Before penning this column, yours truly was given one instruction by my esteemed editor. Knowing that for various reasons this would be written in August, he insisted: "Write something that isn’t time sensitive." However, recognizing the danger of creating a hostage to fortune, this advice is going to be ignored. For one month only, this column starts with a prediction.
By the time the print issue of Euromoney lands on your desk, the distress at two Bear Stearns hedge funds, Basis Capital Funds Management and Sowood Capital Management, will have been all but forgotten. They will have been displaced in the headlines by other funds in trouble. From Boylston Street, Boston to Macquarie Place, Sydney, credit hedge funds face an existential crisis.
What has prompted this outbreak of crystal ball gazing? Consider the facts so far. It is perhaps not clever of a hedge fund analyst sitting comfortably in an office overlooking Sydney’s Circular Quay to believe that he can second-guess the mind of a financially stretched American blue-collar worker faced with sharply rising mortgage payments on a depreciating asset. But is Basis Point Capital the dumbest hedge fund out there? Probably not.
Likewise, leveraging up 25 times is pretty ballsy. But is Bear’s High Grade Structured Credit Strategies Enhanced Leverage fund the most egregious example of greed gone mad? Possibly – but, in all likelihood, it is not. Is Jeffrey Larson, principal of Sowood Capital Management, a bad fund manager? His recent performance might suggest that he is.
However, this is the same Jeffrey Larson that was once running money at Harvard Management Company. This firm generated extraordinary investment performance, turning $1 into $7 between 1991 and 2005, partly because of the talents of Larson. Such was the cachet of Harvard that Larson could raise $2 billion in a trice when he hung up his shingle. His won’t be the last reputation to lose a little of its lustre.
At some time in the next few months, across the credit hedge fund world, stale NAVs will have to be marked to market. This will happen against a backdrop that the CFO of Bear Stearns has dubbed the worst in 22 years. Fund managers will be frightened and so will their prime brokers. Value at risk models will be telling credit officers at the big investment banks to cut prop trading positions internally and the leverage they offer their external clients pursuing similar strategies.
Evolution
These primes will be demanding bigger haircuts on collateral that is being priced inexorably downward. Investors in funds will also be jittery. When the new NAVs come through, signs of poor performance will give them an excuse to sell out, just when margin calls are being made. There will be fire sales of collateral, driving prices and performance down further. Such is the Darwinism of markets.
Since this column is now in the prediction business, here’s another. Every time a hedge fund goes bust, the calls for more regulation will increase. There will be demands for scrutiny, for oversight, for tighter controls. A spotlight will be shone into the bolt holes of Greenwich and Knightsbridge. As usual, conventional wisdom is wrong. Worse, in this case it is downright dangerous. In times of financial dislocation, markets need hedge funds more than ever.
Hedge funds make money in a number of ways: high fees; beta; some even add alpha. But one of the least understood functions that they serve is as providers of liquidity – as intermediaries to other intermediaries. When the VaR models at banks tell them they have to rein in, it is the hedge funds that step in and take on those positions.
We have already seen an example of this in the present crisis. Wall Street had little appetite for Sowood Capital’s credit portfolio. But Chicago-based hedge fund Citadel Investment Group did. This won’t be the last such deal. Investment is a zero-sum game. For every winner there is a loser. For every hedge fund that goes bust, another will be making hay.
When regulation, risk management practices or capital requirements begin to bite for banks and insurers, it is usually when markets are at their most distressed. Just when liquidity is needed, it is taken away. That is dangerous. Fortunately, though, the traditional role these entities played in times of dislocation has been taken up by hedge funds, which can now call on $1.74 trillion in assets.
Unregulated and unfettered, hedge funds are the final safety valve for markets, providing liquidity to the regulated and constrained. If regulators start to treat hedge funds like banks and insurers they won’t stop periods of market distress. Instead, they will make them far worse. There will be times in the coming weeks when we will all have cause to thank heaven for hedge funds.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own