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Hedge fund loans pose risk: Sprott

Date: Friday, November 24, 2006
Author: Boyd Erman, Globe and Mail

Bank lending may threaten system.

TORONTO -- As stock indexes in North America climb to records, influential Canadian money manager Eric Sprott is sticking to his belief that stocks are in a bear market and risks of a big slump in share prices are building.

"We still believe we are in a secular bear market," Mr. Sprott told an audience of hedge fund managers in Toronto yesterday, acknowledging that the stance "seems silly when the Dow is hitting new highs."

Mr. Sprott's belief that the markets are on shaky ground hinges on his assessment that there are numerous factors that could prompt a plunge in share prices, including the rapidly deteriorating U.S. housing market and the possibility that the U.S. dollar's value could crack under the strain of a yawning trade deficit.

But the biggest worry, Mr. Sprott said, is that the financial system could collapse because of the massive leverage that banks are offering to hedge funds in the form of loans. The hedge funds are fond of borrowing money, often three or four times their invested capital, to enable bigger returns on winning bets.

"I'm the only person in the world, I think, who worries about the banking system," he said. "And I worry every day about the banking system."

He pointed to the "tremendous leverage taking place within the hedge funds and the banking system," he said. The biggest example, he said, is the burgeoning market for credit default swaps that allow funds to bet on the likelihood of companies defaulting on bonds. Most of those bets are made with borrowed money.

"It's gone absolutely bonkers and you have to debate whether it's a mania," said Mr. Sprott, whose firm, Sprott Asset Management Inc., runs assets of about $4-billion. About $1.5-billion of that is in the form of hedge funds, he said. Should the market collapse, banks could have trouble with the loan losses, he said.

"It can happen -- you can get too levered and anyone can go down."

So far, while Mr. Sprott has been wrong about an all-out collapse of the U.S. economy, his bets on energy, gold and uranium stocks have still enabled his firm to rack up big returns.

So bearish is the money manager that he said he hasn't in recent years been able to recommend investors put money into Sprott's own long Canadian equity fund. Instead, he steers them to the company's hedge funds. Too bad for those investors, as the Sprott Canadian Equity Fund has risen 39 per cent over the past year, about twice the return of the company's hedge funds.

But should the market fall, hedge funds, with their ability to bet on stocks falling, are the "defensive team," he said.

Because of his contention that banks and hedge funds are working too much with borrowed money, Mr. Sprott said he is an advocate of more regulation that would control leverage offered to hedge funds -- not by rules on the funds but by rules on the already-regulated banks that would govern the amount of money that can be lent to managers.

"There are lots of rules in place for regulated entities that should keep you out of trouble if the regulated entities stick to the script," he said.

He also suggested that hedge funds should be audited more often, with tighter rules on who is qualified to check out the bookkeeping.