Derivatives Banks Concerned by Hedge Fund Leverage (Update3)

Date: Tuesday, July 17, 2007
Author: Hamish Risk, Bloomberg

July 17 (Bloomberg) -- Hedge fund borrowing to invest in credit derivatives may magnify volatility in a market slump, according to a Fitch Ratings survey of 65 banks and insurers.

A ``dramatic'' increase in hedge funds' use of credit derivatives has pushed their share of trading to 60 percent of credit-default swaps, and about 33 percent of collateralized debt obligations, Fitch said in the report today, citing data from Greenwich Associates.

U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns Cos. was forced to provide $1.6 billion for one of two funds that made wrong-way bets on subprime debt. The New York-based firm didn't bail out lenders to the other fund, which borrowed against its investors' capital to take bigger risks.

In a market slump, large deals financed with borrowed money, or leverage, may ``result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' analysts led by Ian Linnell in London wrote in the report for the 2006 survey.

Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started the survey in 2003, the ratings company said. The contracts, based on bonds and loans, are used to speculate on the ability of companies to repay debt.

Leverage Increase

``Until all of this recent volatility, investors had been forced down the credit quality ladder, and up in leverage to meet investment targets,'' said Matt King, head of credit products strategy at Citigroup Inc. in London. ``Now it appears hedge funds are deleveraging'' to meet demands from their lenders.

Hedge funds typically leverage their assets by five to six times, Fitch said in a report in June. The funds' holdings of corporate debt reached more than $300 billion in 2005, Fitch said, citing International Monetary Fund data.

In-depth, up-to-date data on hedge fund investment in corporate bonds, loans and their derivatives ``remains elusive,'' Fitch said in today's report.

In credit-default swaps, the buyer pays an annual premium to guard against a borrower failing to pay its debts. In a default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller.

Trader Rankings

Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, up from 86 percent in the previous year, Fitch said.

``For better or worse, counterparty concentration appears to remain a feature of this market,'' Fitch analysts wrote.

Credit-default swaps based on the debt of General Motors Corp., the largest U.S. automaker, were the most frequently traded single-name contracts last year, Fitch said, followed by DaimlerChrysler AG, the world's second-largest luxury carmaker.

Investors put the most money into default swaps on GM and the government of Brazil, Fitch said.

Contracts based on 10 million euros ($13 million) of debt included in the iTraxx Crossover Index of default swaps on 50 European companies jumped 20,500 euros to 288,000 euros at 5:10 p.m. in London, according to JPMorgan Chase & Co. The CDX North America Investment-Grade Index of 125 companies rose $1,750 to an offered price of $45,750, Deutsche Bank AG prices show.

Prices of the derivatives typically decline when creditworthiness improves, and rise when it worsens.

A derivative is a financial obligation whose value is derived from such underlying assets as debt and equity, commodities and currencies.

To contact the reporter on this story: Hamish Risk in London hrisk@bloomberg.net