Institutional Investor's Alpha Magazine - October 2008 - (Page 47)

tem but failures, actual as well as threatened, among the banks and investment banks. Tanya Beder, chairman of risk consulting group SBCC Group in New York and former CEO of Tribeca Capital Management, Citigroup’s multistrategy hedge fund ﬁrm, points out that the degree of leverage used by most hedge funds is tiny compared with that of the investment banks. Lehman Brothers Holdings, Merrill Lynch & Co. and Morgan Stanley all had leverage ratios in excess of 30 times assets going into the mortgage market collapse. Goldman, Sachs & Co. was levered by 22 times assets. As the investment banks pare their leverage — Morgan Stanley has already reduced it to 18 times assets — the amount of ﬁnancing that hedge funds can get is also reduced. In the repo market, through which Wall Street dealers and banks provide short-term ﬁnancing by lending to one another, the size of haircuts — the initial collateral level in repurchase transactions — has increased dramatically for banks where lending is available at all. Hedge fund ﬁnancing started drying up 18 months ago. Early casualties were often highly leveraged, creditfocused funds, like Boston-based Sowood Capital Management and London’s Peloton Partners, that borrowed through the repo markets and had exposure to subprime mortgages. Both ﬁrms were highly levered in credit-based strategies and had their ﬁnancing pulled by banks. Increased borrowing costs have also contributed to negative returns, leading investors to redeem and hedge funds, in some cases, to erect gates to prevent massive redemptions. In August, New York–based Ore Hill Partners put up a gate to limit withdrawals on about half of its $3 billion in assets in response to client redemption requests. Ore Hill invests in leveraged loans, where ﬁnancing now is virtually nonexistent. Funds specializing in convertible arbitrage, such as CQS “There has never been lower reward for taking more risk than there is right now. Leverage is going to get more expensive.” — ALEX EHRLICH, GLOBAL HEAD OF PRIME SERVICES, UBS Management in London, have been hit especially hard both by the difﬁculty of ﬁnancing their bond positions and by prohibitions on short-selling (see “Caging the Shorts,” page 50). CQS’s Convertible and Quantitative Strategies Feeder is seeking to recoup $ 250 million. Londonbased MKM Longboat Capital Advisors told investors at the end of last month that it will have to close its $1.5 billion flagship MKM Multi-Strategy Fund because of poor performance and its prime brokerage relationship with Lehman. But the most unnerving aspect of Lehman’s failure is the bank’s role as an aggressive counterparty to a wide range of over-the-counter derivatives, from plain-vanilla interest rate and equity swap contracts to more-exotic credit default swaps, which alone now constitute a massive, unregulated $54.6 trillion global market, according to midyear statistics from the International Swaps and Derivatives Association. In practical terms, institutional asset managers and hedge fund ﬁrms that had purchased protection through Lehman against a speciﬁc company’s default risk no longer have any safeguard. Those hedges have simply disappeared. So have the many millions in cash that individual hedge fund ﬁrms put up as margin, or collateral, with Lehman. “I don’t think people understand how big a problem this is,” says one hedge fund manager who declines to be named. “It is absolutely enormous. If your assets were secured and ring-fenced within Lehman, you should be ﬁne, in theory — but that is just a theory. If your assets weren’t secured, I think you’re out of business, because you’ve just lost whatever was in there, including any proﬁ ts. You’re now just another unsecured creditor.” Complicating matters is the timing of Lehman’s downfall. In mid-September every manager of a hedge fund was working feverishly to determine proﬁ ts, losses and total portfolio net asset value by September 30 — the close of the third quarter and the last window of opportunity for many investors to give notification of redemption requests to get their money out at year-end. How individual firms and their administrators were going to assess their funds’ exposure to Lehman, and calibrate it successfully, was still an open question before the end of the month. “The problem is that many managers have no clarity right now about what their OTC-traded swaps and derivatives are worth or what the likely settlement is going to be,” says John Godden, founder and CEO of London-based IGS Group, a hedge fund advisory ﬁrm that assists managers with risk management and portfolio modeling. “This is what PricewaterhouseCoopers is going to have to work through — and fast — but it will probably take some time.” At the easy end of the scale of net asset reconciliation, says Godden, managers may be able to specify a certain percentage of their portfolio’s value and hold it back to reﬂ ect the unknown valuation of any outstanding swaps. At the tougher end some hedge funds — many of which are already facing redemptions irrespective of their relative performance — may get into trouble if their exposure to Lehman turns out to be more than a few percentage points or if their redemption requests are greater than the free liquidity in their funds. In such cases, redemptions will be suspended, he says, which may sound the death knell for some funds. The only sure bet is that the business of prime brokerage will never look the same. Lehman may be gone, but Morgan Stanley and Goldman, Sachs & Co. will face new competition from the commercial banks, which have historically been much better capitalized, and from European banks like BNP Paribas, Credit Suisse and Deutsche Bank, which are eager to win market share. Prime brokerage will become more competitive, but it will remain expensive and there will be fewer choices. — Loch Adamson OCTOBER 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 47

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2008

Institutional Investor's Alpha Magazine - October 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Process of Evolution The Good Guys: Israel's Champion Interview: Fast Lessons for Hard Times Cover Story: Industry Under Siege The New Hedge Fund Economics Good-Bye, Easy Money Caging the Shorts Strategies: Bottom Fishing Profile: Cult of Personalities Research Center: Alpha Awards: Eye of the Storm Alpha Bytes: Funneling the Chatter Unhedged: Commentary: Attention, Hedge Fund Shoppers

Institutional Investor's Alpha Magazine - October 2008

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