Hedge Funds: The Quiet Epidemic

Hedge Funds: The Quiet Epidemic

We haven’t been hearing too much about hedge funds lately. But I suspect that there will be some news about them fairly soon, as they become the next group to wash out from today’s financial crisis.

The typical hedge fund raises money from “accredited investors” through private placements that allow them to operation outside the scrutiny of the Securities Exchange Commission.

We will soon be finding that many hedge investors consisted of corporations, pension plans and college endowments.

Hedge funds started becoming popular in the 1990s. Among the very wealthy, investing in hedge funds became a kind of status symbol. Waiters at cocktail parties and charity banquets regularly overheard such statements as, “Yes, buy my hedge fund returned 89% last year.”

Some of the nation’s top money managers gravitated to this environment because, being unregulated, hedge managers can actually take a share of investor profits. Managers are also (virtually) unrestrained in the leverage they can use.

Hedge managers borrowed large sums of money and placed big bets on things like currencies, stocks and commodities. Hedge funds have been blamed for driving the price of oil futures to astronomical levels. They have been blamed for driving stocks down by taking huge short positions (selling shares you do not own, with the expectation of buying them after prices fall), particularly in financial services companies. They have been charged with collusion and market manipulation. But, because they are unregulated, there is little documentation about how they have invested or what they own—until the roof caves in.

Popular Hedging Strategy

For years, one of the biggest hedging strategies was borrowing money in the U.S. or Japan, because interest rates were low. This cash is then converted into Icelandic krona and used to purchase Icelandic government bonds. http://www.nysun.com/business/low-us-interest-rates-mean-dollar-is-used/73644/

It has not been unusual for there to be a spread of 10% or more between the borrowing cost and the Icelandic bond yield. The spread detailed in March, 2008 (hyperlink above), showed a 2.25% U.S. interest rate and a 15% Icelandic yield, a difference of 12.75%. Let’s say I have $1 billion in investor money. I then go out and borrow $10 billion at 2.25% interest. I pay $225 million in interest to a U.S. bank. I earn 15% on my bonds, which is $1.5 billion. This gives me a net profit of $1.275 billion. This is a 127% return on my invested capital. Let’s say the hedge manager takes its share of the profits. This still leaves 100% to the investors in one year.

This would seem like a slam dunk. And it has been, for a good while. During the past year, there has been a huge swing in the exchange rate between the krona and the dollar. On September 8, 2008, it took 86.1 krona to purchase $1. On October 6, 2008 it took 127.8 krona to buy $1. This is a 48% drop in value in one month. My $10 billion in Icelandic bonds is now worth just $5.2 billion. This is a $4.8 billion loss on the original hedge fund investment amount of $1 billion. In other words, on paper, the investors in this fund have lost 480%.
http://www.exchange-rates.org/history/ISK/USD/G/30
http://www.spiegel.de/international/business/0,1518,582487,00.html

Now, don’t quibble with me that there would be interest on the bonds (about 1.25%) during the month. Yes, I understand that there is a chance that the bonds will return to their original value. There is also a chance that things will get worse.

Here’s the big problem. Investors in hedge funds typically have to wait at least 90 days before withdrawing cash from the fund. They issue a call on their cash, and the manager has 90 days to unwind his investments and send the money. We know that many big investors are running short of cash. They are doing everything they can to get out of a sinking ship before losing everything. In our example, lets assume that half of our investors ask for their money back. This leaves about $200 million in bonds and a $5 billion note to some U.S. bank. Do we really think this loan will be repaid?

This same sort of thing has been going on with investments in CDOs (mortgage backed securities). This time our hedge manager borrows $10 billion in Japan at 1%. The manager turns around and buys CDOs yielding 6%. We have a neat little profit of 50% on our invested cash. After splits with the manager, investors earn a solid 40%. Not bad, until these CDOs prove to be worthless.

And entire unregulated industry has been feeding on these types of investments for years. And there are going to be many wealthy people selling their McMansions in Beverly Hills and Westport because of this collapse. We haven’t read too much about this yet. But we will.

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