Hedge funds leverage rising through repo and falling through prime brokers

Hedge funds are using more leverage, reflecting an increase in risk appetite, and are further diversifing credit exposures to bank counterparties, says a UK Financial Services Authority (FSA) report.

Funds are borrowing more through repo and less through prime brokerage, according to findings from the FSA's latest hedge fund and hedge fund as counterparty survey.

The April 2010 survey follows a similar one carried out in October 2009. The April survey approached 50 FSA-authorised investment managers with nearly $345 billion of assets under management (AUM), accounting for a majority of AUM managed by European-based managers.

The FSA looked at leverage used by hedge funds in terms of total gross footprint across asset classes, compared with equity raised from investors. It showed leverage by footprint at April 2010 was 399%, an increase from 328% in October 2009.

Fixed income arbitrage had a footprint of nearly 1,400% in April 2010, compared with just over 800% in October 2009.

The report said borrowing as a multiple of net equity had increased from 244% to 272% since October 2009. Fixed income arbitrage was the highest with 1,400% borrowings as a multiple of net equity.

Borrowing under repo increased with the latest survey showing over 70% of cash-out reverse repo financing between companies and their hedge fund counterparties comprised G10 government bond collateral.

The report showed synthetic borrowing had also increased but not to the extent repo had. The data also showed most fixed income reference assets for synthetic financing were loans while most reference assets for equity synthetic swaps were G10 equities.

Borrowing on an unsecured basis remained negligible with the amount outstanding in April 2010 lower than in October 2009, noted the report.

"The reported levels of unencumbered cash for fixed income arbitrage funds are relatively high, on average 85% of net asset value at April 2010," said the report. This should provide some liquidity buffer for these funds in the event of a "sudden or rapid deleveraging, according to the survey.

The maximum credit exposure of any one bank to any one hedge fund was approximately $600 million. This compared with $500 million in October 2009. Most potential credit exposures of single banks to single hedge funds amounted to less than $51 million, said the FSA report.

"Hedge funds appear to have further diversified their credit exposures to bank counterparties," the report concluded.

The surveys will be repeated in September 2010.