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Hedge funds may be next

Date: Thursday, September 18, 2008
Author: Barbara Shecter, Financial Post

The next wave of failures in the growing U.S. economic crisis is likely to occur in the opaque hedge fund industry, which is facing mounting losses from interconnected contracts that failed or crippled such financial services businesses as Lehman Brothers Holdings Inc. and American International Group Inc.

"We're going to see five hedge funds fail for every bank, maybe more," says Christopher Whalen, senior vice-president and managing partner at Torrance, Calif.-based Institutional Risk Analytics.

The implications for the big financial names that are still standing after the disappearance this week of Lehman and independent investment bank MerrillLynch&Co. - such as JPMorgan Chase&Co. and Goldman Sachs and Co. is enormous. He says the web of financial obligations between the banking and hedge fund industries has grown unchecked over the past few years and will likely, ultimately weigh on their already stressed balance sheets.

The problems the current crisis has created for hedge funds is clear to Nouriel Roubini, an economics professor at New York University's Stern School of Business, and one of the few high-profile market forecasters who accurately predicted the demise of some of Wall Street's biggest names.

"Many hedge funds are now teetering as their losses are mounting," he said on Wednesday in his online catalogue The Global EconoMonitor.

At the heart of the losses is the largely unregulated and private market for credit default swaps, which are essentially a gamble on the ability of a corporation to repay its debt. The rapid growth of technical and actual defaults in recent weeks - including giant U. S. mortgage lenders Frannie Mae and Freddie Mac and Lehman Bros. - has created calls for collateral on these obligations far beyond the capability of many hedge funds to make good on them.

Financial institutions such as AIG struggled with the same issues, which played a role in the Federal Reserve's decision to take control of the insurance giant on Tuesday.

But the problem of meeting the demand for additional collateral for the obligations is magnified for hedge funds which have no regulatory requirements on how much capital they have on their balance sheets.

The vast majority have little more than their clients' money, even though there are well-capitalized hedge funds such as Tudor Investment Corp., Mr. Whalen said.

If a hedge fund is pushed into liquidation by its credit default swap obligations, the person or company on the other end of the CDS may demand payment from the bank that acted as the middle man in the transaction, the so-called prime broker.

"Much like the bookie ... the prime broker will have to step in for the itinerant gambler," said Mr. Whalen, a former investment banker who provides risk-management advice to auditors, regulators and financial professionals. "This is just a dealer market. There's no [stock] exchange to make good on the transaction. There's a gun to [the prime broker's] head to make good or the whole market unravels."

Among the biggest prime brokers in the credit default market are Goldman Sachs and Morgan Stanley. Even deposit-taking commercial banks such as Deutsche Bank and Citigroup Inc., the largest bank in the United States, took on the role of prime broker in the credit default swap market. The CDS market has ballooned to about US$62-trillion, with hedge funds making up much of the trading before the credit crisis began.

A Toronto-based investment professional with experience in the credit default market said a moment of reckoning for many hedge funds may come at the end of this month, when their exposure to credit default swaps must be "marked to market" to reflect the increased obligations at the end of the third quarter.

It may be a very quiet exercise, however, as most hedge funds are private and report only to their investors. Operating largely outside public markets and regulatory scrutiny, the failures, too, may take place largely behind the scenes and may already have begun.