IT OUGHT TO be a symbiotic relationship. "Prime brokers need hedge funds, and hedge funds need prime brokers. They may moan about each other, but it’s a marriage and it works," says an Asia-based hedge fund manager. "But this summer’s events underlined again the issues of liquidity and valuation, and some of the partners in those marriages were left wondering just how much they knew about each other after all."
As sub-prime mortgage-backed securities took a dive early in the summer, multi-strategy funds were forced to sell off their most liquid assets in order to post collateral to meet their prime brokers’ terms. It resulted in a steep drop in the equity market as positions were sold, and equity-related hedge funds in turn had to sell off sharply to meet their margin requirements. Other hedge funds that had large sub-prime mortgage exposure saw collateral seized, and valuations were slashed with some dubious calculations; a handful of funds were forced to close their doors. Hedge fund firms that had exposure to these hard to value CDOs are still battling with how to value their portfolios, and halting investors from leaving.
"August was instructive in two ways," says Philip Vasan, head of global prime services at Credit Suisse. "First was how quickly confidence could drop in the collateral that hedge funds and others were posting. Second was how quickly the status of hedge funds as a liquidity transmission mechanism could reverse. These conspired to send a tornado-like disruption across the liquidity grid, with many players spending weeks sorting through and likely facing very different ways forward."
Prime brokers were the first to feel the agitation among the hedge funds about the enforcement of margin requirements, and some managers were quick to end their relationships and move to different brokerage firms. But some believe that the prime broker is just the middleman between administrators, investment banks’ balance sheets and the end client.
Margin requirements – the confusion
Whether margin requirements were or were not increased during August by prime brokers is subject to debate. One hedge fund manager claims: "Any prime broker who says they didn’t up their margin requirements is lying", yet most prime brokers when questioned say they have not raised their margin requirements at all. The answer to whether they did or didn’t seems to lie in a grey area somewhere inbetween.
For a long/short pure equity player, the answer is probably no, prime brokers did not increase margin requirements. Was more collateral needed, however, as values of the securities posted dropped? The answer is likely to be yes. It’s not so much: ‘We are changing how much we will lend you’, but rather ‘You have to post more collateral’ that some clients are confusing.
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"Margin lock-ups will still be available but I expect that the bar has been raised with regards to the performance history now necessary to be offered them and that the terms offered will be less favourable" Jerome Ranawake, Freshfields Bruckhaus Deringer |
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"When the value of a hedge fund’s portfolio holdings changes, the amount of collateral to be posted also naturally changes," says Barry Bausano, co-head of global prime finance at Deutsche Bank. Furthermore, clients are continually able to check what impact changes to their portfolio values would have on their collateral postings through Deutsche’s Rules of the road risk management tool. "It’s a long-established system that we continually review, so the fund manager will not be surprised by what might occur in the event of portfolio changes," says Bausano.
For less-liquid securities, specifically those that were called into question in the summer, the issue of margin requirements being increased becomes much more vague, and highlights the importance of hedge funds knowing whom they are dealing with.
The fate of Bear Stearns’ credit strategies funds, Australia’s Basis Capital and BNP Paribas’ hedge funds, among others, has been well documented. Bad bets on sub-prime mortgages incurred huge losses and lenders increased margin requirements. In the case of Bear Stearns, Merrill Lynch seized collateral and tried to sell off $800 million in CDO-related bonds. Basis Capital’s lenders revalued its CDO investments, which called for more collateral to be posted than it could meet.
So clearly, margin requirements have been increased for funds investing in credit? Well, not necessarily. "There were certainly banks out there that had been using aggressive credit pricing as a tool to win market share, and they had to pull back from those terms and increase margin requirements," says a senior executive at a prime broker. This executive, however, says his firm is among a handful that have priced credit conservatively and so have not increased margin requirements.
Craig O’Neill, managing director at RCM Prime in New York, says his firm has increased margin requirements on the fixed-income side. "Luckily we were immune to some of the problems of July and August regarding the credit markets as we do not service many fixed-income clients, and traditionally offer only standard leverage," says O’Neill. "That said we have tightened our margin requirements on the fixed-income side and are reeling in margin requirements on non-investment-grade paper."
Another head of a global prime brokerage says his firm has been increasing haircuts on the asset-backed side. "The industry is not through this yet. Haircuts were far too low on the asset classes involved, and as we see things start to come up on a term basis, we’re going to see rises in haircuts. Unless clients haven’t breached their Nav requirements. But for the first time, there is some real scarcity of value in and around balance sheets." Participants say that triple-A mortgage-related CDOs that were haircut at 2% to 4% at the beginning of the year are now being haircut at more than 10%.
A head of prime brokerage at a New York investment bank says that RCM Prime’s O’Neill is being more honest than most in the business. "Prime brokers will say they did not up margin requirements, and will feel no guilt in saying that. But ask them what their repo desks did or are doing? They are certainly upping margin requirements. They have to. Prime brokers consider themselves very separate to the traditional fixed-income financing guys within the same investment bank but that doesn’t mean much to hedge fund clients that use the same bank."