Banks need to be bold and show hedge funds the money

Is this the beginning of the end of the credit crisis?

The US debt markets have shown signs of a renaissance in recent weeks.

Both investment-grade and riskier high-yield corporate credit have rallied forcefully this month. The supply of new issues has also picked up, as companies have tempted investors back with attractive yields. Banks such as Citigroup and Deutsche Bank have negotiated multi-billion dollar sales of leveraged loans to private equity groups, meaningfully reducing the overhang of such debt on their balance sheets.

Meanwhile, in the US government bond markets where the credit crisis once fuelled extraordinary safe-haven buying, there has been a dramatic sell-off. Investors appear to have adopted the view that central bank interventions have been effective in restoring market stability and the Federal Reserve is nearing the end of its interest rate cutting cycle.

But it is premature to proclaim an end to what Paul Volcker, former Fed chairman, recently described as "the mother of all crises".

Certainly many of the symptoms of the crisis have begun to ebb, but the underlying cause of the market's maladies - the still declining value of US housing and mortgage-related assets - remains.

Until buyers for these beleaguered assets emerge, they will continue to put pressure on bank balance sheets.

So where are the buyers?

The irony is that since the start of the credit crisis, dozens of asset managers have established funds to invest in distressed asset-backed securities, collateralised debt obligations and other structured credit instruments.

Structured credit advisory group Palomar Financial Services has seen between 60 and 70 funds begin raising money for such strategies in the past six months. Such funds saw significant positive flows in the first quarter of the year, with distressed and special situations strategies attracting almost $8bn in new money, according to Hedge Fund Research, an industry data provider.

But hedge funds rely on using borrowed money to amplify their returns. And therein lies the rub.

As banks withdraw from risk-taking to repair their tattered balance sheets, providing hedge funds with leverage is low on the priority list, even if those funds are the very buyers that banks need to take distressed structured credit assets off their hands.

Banks have dramatically cut back the amount of money they are willing to lend to almost all types of hedge fund strategies, causing some funds to cut leverage by up to half.

The most levered funds are now borrowing no more than five times their asset base, compared with 10 times their asset base just six months ago, according to fund of hedge fund managers.

Several prime brokers say hedge fund lending criteria are increasingly judged on a case-by-case basis, with funds focused on still-performing macro or emerging markets strategies avoiding the tighter standards.

But on the flip side, funds focused on structured credit have been the most squeezed. The average leverage available for funds investing in structured credit assets has plummeted, with the most levered funds in this area borrowing no more than three times their asset base, and some using no leverage at all.

Prime brokers have also imposed drastic "haircuts" on collateral posted by hedge funds as margin, meaning funds have to post more margin than ever in order to stay in business.

The uncertainty has prompted many top hedge funds to demand "lock-ups" on their margin agreements to try to protect themselves from a further clampdown from prime brokers, which could force sales of assets into falling markets and potentially put funds into a death spiral.

Such "lock-ups" are contractual periods as long as 120 days during which the prime brokers cannot change terms even if the market environment worsens.

Steve Gross, principal at Penso Capital Markets, a fund of hedge funds, says that if the prospects for obtaining leverage were to get significantly worse, the large established hedge funds, some of whom have access to the public debt markets and alternative leverage options, will survive while smaller funds will struggle. "Investors need to take a long-term view on how bank business models are likely to change, and to what extent providing hedge fund leverage is going to fit in those new models," he says.

There is a chance, he says, that banks will not return to providing leverage any time soon.

But this means that in the structured credit markets, asset prices could fall further still before enough buyers emerge to restore stability.

Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund, says: "If leverage is unavailable, then unlevered spreads should widen to the point that they at least equal, on a risk-adjusted basis, spreads that were formerly attainable with the use of leverage."

Bankers are notorious for amplifying market cycles.

But this time, the banks may fall victim to their own precautions. With leverage, hedge funds might buy structured assets from bank balance sheets at current prices. Without it, hedge funds will demand a better deal, banks will have further writedowns and the credit crisis will rumble on.

saskia.scholtes@ft.com