'Reckless' loans spark retreat from hedge funds

Banks in the City and on Wall Street are slashing the amount they lend to hedge funds after it emerged that more than $500bn (£280m) has been advanced by just a handful of banks.

The number and size of hedge funds has ballooned in recent years to create an industry managing over $1,000bn of clients' money. It is believed that as much again has been borrowed by funds keen to "leverage" their investments.

Concern over the level of lending has come from the US Securities and Exchange Commission and the Financial Services Authority in London. This has led many banks to review lending criteria, described by one bank insider as "reckless" and "counter-productive".

This review was started even before recent scandals shook the sector. Two US hedge funds, Bayou Capital and Wood River, have collapsed and futures broker Refco, one of the major traders with hedge funds, saw its US business in effect closed down last week after its former chief executive, British-born Phillip Bennett, admitted he had hidden a $430m loan by Refco to companies controlled by him.

It is understood that a review of hedge fund exposure by one major European bank in recent weeks revealed it totalled $88bn, over 50 per cent more than the market value of the bank.

A source close to the bank said: "We are one of the big five exposed to hedge funds. Many were shocked by our exposure and we are doing something about it."

It has calculated that a small group of big banks have over $500bn at risk in hedge funds. These are believed to include JP Morgan Chase, Deutsche Bank, UBS and Credit Suisse.

These companies refute suggestions that the exposure could be a problem. "All of our lending is secured," said a spokeswoman for a leading European bank.

A senior financier at a US bank told The Independent on Sunday that much of the lending to hedge funds was "reckless" because it was secured on the value of volatile investments that could easily lose value.

"Some of this business is counter-productive because we end up making less money that we would have if the hedge funds were not there," he added. The financier cited the example of recent loans made to Naguib Sawiris, the Egyptian entrepreneur, to finance his €12bn (£8.2bn) purchase of Italian mobile phone group Wind. Much of the high-yield debt - which was priced at 3.25 per cent over Libor (the standard interbank loan rate) was bought by hedge funds. "They could borrow 90 per cent of what they paid at 70 basis points [0.7 per cent] over Libor," he said. "Nice work if you can get it."

The hedge fund sector was rocked earlier this year by the downgrading of bonds in General Motors, which had a ripple effect through the market. Many funds showed poor second-quarter returns, though they are believed to have recovered since the summer.