HEDGE FUND NEWS
@ Fri 21 December 2007 : GMT

All of a sudden, it seems that the mainstream media and the blogosphere are being overrun with "experts" who claim they saw many of the current problems coming, especially insofar as the derivatives market is concerned.

Under the circumstances, I thought it would be an great time to reprint an article I published two years ago, when many of these people had absolutely no clue what was coming down the pike.

The Coming Disaster in the Derivatives Market

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear....[They] are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. -- Warren Buffett, Chairman and Chief Executive, from his Letter to Shareholders, 2002 Berkshire Hathaway annual report...

When the subprime mortgage market began to unravel late in 2006, global bond markets barely flinched. But when two Bear Stearns (BSC) hedge funds collapsed in June, the event sparked a global credit crisis that has yet to ease. New evidence sheds light on how those hedge funds—and their managers—became star players in the subprime bust, the biggest financial disaster in decades. The revelations also show how other players in the mortgage market adopted the Bear funds' tactics, collectively building a financing structure with many of the hallmarks of a pyramid scheme.

The legal consequences are still unfolding. In recent weeks securities regulators and federal prosecutors have stepped up their investigations into the two funds, probing the fuzzy math used to value the underlying assets, the aggressive sales pitches that portrayed the funds as safe, and frequent trades with other Bear-managed portfolios. On Dec. 19, Barclays (BCS), which lent one Bear fund hundreds of millions, filed a lawsuit alleging fraud over misleading statements about the portfolio's health. Says a Bear spokesman: "We believe that any such lawsuit is unjustified and without merit."

A top RAB Capital executive has left the firm to lead the asset management arm of Russia's Renaissance Group.

Rod Barker has been named co-CEO of Renaissance Investment Management and CEO of RIM International. Barker joins the US$6 billion shop from London-based RAB, where he served as executive director of business development.

Andrei Movchan, who has served as the sole CEO of RIM since its founding in 2003, will be co-CEO with Barker, focusing on Russia and other former Soviet republics. “During its five years of existence, RIM has become the dominant player in the CIS markets, with an exceptional product range and a very loyal client base,” Movchan said.

The trail of hedge fund collapses, suspensions and sharp declines that occurred this year was triggered by the sub-prime crisis.

The collapse of the riskiest section of the mortgage market spurred the unwinding of securities tied to sub-prime mortgages. Widespread defaults on loans prompted a liquidity crisis and subsequent credit crunch, worsened by the complexity of mortgage-backed securities such as collateralized debt obligations. These securities were difficult to price and declined sharply in value.

The sub-prime crisis set the stage for hedge fund losses and exposed the weaknesses of banks and ratings agencies. It also highlighted valuation issues.

Bad bets in the sub-prime market were the undoing of two Bear Stearns hedge funds. The High Grade Structured Credit Strategies fund invested $925m (€632m) to make a nearly $10bn bet in favour of the sub-prime mortgage market and $4bn against sub-prime. The Structured Enhanced Leveraged fund had $638m and borrowed $6bn to make $11.5bn in bullish bets and $4.5bn in bearish bets. In the first quarter, the enhanced leverage fund dropped 23%. After Merrill Lynch failed to reclaim its investment, it tried to sell its collateral but found it had fallen to 85 cents in the dollar.

A plan by alternatives group Blackstone to rescue one of the hedge funds failed to win the support of investors. Some banks seized assets and tried to auction them only to find they failed to fetch full price. The dissipating value of the CDOs tied to the sub-prime market sparked a rush of withdrawals from funds underpinned by mortgage-backed securities. The event was key to the start of the credit crunch.

Despite the slide in the value of assets tied to the more leveraged fund, Moody's did not change its rating until August and even then it only downgraded its outlook.

Raj Gupta, research coordinator for the Center for International Derivatives and Securities Markets, said the events exposed the shortcomings of ratings, but by June the Ratings Agency Act had tightened the rules on how assets are valued. He said: “Moody's started downgrading the bonds after the hedge fund collapsed. The Securities and Exchange Commission did not have the authority to enforce the Act until June. By virtue of the mark to rating model, if you use a triple-A rating when it's triple C the value of the fund drops dramatically.”

Hedge fund Sowood Capital Management collapsed because it failed to meet its bankers' margin calls, after it over-borrowed to fund its trading positions. Founder Jeff Larson said the firm was caught out by a sharp widening in credit spreads: “Our actions followed severe declines in the value of our credit positions and non-performance of offsetting hedges.” The fund lost 50% of its value, or $1.5bn, in July. Citadel Investment Group, the alternatives manager, bought the portfolio.

Cambridge Place Investment Management said in June it would sell the assets of its $908m Caliber Global Investment fund and close it down within a year, after mortgage and asset-backed debt investments fell flat. The funds' assets fell almost 10% in the second quarter, and $8.8m in the first.

The $5.2bn mortgage-backed securities hedge fund manager Ellington Capital Management froze withdrawals from its two mortgage credit funds, New Ellington Credit Partners fund and Ellington Mortgage Partners fund, which collectively run $1.9bn in assets. Its focus on mortgage-backed securities made Ellington vulnerable. The firm may have exacerbated its position with its April purchase of mortgage lender Fremont's sub-prime lending business.

