Hedge funds: Why are they surprised?

With financial markets in crisis mode and angry investors demanding to know how so many hedge funds and supposedly fail-safe securities fell to pieces so fast, the new buzz word among fund managers and executives in the hot seat is "unprecedented."  

The Wall Street Journal alone quoted at least eight hedge funds or companies between Aug. 15 and 21 using the word to describe market conditions when explaining why they have lost money, why the need to raise money or why they are shutting down funds or business units.

But the history of capitalism is stuffed with crises, and experts believe today's financial wizards should have seen this liquidity coming. Those who did are making a fortune.

The recent liquidity troubles started as consumers in the United States defaulted on subprime mortgages, or debt extended to consumers with poor credit histories, and then spread to the global credit market in recent weeks. This has led to a credit crunch in which lending between banks has cratered and the market for commercial paper has dried up.

Take KKR Financial Holdings LLC, an arm of the widely worshiped Kohlberg Kravis Roberts & Co., as an example. KKR Financial, a specialty finance company, invests in a number of areas hit hardest by recent market turbulence, such as residential mortgage loans, mortgage-backed securities, asset-backed securities, corporate loans and debt securities and commercial real estate loans and debt securities. KKR Financial, which turned to the market to raise cash this week, said the "unprecedented disruption" in the credit market forced it to sell US$5.1-billion in assets at a loss of $40-million.

"These hedge funds are in the business of taking risk and right now the set of circumstances that have come to bear means the risk has been realized," said Basil Kalymon, a finance professor at the Richard Ivey School of Business at the University of Western Ontario. "And they are squealing because they are losing money."

Moreover, these sophisticated investors should know better.

"The market is subject to a variety of different shocks," Mr. Kalymon said. "This particular shock may be slightly different than what has occurred in the past, but the nature of the markets are such that you can certainly expect these types of disruptions."

Those echoing KKR Financial's don't-blame-us-attitude include credit card giant Capital One Financial Corp., which plans to close a mortgage unit because of "an unprecedented set of market circumstances"; Black Mesa Capital, a hedge fund, which said "unprecedented market events" were to blame for it losing about 10% in the first eight days of August; and Countrywide Financial, which said "unprecedented disruptions" in credit markets would have an "unknown" effect on the company. "Unprecedented volatility" and "sudden and unprecedented decline" were also used by other struggling market players.

While billions of dollars have evaporated during this liquidity crunch, "unprecedented disruption" in the market is not necessarily synonymous with "pain for investors," as KKR Financial and others might want investors to believe.

Take the case of Jim Melcher, who runs a hedge fund called Balestra Capital. According to The New York Times, he risked $60-million betting that mortgage-backed bonds would fall. He placed his initial wager in October.

"We saw the opportunity of a lifetime, and since then events have unfolded on schedule," he told the Times. His flagship fund has doubled in size to $200-million because of the subprime shakeup.

Mr. Melcher's success is not just because of the market's turbulence, it is because he saw it coming and acted accordingly.  Following the same logic, KKR Financial's troubles are not because of market disruption, but because they failed to heed the warning signs.

"What we're seeing currently is a disruption that is completely predictable based on what has been happening," said Ivey's  Mr. Kalymon. "The liquidity crisis is there because a lot of these funds have been using short-term funding for long-term assets.  And this is a recipe which just invites a crisis of funding."

Added to that, this is not the first time the market has gone through a liquidity crunch.  For example, the commercial paper market in Canada dried up for a while after Olympia & York Developments Ltd. defaulted on its commercial paper in 1992, notes Stephen Foerster, finance professor at the Richard Ivey School of Business at the University of Western Ontario.

And history is littered with more significant examples which have gripped the markets, causing major disruptions: the Asian financial crisis in 1997, Long-Term Capital Management's collapse shortly after that, the bursting of the tech bubble in 2000. The oil shocks of the mid-70s pinched the market, and the recession in the early 1980s did not help liquidity either. Black Monday, Black Tuesday and Black Thursday in October 1929; Black Monday in October 1987; September 11th - all precedents which highlight how risk can manifest itself at any time and should be expected.

KKR Financial, one of the funds caught in the current squeeze, even says on its Web site that it understands how quickly the market can turn: "As long-time, experienced investors, we recognize that sectors in favor today will very likely be out-of-favor tomorrow."