Hedge funds face bigger 'haircuts' Renée Schultes and William Hutchings
05 Mar 2008
Banks are forcing hedge funds to reduce their leverage by demanding they make larger cash downpayments to trade across a range of asset classes compared to 12 months ago, as lenders become more conservative and hedge fund failures increase.
Prime brokers, which finance hedge fund trades, demand a downpayment, also known as a "haircut," to cushion their losses if the fund's portfolio declines in value.
The downpayment required to buy certain types of structured credit on a leveraged basis started to rise last summer following the collapse of two hedge funds managed by Bear Stearns in August.
Since then, downpayments on almost all asset classes have increased, according to data from Citigroup.
For leveraged investors buying AA-rated corporate bonds, the average downpayment demanded by prime brokers, has increased from 0% to 3% of the value of the leveraged portfolio in March last year to 8% to 12% this month, according to Citigroup data, based on the bank's best estimates.
That means the maximum leverage has fallen from over 30 times last March to 8.3 times this month.
Similarly, the haircut on high-yield bonds rated BB has increased from between 10% and 15% to between 25% and 40%, reducing leverage from 6.7 times to 2.5 times.
On equities, the haircut has increased from 15% to 20%, which means leverage has fallen from 6.7 times last year to five times.
Some hedge funds have come under pressure to secure financing from prime brokers.
Last week, UK hedge fund Peloton Partners liquidated its $2bn (€1.3bn) fund that was invested in asset-backed securities. Banks were unwilling to continue extending credit in the face of losses accumulated by the fund.
Hans Peter Lorenzen, senior credit strategist at Citigroup in London said: "If banks face constraints because they have lots of assets coming back onto their balance sheets, it becomes harder for them to provide funding for leveraged transactions.”
He said there was also an issue for banks that have become more risk averse.
Banks will require higher haircuts to protect them against potential losses in a climate of increased volatility, but in so doing they are also making it more difficult for hedge funds to buy assets from them because the higher haircuts constrain the volume hedge funds can buy, compared to 12 months ago.
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