One thing that has been a bit mysterious to me is that, given the nervousness among prime brokers who have been financing collateralized debt obligations and evidence that these lenders are tightening credit considerably, why haven’t more hedge funds gotten in trouble by being forced to liquidate or at least partially liquidate?
The Lex column of the Financial Times gives us the answer: rather than being financed with repos, margin loans or other facilities that are marked to market daily and require daily cash settlement, hedge funds are now making greater use of term facilities.
This arrangement, of course, is better for investors with not-so-liquid assets, but it then begs the question of whether these credit arrangements are too favorable to borrowers (for the last few years, hedge funds have been the most profitable customers on Wall Street, and hence would be able to extract particularly favorable terms). In the Bear situation, if there hadn’t been a deep pockets sponsor, a lot of major Wall Street firms would have been stuck with losses on their lending. The proof of the pudding will be whether we see prime brokers again taking losses on their loans to hedge funds.
From the Financial Times:
There is nothing like a hedge fund blow-up to concentrate minds on Wall Street. The implosion of two Bear Stearns funds and this week’s news of attempted redemptions at another smaller hedge fund have focused attention on the quality of the underlying assets. Credit hedge funds with a penchant for subprime asset backed securities (ABS) have become more than a tad worried about the liquidity and the value of the underlying investments.
But what about the debt taken on by the hedge funds? How well financed are these particular hedge funds, especially those that are, like the Bear Stearns funds, highly leveraged? The issue here is if you are funding illiquid assets that do not trade very much using short-term money, you may have an extra problem on your hands.
Of course, the hedge fund world has moved on since the dark days of Long Term Capital Management. Most big funds no longer gear up with overnight repurchase agreements but instead have taken advantage of some kinds of term commitments, with notice periods that can stretch for several months. What this means is that the banks cannot suddenly change key terms on their hedge fund clients, so elements such as the pricing of the debt or the amount they will lend against certain securities cannot be altered without some warning.
A bank that has done its homework well, by analysing the collateral properly and securing good collateral terms, should not need to make much use of these notice periods, especially since, if the collateral falls in value, the bank can always make margin calls. But when an asset class goes into convulsions, these notice periods are an extra protection for the creditors. Investors in hedge funds should make it their business to find out what negotiating clout their managers have with creditors. Not every fund has an investment bank, such as Bear Stearns, that can buy it some time.