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Hedge funds now feeling the pain from The Great Unwind

Date: Friday, March 14, 2008
Author: Harry Koza, theglobeandmail.com

When I was in B-school, on the first day in second-year Finance class, our professor asked us if anyone knew what margin was. Having had a very recent brush myself with the dark side of leverage - been there, done that, took the haircut, in fact - I quickly raised my hand. The professor nodded at me, and I answered: "Margin is when your broker calls you and gives you 24 hours to come up with more money or he'll sell you out." That's pretty much what's happening these days in credit markets.

Banks need to raise capital to absorb some of their off-balance-sheet follies, and since there is no bid for the really sweaty stuff and even high-grade loans and debt securitizations are selling at 80 cents on the dollar, it's way easier for them to squeeze hedgies and private equity Geckos by raising margin requirements.

Spreads on bank bonds are at their widest levels in years, making bank borrowing more expensive, even with lower central bank rates and enhanced liquidity facilities like the one announced this week by the Federal Reserve and other G10 central banks (including Canada's). Besides, banks need to de-leverage their balance sheets as all their subprime chickens come home to roost, so more borrowing isn't much help.

Hence the higher margin requirements for their broker, hedge fund and private equity clients, and they are also starting to squeeze operating lines of credit on their big and small-business customers. They'll be coming after individual borrowers, too, cutting credit card limits and personal lines of credit.

Now, say you are our old friend Joe, from Joe's Hedge Fund & Dive Shop down in the Caymans. You raised a billion dollars from credulous institutional investors a few years back, and leveraged it into a $25-billion portfolio of CDOs and mortgage securitizations. Let's assume that you don't even own any subprime paper, that all your holdings are still rock-solid credits.

You've financed your portfolio with loans from banks and dealers, secured with your assets. So far, so good. But now, given the recent constant crunching of credit everywhere, your bankers want more collateral against those loans.

Of course, people are no longer lined up to give you money for you to sink into alphabet soup derivatives, so the only way you can get more collateral is by selling some of your assets. Unfortunately, the only bid for even the good stuff is at 80 cents on the dollar. If you sell any, you have to mark everything else to market, and, since you are leveraged 25 to one, all your investors' equity is gone.

Not only is Joe's hedge fund wiped out, he'll probably lose the Dive Shop, too. Liquidating Joe's collateral drives prices even lower, making everybody else's loans look dodgier, so the banks and dealers demand more collateral from them as well, causing more selling. And this particular vicious cycle is just getting started.

On Wednesday, Drake Management said it may liquidate its largest hedge fund, the $3-billion (U.S.) Global Opportunities Fund, and Dutch hedge fund GO Capital (perhaps soon to be referred to as GONE Capital) stopped investors from withdrawing money from its $880-million Global Opportunities Fund. I'm starting to think that it might be a good idea to avoid investing in anything with the words "Global" and "Opportunities" in the name.

At least a dozen hedge funds have gone belly up, restricted withdrawals, hustled for new capital or dumped assets in the past month or so because of margin calls, and there will be many more in the months ahead.

Meanwhile, it's also having an effect on the bond market. Bond trading volumes this week have been lousy. It feels like word has come down from the boardrooms to the trading desks that risk of all kinds must be reduced, and thus shorts covered, longs pared, credit exposure trimmed.

Yield spreads on credit product - corporate and provincial bonds - continue to grind wider, and any strengthening draws more sellers. Corporate bond spreads haven't been this wide in ages, and are, as they say on the bond desk, trading at their wides.

Since May of 2007, just a few months before the Great Unwind got kicked off by the ABCP debacle, the yield on five-year subordinated bonds issued by one of the big Canadian banks has widened from around 44 basis points over five-year Canada bonds to, depending on which bank, to between 170 beeps to 190 beeps.

I expect to see more hedge trimming, more forced selling, more blood spilled than in a David Cronenberg film version of a Shakespearean tragedy, and still wider corporate bond spreads. So, as the Bard himself might have put it, "Beware the Wides of March."

Harry Koza is senior Canadian markets analyst at Thomson Financial and a columnist for GlobeinvestorGOLD.com.