Thursday September 24, 2:52 pm Eastern Time
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Hedge funds -- the high rollers of the markets
By Andrew Priest
LONDON, Sept 24 (Reuters) - Hedge funds -- the oddly misnamed investment firms
which
have become notorious for placing huge market bets -- have a key but potentially
dangerous
role in global markets.
The decision late on Wednesday by U.S. authorities to get involved in the rescue of one
of the world's largest hedge funds
shows how important these mysterious firms have become for regulators and financial
leaders.
Analysts said the $3.75 billion bank bailout of Long-Term Capital Management
(LTCM), as brokered by the Federal Reserve
Bank of New York, was vital to avoid huge losses at banks which in turn could have led
to sharp moves in all kinds of markets.
The hedge fund industry is estimated to total $300 billion, but their use of bank
borrowings, or leverage, means their exposure
to markets can be even larger.
''If you allow a forced liquidation of such a large hedge fund's major positions then you
could have a disastrous effect on global
markets,'' said Nichola Meadon, managing director of Tass Management, a consultant
for the hedge fund industry.
''Losses would cause a domino effect through the hedge fund industry not to mention the
banks and securities houses who hold
similar proprietary positions,'' said Meadon, based in London.
Here is how it works:
-- Wealthy private individuals or institutions invest money in a hedge fund, which has
been set up to trade markets aggressively.
Many traditional funds, such as pensions and mutual funds, are far more conservative.
-- The hedge funds develop close relationships with banks, which value the heavy
turnover generated by these market
specialists.
-- The funds, when they trade, borrow money from the banks and take positions in the
markets.
-- If the trade goes favourably, there is no problem. If it goes the wrong way, a bank
will call on the hedge fund to put up more
money behind the transaction, referred to as calling in a margin.
But markets are so shaky these days that banks have turned cautious.
''As volatility has increased over recent weeks, lenders have increased the cushion, or
''haircut,'' they require to continue
running the positions with hedge funds,'' said John Leonard, banking analyst at Salomon
Smith Barney in London.
As markets have fallen, the fall in funds' capital has meant they have had to close out
positions to meet margin payments, adding
to the selling pressure on the markets.
More than three-quarters of hedge funds recorded losses in August with more than a
quarter falling over 10 percent, according
to Managed Accounts Reports, a U.S. hedge fund consultancy.
Analysts estimate LTCM, a bond market arbitrageur, held positions totalling $100
billion or more by mid-September,
supported by capital of only $500 million. The fund's capital was more than $4.8 billion
in June.
''Running large, heavily leveraged positions...makes (hedge) funds the weakest link in the
financial system and that link appears
to have been broken,'' said Adrian Davies, senior bond analyst at ABN Amro in
London.
Tass's Meadon said not all hedge fund positions are fully collateralised. The terms vary
according to the nature of the
relationship between the hedge fund and securities firms.
''The leverage provided by counterparties is anything from gentle to exceptionally
generous,'' she said.
Hedge fund losses can send shockwaves with alarming speed.
Sohail Jaffer, chairman of the London-based Alternative Investment Management
Association, said trading in emerging markets
showed this all too clearly.
''As hedge funds with leveraged positions have liquidated to meet margin calls from
banks, this has had a cascading effect
through the global system,'' said Jaffer.
Of the 3,000 or so hedge funds in operation -- the vast majority based in the United
States -- the most affected by the current
global turmoil are emerging market and global macro funds.
The guru-like status of many fund managers such as Quantum's George Soros and
LTCM's John Meriwether has meant
investors have flocked to their global macro funds, which invest in all kinds of assets
worldwide.
A proprietary trader at a London-based investment bank estimated the assets of the
largest macro and emerging market funds
could total around $50 billion to $60 billion. With leverage, the market exposure of
these funds would be more than $500
billion, he said.
Raising the spectre of the crash of 1987, Leonard of Salomon Smith Barney said hedge
fund losses had the potential to
snowball. He stopped short of predicting such a catastrophe, but said LTCM's
problems were by no means unique.
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