Tim Selby, a partner with alternative investment firm Alston & Bird in New York, said the crisis reiterated the value of diversification: “No matter how promising a particular sector is, people should not throw all their money into it. ”

Goldman Sachs' Global Alpha fund, run by the bank's asset management division, lost 60% of its value from January to November this year, leaving it with $4bn in assets. The fund is based on a quant strategy and was caught in August's meltdown when several funds deleveraged their positions.

Hedge funds are scrutinising their levels of exposure to bank defaults, in a telling reversal of conventional risk management concerns.

While bank exposure to the hedge funds they trade with has been in sharp focus since the 1998 collapse of Long Term Capital Management, a run of record-breaking losses and bailouts in banking has hedge funds re-examining how much they can be hurt by a bank collapse.

Bear Stearns yesterday reported losses four times analysts' expectations and a $1.9bn writedown on subprime losses, and on Wed-nesday, Morgan Stanley became the third big investment bank in a month to raise capital from a sovereign wealth fund after it announced $9.4bn writedowns, also from subprime.

In this environment, some hedge funds have found they are more exposed to the risk of bank failure because they agreed to trading terms that did not require banks to post collateral against certain derivatives trades, said Lauren Tiegland-Hunt, managing partner at law firm Tiegland-Hunt.

"When the credit crunch took hold, many firms were surprised to discover they had entered 'one-way' collateral agreements that not only left money on the table, but also left them exposed to increased counter-party credit risk," she said.

"In the current era of falling credit ratings and banks announcing huge . . . writedowns, this kind of risk is a real and pressing concern."

Many industry-standard collateral agreements are intended to be bilateral, meaning either party can call for collateral when market prices move in their favour.

However, some banks revised the documents so that only they could call for collateral. In other cases, bilateral agreements were amended to prevent hedge funds from calling for collateral before a bank's losses on the trade reached a certain threshold, with the bank's threshold marked as "infinity", said Ms Tiegland-Hunt.

US banks such as Citigroup, Merrill Lynch and UBS are facing a wave of multibillion-dollar class-action lawsuits, as law firms race to build cases against them on the basis that they did not reveal to investors the dangers lurking in their sub-prime mortgage-related investment portfolios.

The investors are seeking compensation for their losses in the American mortgage meltdown.

Barclays launched a legal action against Bear Stearns this week in which it seeks to retrieve about $400 million (£201 million) that it lent to two hedge funds run by the Wall Street firm. The funds collapsed in the summer under the weight of their sub-prime investment losses.

Lawyers are also preparing cases against financial services firms including Countrywide, America's biggest mortgage lender, and Etrade, the online brokerage, whose share prices suffered massive declines as the damage inflicted on their businesses by the mortgage crisis came to light.

Fred Fox, a partner at Kaplan Fox, the securities law firm in New York, said: “This is a big deal. We are looking at all sorts of possible cases; some we initiate and some come from our clients. We are examining them from various different angles and some could potentially result in payouts of billions and billions of dollars.”

Mr Fox is preparing cases against Citigroup, Merrill Lynch and UBS, although he has yet to file in court.

Merrill Lynch, facing the likelihood of billions of dollars in additional Q4 mortgage-related write-downs, is expected to become the latest financial firm to get a capital infusion from an Asian government investment fund, reports the Wall Street Journal. Temasek, a Singapore state-owned investment company, is in advanced talks to inject as much as $5bn into Merrill, a person familiar with the situation said. The news comes amid analyst predictions that mortgage write-downs at Merrill may double with another $8bn or more in the fourth quarter - the latest sign that Wall Street isn't out of the subprime woods yet. Temasek's board has given preliminary approval to the investment in Merrill, although pricing, timing and regulatory issues remain to be negotiated. As such, a deal may still not materialise. It is possible that Merrill may be in discussions with other government investment funds in addition to Temasek, said the Journal. The deal follows Morgan Stanley's agreement this week to sell a stake of up to 9.9% for $5bn to state-run China Investment Corp.

The dollar headed for a second weekly gain against the euro before a U.S. government report that economists said will show the Federal Reserve's preferred inflation gauge accelerated last month.

The U.S. currency traded near a six-week high versus the yen and was poised for the biggest weekly advance against the British pound in a month, on speculation rising consumer prices will discourage the Fed from cutting borrowing costs even as economic growth slows. The yuan rose to the highest since a dollar link was scrapped in 2005 after China raised interest rates yesterday for a sixth time this year.

``It may be easy to buy the dollar against European currencies,'' said Tsutomu Soma, a bond and currency dealer at Okasan Securities Co. in Tokyo, Japan's sixth-largest brokerage. ``Inflationary pressure means the Fed doesn't have much leeway to lower rates. The same can't be said about European central banks.''

I love these Zen-ish financial questions: Why do hedge funds stop reporting performance? As most people will know, hedge funds are not required to report performance, but many still do, at least until they don't.

So, why do they stop? A cynic/realist would say the answer is obvious: They stop reporting when their returns go to hell. Why report poor returns if you don't have to? And further, once returns are bad for a while there is no need to report anything at all, as the fund is generally being wound down.

That's it then, right? Yes, unless you're a conspiracy theorist, a hedge fund booster, or an academic. Because there is another view out there, one that says some hedge funds stop reporting returns because they don't need more money. I hear hedge fund managers whisper regularly about such-and-such a fund that doesn't report returns, but is turning in a 28% net annualized, and has for years.