Hedge Funds Feeling the Heat

As risk-takers of last resort, hedge funds have played a starring role in improving liquidity throughout the global financial system (however fleeting that state of affairs may eventually turn out to be).

Their aggressive interest in acquiring toxic slugs of myriad derivatives deals, buying illiquid interests in dodgy companies, and selling protection against the possibility of corporate default -- even for the shakiest borrowers -- enabled all sorts of deals to happen and exotic markets to develop that might not otherwise have seen the light of day (Hmmm....).

Their role as facilitators of modern-day financial alchemy has, in large part, depended on their ability to obtain cheap financing from prime brokers -- bulge-bracket broker-dealers. However, with losses mounting and balance sheets ballooning at many Wall Street firms on the heels of a sudden and dramatic change in sentiment in credit markets, some new age investors are discovering, as FT.com notes in "Tougher Terms for Hedge Funds," that the credit spigot is starting to run dry.

Investmet banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.

Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil.

"Financing terms for hedge funds are being tightened and this is forcing a further deleveraging of risk across global markets," said Gerald Lucas, senior investment adviser at Deutsche Bank.

One prime broker said his bank had started examining its lending criteria in the wake of the much publicised problems at two hedge funds run by Bear Stearns.

"Recently we have broadened our stricter standards to funds beyond those with exposure to US mortgage market. I'd say this is now a pretty broad-based retreat from leverage."

The move could raise the pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of recent market swings.

The average hedge fund, across all strategies, returned just 0.8 per cent in June, down from 2.3 per cent in May, according to Credit Suisse Tremont. Fixed income-focused hedge funds were the worst affected, returning just 0.2 per cent in June.

If a hedge fund's performance deteriorates sufficiently, its prime broker's bank can demand that it sells assets to repay loans.

Ciaran O'Hagan, strategist at Société Générale, said: "Borrowers [now] find it harder to finance their leverage and that is proving a millstone for all risk-based strategies."

The stricter approach to lending to hedge funds by investment banks comes as markets continue to suffer as a result of concerns about the state of the US credit markets.

Doesn't sound anything like "containment" to me.