don't have to tell you what's inside the black box. What is known is that the default rate on corporate bonds is rising as various economies slow down or go into recession (the United States, Canada, Britain, Ireland, Spain, Italy, to name a few). Any hedge fund that sold these protection products has to be worried. Buyers of the products would be doomed if the sellers collapse. The buyers would bear the full brunt of the credit losses.

What will prevent disaster for the hedge funds, and no small number of private equity funds, which bought huge companies at the top of the market with heaps of borrowed money, is a broad-based economic upturn.

Well, good luck. House prices in the United States could easily take another tumble; already, they are about 15 per cent below their mid-2006 peak. A fall of another 15 per cent would eliminate trillions of dollars of household wealth, with predictable effects on the economy.

Europe seems in better shape, thanks to the German export juggernaut, but the eurozone is not immune to what's happening in North America and Britain. On Friday [May 23], the eurozone purchasing manager's index showed that economic growth had slowed to its weakest level since July, 2003. Jobs were added at the slowest rate since early 2006.

You can assume the hedge fund managers are on tenterhooks. Relax while you can because the next few months could be horrific in Hedgeville.