Hedge Fund Managers Wary of Primes

Date: Thursday, March 20, 2008
Author: Gregory Bresiger, Tradersmagazine.com

The tables are turned. Now, instead of prime brokers worrying about the financial health of their customers, hedge funds are worried about the financial health of their prime brokers--and the investment banking parents of their primes. Earlier this week, Bear Stearns agreed to what was, effectively, a forced sale to JPMorgan as a result of its deteriorating liquidity.

Will another firm--or firms--follow in Bear Stearns? footsteps? wonder executives at hedge funds.

That's the question several hedge funds managers who rely on investment banks' prime brokerages for loans and other services are asking in the wake of the Bear Stearns collapse. These managers fear that bad oversight and unreliable accounting practices are common among investment banks.

"All investment banks are now essentially black holes," says a hedge fund manager who declined to be quoted by name.

William Fleckenstein, a hedge fund manager who is president of Seattle-based Fleckenstein Capital, says he suspects the problems go beyond Bear Stearns.

"There are no adults running these institutions," he says. In his view, there's cause to wonder about every investment bank on the Street.

Fleckenstein's doubts stem from what he says are poor accounting standards. The problem? It is difficult to accurately value some of the less-liquid assets that investment banks carry.

These assets include private equity and real estate that can rapidly change in value. Firms are now allowed to use in-house models to value these instruments.
Said another hedge fund exec who declined be identified: "You look at their numbers and you just don't know. There is no transparency."
 
That alarms Fleckenstein and several of his fund manager colleagues. Some fear that if a bank collapses, its prime brokerage unit could fall down on a trade, sticking a fund with a bad trade.

An industry observer agrees. "There's a genuine concern about the level of accuracy," says Josh Galper, a principal of Vodia Group, a consulting firm. "The fear of hedge funds, of counterparty risk, is valid."

Nevertheless, Galper believes investment banks are stable for now because the Federal Reserve Board, fearing the ripple effect of an investment bank failure, won't let them collapse. Galper, however, has no final answer to the problem of fast-changing markets and how they affect the values of investment banks.

Fleckenstein, who has just written a book on what he says are the disastrous policies of former Fed Chairman Alan Greenspan, contends that the problem is the investment banking system. He says that investment banks, since the abolition of the Glass-Steagall Act in 1999, have been allowed to inflate assets and underestimate debts.

Glass-Steagall, a 1933 law passed in the midst of the Great Depression, required the separation of investment and commercial banks. Lawmakers believed that bank speculation led to the Crash of 1929.