Wednesday, May 19, 2004

Hedge Fund Watch: Financial Times Weighs In

This hedge fund investment risk thing is supposed to be Brad Delong's sthick but since it feeds into my market movement analysis I'll throw up a quickie on this one. As the Financial Times reports competition may be spurring Hedge Fund risk-taking.

Fears over banks' lending to hedge funds
By Jennifer Hughes and Jenny Wiggins in New York, and Elizabeth Rigby in London
Published: May 19 2004 22:08 | Last Updated: May 19 2004 22:08

Competition among banks for lucrative hedge fund business may be leading them to relax their controls over the credit they extend to the funds, a survey has warned.

A quarter of the funds surveyed said their banks had extended their credit lines over the past six months, according to Greenwich Associates, a US-based research consultancy. This in turn is fuelling leverage, with almost a third of the funds reporting that they had geared up their borrowing over the past year.

Twenty per cent of funds also said their banks had decreased the margin requirements on their business over the past year.

The Greenwich survey was based on interviews with 36 funds, which between them run $25bn of assets.

Prime brokerage - the umbrella under which banks provide credit, clearing and other services to hedge funds - is one of the fastest-growing areas in financial services, driven by the proliferation of funds over recent years. A recent survey said hedge fund assets under management now stood at more than $1,000bn, against $745bn in mid-2003.

But Tim Sangston, one of the report's authors, said the rapid pace of growth had raised concerns about prime broking. "When banks and dealers are having so much success with hedge funds, they can tend to overlook things," he warned.

In January, the Financial Services Authority, the UK regulator, signalled its concern over potentially lax controls. It has since conducted interviews with prime brokers in London over their relationships with hedge funds.

One London-based prime broker said: "What they are worried about is that unqualified hedge fund managers are finding prime brokers to sponsor them, finance them and find them investors, all because they want to get new clients on board. But they are not applying quality control because all they want is new business. That is their only concern."

Hedge funds were the fastest growing client base for investment banks, so prime brokerage had become a focus and banks were investing heavily in this area, he said.

Some analysts said banks' exposure to the hedge funds could put them in a difficult position if there was a financial crisis. "The brokerage firms are the lender of last resort to the hedge funds," said Brad Hintz, securities industry analyst at Sanford Bernstein.

However, credit analysts said they were not worried about the exposure of the largest prime brokers - Morgan Stanley, Goldman Sachs and Bear Stearns - because they could choose their borrowers.

"Standards have stayed pretty rigorous," one credit analyst said, adding that these big brokers examined hedge funds' collateral and ran stress tests on their operations.

But measuring a fund's total exposure is tricky even for the largest brokers because funds typically obtain loans and derivatives from more than one source.[emphasis added]

Hedge funds are a notoriously under-regulated part of the financial investment business. One could more or less accurately say that they were essentially pure vehicles for speculation that attempt to achieve exorbiantly high returns. See here a list of the various differences between Hedge Funds and Mutual Funds from ICI. They came into public prominence during the late nineties when an unusually highly leverage firm called Long Term Capital Management had its trades unwind in such a way that it required active intervention by Fed Chief Alan Greenspan to avert systemetic risk to the US and world equities markets or at least so that was the claim. (CATO Institute) For one, I'm glad we didn't have to find out.

I rather doubt that we are going to have another LTCM around this time, but we might have several "mini-LTCM"'s and I'm not sure whether that's better or worse!

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