Who would lend to a hedge fund?: James Saft

By James Saft

LONDON (Reuters) - The current brutal conditions in markets from mortgages to corporate loans should be giving banks good reason to think long and hard about their loans to hedge funds.

And if they do, watch out, because it would kick one more support from beneath a broad credit market that is already tottering. It would also deal a fresh blow to stock markets that are only now realizing the extent to which they too are addicted to cheap credit.

The business of lending to hedge funds, made by "prime desks" at banks, has been a glorious one in recent years, racking up massive profits for banks and allowing hedge funds to magnify their returns.

The numbers are staggering. Hedge funds are estimated to have $2 trillion in capital under management, and Fitch Ratings has estimated that they borrow as much as twice that amount, giving them investable assets of as much as $6 trillion.

Fitch thinks that more than $1.8 trillion of that is deployed in credit markets, based on an assumption that credit hedge funds are leveraged by between five and six times their capital base.

With that kind of very aggressive borrowing, it doesn't take too much of a move in the market for alarm bells to begin ringing in the offices of banks' risk managers.

And big moves we have had. The cost of insuring European speculative grade borrowers against default, as measured by the Itraxx Crossover index, has more than doubled since June 15, prompted in part by the impact of losses investors have suffered in subprime mortgage debt.

The loan market, which now gets much of its liquidity from hedge funds, has also been hit. Chrysler Corp. was forced to delay its $12 billion auto loan on Wednesday, and Alliance Boots AB.UL postponed its $10.4 billion deal, in both instances leaving arranging banks holding debt they had hoped to sell to others.

Secondary market prices for U.S. liquid loans have also moved dramatically, according to Reuters Loan Pricing Corporation, falling two points in five weeks, a small move in many markets but the biggest in a similar period on record for loans.

RAISING MARGIN REQUIREMENTS

Hedge funds typically operate at about half the maximum leverage they have available from banks, giving them a cushion against bumping up against margin requirements.

If a hedge fund's performance deteriorates sufficiently, its banks may require it to sell assets to repay loans.

Thus far, news has only emerged about funds involved in mortgage securities being forced by their lenders to sell.

Australian hedge fund Basis Capital said on Tuesday it has hired Blackstone Group (BX.N) to negotiate with its banks, and Australian media have reported that some of its lenders have already seized assets which they then sold at deep discounts. Bear Stearns BSC.N last week told investors in two funds that their investments now have "very little value."

"Tightening in lending margins to hedge funds in a period of heightened risk aversion for credit is a real possibility," said Roger Merritt, chief credit officer at Derivative Fitch in New York.