In the giant casino that is the world's financial markets, hedge funds are some of the ballsiest gamblers, raising vast amounts of debt so that they can place bigger and more potentially lucrative bets.
One might have thought theirs would be the first activity to be reined in when the credit crisis struck and Wall Street banks began rationing debt for mortgage borrowers, robust businesses and fellow financial institutions. In fact, surprisingly few hedge funds had their wings clipped by lenders last year. Even when funds had a month or two of big losses, their banks looked through the difficulties and extended more credit. Now that has changed – and how.
It was lights out yesterday for Carlyle Capital Corporation (CCC), the most high-profile casualty so far of the turmoil that is sweeping the $1.9 trillion hedge fund industry. Having failed to put up the extra collateral required when its mortgage investments lost value, the fund pleaded for days with its lenders – among them Citigroup, UBS and Merrill Lynch, some of the biggest financial losers from the credit crisis to date – for a reprieve. But no. There was no restructuring deal, and the banks will seize its assets in the coming days.
John Stomber, CCC's chief executive, complained that his portfolio was being undervalued, and the banks' margin calls were therefore excessive, but at the end of the day, when a fund has borrowed 32 times as much money as its original investors put in ($21bn on an original $650m), the banks are the guys in control. CCC's lenders are increasingly focused on rebuilding their own balance sheets rather than extending risky loans.
It is happening across the industry, day after day, sometimes in public view, sometimes not. Cash-strapped banks, many of whom have had to go cap in hand to overseas governments to replace the estimated $160bn (£79bn) that has already been lost on mortgage-related investments, are advancing money on much more cautious terms to hedge funds and are more willing to pull the rug when those terms are breached.
Funds are liquidating, others are finding that banks are charging them greater fees for their borrowings and being forced to downsize. Many funds are laying off staff.
Peloton Partners, a London-based fund that had won awards just months earlier for being one of the best newcomers of last year, was forced to liquidate its $2bn flagship credit market investment fund last month. The co-founders, former Goldman Sachs bankers Ron Beller and Geoff Grant, blamed the changed attitudes among their bank lenders. Drake Management, a $5bn New York fund manager, said on Wednesday it is considering winding up. In recent weeks, names such as Tequesta, Blue River and Sailfish are among the previously obscure funds that have been reported winding up their operations.
The chief executive of one powerful "fund of funds" manager, which surveys the hedge fund universe for the best investments, thinks that it is all adding up to a major shake-out for the industry. "This is happening at a rate of one a day," he mused privately this week. "They are snapping like twigs."
John Hardy, a strategist at Saxo Bank, said: "It has become a self feeding cycle. The problem for hedge funds is they are the most sophisticated employers of leverage. That will bring you huge returns on the way up but will kill you on the way down. Another problem is they are just so opaque, we don't know what the exposure is, and then boom, they miss a margin call."
The global hedge fund industry had one of its worst months ever in January, returning 1.8 per cent, according to Hedge Fund Research, and the overall figure masks blow-out losses of 50 per cent or more for the worst hit. Figures for February are also believed to be poor. US Treasury secretary Hank Paulson expressed his mounting concern yesterday. "With a few exceptions, the hedge fund sector thus far has proven resilient to market volatility and protracted illiquidity," he said. "But we know a number are now facing difficulties, as some are missing margin calls, and we are monitoring that closely."
Regulators have become especially nervous in the past 10 days, because of the sliding value of the previously solid mortgage-backed securities sold by Freddie Mac and Fannie Mae. These companies, integral to the US financial markets, are mortgage companies operating with a US government guarantee, which means their bonds have traditionally been seen as safe as government treasuries. Large numbers of hedge funds use Fannie and Freddie paper in their credit market trading strategies, and such strategies have grown in popularity in the past two years.
It was concern over instability in this market that prompted the Federal Reserve on Monday to say it will swap $200bn of US treasuries from its vaults for Fannie and Freddie-backed bonds, which could stabilise matters when the scheme kicks in later this month. But the credit crisis has formed a habit of flaring up again in new areas of the debt markets, and no one is confident they are through the worst.
"I'm not sure anyone has truly reliable figures on how much of the industry's assets are at risk from similar collapses as we have seen recently," said Andrew Baker, deputy chief executive of the Alternative Investment Management Association, the hedge fund industry lobby group.
"If there is volatility in the underlying collateral then bankers will change their margin requirements." But Mr Baker added: "There are probably as many hedge funds making a great deal of money from being on the right side of these trades as there are going under."
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