When it rains, it pours. Here many hedge funds are braced for investor redemptions today, just when some banks are starting to refuse to lend against subprime holdings.
Now this story isn’t as dramatic as it might seem. It appears that only a few banks have stopped lending against subprime-related debt. And the ones named, Bank of America and Countrywide, are marginal participants in the prime brokerage game.
In addition, the author comments that no prime brokers have yet to be reported to be turning down their clients, and then quotes a fund that goes beyond its prime broker to get financing that has suffered rejection. This is likely to be a pretty small fund, since most funds of any size have more than one prime broker.
Thus, this appears to be a minor problem. But it is worth noting that it is typical bank foolishness to refuse to lend against all subprime assets. There’s a price, even in this uncertain market, at which it would make sense.
Although the article (correctly) raises the concern that if more banks refuse to lend against subprime, a lot of hedge funds would suffer, it’s pretty unlikely that the major prime brokers, namely, Morgan Stanley, Goldman, and Bear, would implement this strategy (and they control 70% of the market). First, they know well it would precipitate a meltdown that would damage them. Second, if they effectively say that subprime is too rotten to accept as collateral, the SEC would almost certainly call on them to mark down any similar holdings severely.
From the Financial Times:
US banks caught in the credit market upheaval have started refusing to lend money against hedge funds’ subprime credit portfolios.
Hedge funds said several banks in recent days had cut off lending to funds that use credit portfolios, including mortgages, collateralised debt obligations and subprime securities, as collateral. That leaves the highly leveraged funds heavily reliant on their prime brokers for borrowing.
The banks mentioned were Bank of America and Countrywide, although there were believed to be others. Bank of America declined to comment. Countrywide did not return calls.
Hedge fund managers nervous about the reliability of theirlending sources were likely to attempt to reduce their level of borrowings further, said one hedge fund manager not directly affected by the banks’ actions.
Several hedge fund managers, who spoke to the Financial Times on condition of anonymity, said funds that were heavy investors in the credit markets and, therefore, often highly leveraged, were finding they were no longer able to use their portfolios as collateral to borrow.
One manager said: “My prime broker is my first source of borrowing but I used to get additional financing from other sources. I called my usual banks last week to ask for their terms and they told me there weren’t any terms because they weren’t lending against my credit portfolio any more. I’m not that happy. I need more than just one lender.”
There is no evidence that prime brokers have reduced such lending to their own clients. Yet, prime brokers have recently lifted their requirements for margin lending, contributing to forced selling as funds have to meet margin calls.
Steve Persky, a managing partner at Dalton Investments, said: “The type of investors who are exposed are highly leveraged with CDOs and asset-backed securities. It’s a game of musical chairs . . . people have too much debt and are trying to offload it.”
“If the prime brokers began to pull back, that would have a huge effect on the hedge fund business,” said one hedge fund manager.