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Hedge Funds Reel From Margin Calls Even on Treasuries

Date: Tuesday, March 11, 2008
Author: Tom Cahill and Katherine Burton, Bloomberg

The hedge-fund industry is reeling from its worst crisis in a decade as banks are now demanding more money pledged to support outstanding loans even when the investment is backed by the full faith and credit of the United States.

Since Feb. 15, at least six hedge funds, totaling more than $5.4 billion, have been forced to liquidate or sell holdings because their lenders -- staggered by almost $190 billion of asset writedowns and credit losses caused by the collapse of the subprime-mortgage market -- raised borrowing rates by as much as 10-fold with new claims for extra collateral.

While lenders are most unsettled by credit consisting of real estate and consumer debt, bankers are now attempting to raise the rates they charge on Treasuries, considered the world's safest securities, because of the price fluctuations in the bond market.

``If you have leverage, you're stuffed,'' said Alex Allen, chief investment officer of London-based Eddington Capital Management Ltd., which has $195 million invested in hedge funds for clients. He likens the crisis to a bank panic turned upside down with bankers, not depositors, concerned they won't get their money back.

The lending crackdown is the worst to hit the $1.9 trillion hedge-fund industry since Russia's debt default in 1998 roiled global credit markets and required the U.S. Federal Reserve to pressure the securities industry to arrange a $3.6 billion bailout of Greenwich, Connecticut-based Long-Term Capital Management LP. Today, hedge funds are being forced to sell assets to meet banks' margin calls, resulting in the dissolution of the funds.

``There has to be more in the next weeks,'' Allen said. ``There are people who have been hanging on by their fingernails who can't hold on much, much longer.''

`Mercy of Counterparties'

Ivan Ross, founder of Westport, Connecticut-based hedge fund Tequesta Capital Advisors, received a call from his bankers on Feb. 22 demanding he put up more money or risk losing his loans. Ross was unable to meet the margin call as the market for mortgage- backed debt seized up, preventing him from selling securities to raise the cash. Four days later, lenders liquidated his $150 million fund.

``Because it's impossible in this environment to move among dealers, you're at the mercy of counterparties,'' said the 45-year- old Ross, who has managed hedge funds for 13 years, including a stint handling mortgage-backed debt for billionaire George Soros. ``To the extent they want to shut you down, they can.''

The demise of Tequesta revealed the deathtrap for hedge funds caught in the credit maelstrom of banks selling mortgage-backed bonds as fast as they can while demanding more collateral from clients who use the securities to back loans.

Carlyle Fund

On Feb. 24, London-based Peloton Partners LLP gave up a ``night and day'' effort to stave off demands from banks, including Goldman Sachs Group Inc. and UBS AG, for as much as 25 percent collateral for securities that once required 10 percent, according to investors in the fund. Peloton, run by former Goldman partners Ron Beller and Geoff Grant, liquidated the $1.8 billion ABS Fund, its largest.

The same day, about 5,000 miles (7,770 kilometers) away in Santa Fe, New Mexico, JPMorgan Chase & Co. told Thornburg Mortgage Inc. that it had defaulted on a $320 million loan because it couldn't meet a $28 million margin call, according to U.S. regulatory filings.

Thornburg, the home lender that lost 93 percent of its market value in the past year, was near collapse March 7 after it failed to meet $610 million of margin calls. Chief Executive Officer Larry Goldstone said in a statement the company fell victim to a ``panic that has gripped the mortgage financing industry.''

Repo Agreements

Carlyle Capital Corp., the debt-investment fund started by private-equity firm Carlyle Group of Washington, was suspended from trading in Amsterdam on March 7 after it couldn't meet margin calls, and its banks seized and sold assets.

``Banks are reducing exposure anywhere they can and the shortest way to do that is to cut leverage,'' said John Godden, chief executive officer of London-based hedge-fund consultant IGS AIS LLP.

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether the price of assets will rise or fall.

The managers that trade fixed-income securities generally borrow money through repurchase agreements, or repos. In a repo, the security itself is used as collateral, just as a homeowner puts up the house as collateral for a mortgage.

Collateral `Haircuts'

Banks usually limit their risk on repos by lending less than the value of the securities used as collateral. Tequesta was able to borrow $95 on $100 worth of AAA rated jumbo prime mortgages in early 2007, meaning the bank took a $5, or 5 percent so-called haircut. By last month, the amount required had risen to as much as 30 percent, Ross said. Jumbo mortgages are loans of more than $417,000, typically used to finance more expensive homes.

The losses started in mid-2007, when prices of subprime loans, those to homeowners with bad credit histories, started tumbling because of a surge in delinquencies. The contagion spread to other credit markets, including bonds backed by student loans and credit cards and now mortgages backed by federal agencies, which have an implied guarantee from the U.S. government.

Prices keep falling, with yields on mortgage-backed debt issued by agencies such as Fannie Mae rising last week to the highest level relative to U.S. Treasuries since 1986. Costs to protect corporate bonds from default are close to a record high.

Under such circumstances, lenders have no choice but to ask clients to put up more cash. For AAA rated residential mortgage backed securities, banks have raised haircuts 10-fold in the past year to 20 percent, according to estimates from Citigroup credit analyst Hans Peter Lorenzen in London.

Treasury Swings

On AAA asset-backed securities, banks are demanding a 15 percent haircut, up from 3 percent last summer. Corporate bond haircuts have gone to 10 percent from 5 percent, bankers said.

At least one bank has raised Treasury haircuts, which range from 0.25 percent to 3 percent, depending on the length of the loan and the creditworthiness of the borrower, said bankers, who declined to be identified. They said they wouldn't be surprised if the practice becomes more widespread, not because they expect the U.S. government to default, but rather because there have been bigger price swings in the Treasury market, which affects value.

Some banks may have been late to raise haircuts for their biggest hedge funds because they are lucrative clients, said Jochen Felsenheimer, head of credit strategy at Milan-based UniCredit SpA, Italy's biggest bank.

``Until now, hedge funds have been the big winners of the crisis and this could be as well due to banks not having yet drawn down their margin,'' Felsenheimer said.

Survival of Fittest

Carlyle said in a March 6 statement that margin prices requested for securities weren't ``representative of the underlying recoverable value'' of its securities. Lenders started to liquidate its portfolio of $22 billion of AAA rated mortgage debt issued by Fannie Mae and Freddie Mac.

``It's not a question of prime brokers deciding which firms live and which don't,'' said Odi Lahav, head of the European Alternate Investment Group at Moody's Investors Service in London. ``They're trying to manage their own risk. There's a Darwinian aspect to survivorship in this industry.''

Some managers set themselves up for a stumble by taking on too much leverage and not anticipating that terms could change, said Christopher Cruden, CEO of Lugano, Switzerland-based Insch Capital Management, which oversees $150 million for clients.

``If you're going to dance with the devil, there comes a time when your toes are going to be stepped on,'' Cruden said. ``Prime brokers are there to do business, not be your friend.''

To contact the reporter on this story: Tom Cahill in London at tcahill@bloomberg.net; Katherine Burton in New York at kburton@bloomberg.net