WSJ8/14/07: Keep Eye on Hedge Funds, Banks

As Market Panic Eases for Now, Keep Eye on Hedge Funds, Banks
August 14, 2007

Yesterdaywas a good day in the financial markets, much better than last Thursdayand Friday. It seems that last week's liquidity panic has receded.Investors have seen central banks at work, and they believe thatmarkets won't be crippled by a lack of liquidity. But some questionsremain. We ask and answer them.

Is there worse to come?

Possibly. There are two main ways trouble could spread: via hedge funds or banks.

Why hedge funds?

Manyhedge funds engage in herding behavior. A lot are momentum players,following recent trends. They also typically employ lashings ofleverage. When markets are rising, this triple cocktail tends toaccentuate the upward spiral. When they fall, it can spread trouble.

How come?

Whenasset prices fall, investors want to take out their capital. The hedgefund then has to sell assets -- driving prices down further. The banksthat lend them money then ask them to cut their leverage by making amargin call -- as they did with the troubled mortgage funds at BearStearns. That forces them to sell yet more assets. Other hedge fundsthat have been herding into the same trades come under pressure to sell-- giving the vicious spiral a further twist. This is why bighigh-profile "quant" hedge funds like Renaissance Equity Hedge Fund,Goldman Alpha and Man's AHL fund have had an awful few weeks.

Why should this spread contagion beyond subprime?

Hedgefunds that need cash quickly don't sell subprime assets because they'dget fire-sale prices. Instead, they sell other assets, like shares.

And the banks?

Theyare exposed to credit-market woes in four main ways: via trading losseson credit instruments they are holding on their own books; viacommercial-paper backup loans; via loans to mega LBOs; and throughlending to hedge funds. What's more, investment banks' equitiesbusinesses may suffer if stock markets fall. And their advisorybusinesses could enter the doldrums if the M&A boom -- of which theLBO bubble has been the most vibrant feature -- comes to an end.

So how does this bank exposure spread contagion?

Ifthe banks get hit on multiple fronts, they will become more risk-averseacross the board. They won't just stop funding LBOs and subprime debt.They could become less keen to fund hedge funds, conduits and otherspecial-purpose vehicles. That could have a further knock-on effect.Worse, even financially sound companies may start to find it hard toroll over existing debt programs or raise new finance, forcingbusinesses to delay investment projects. And banks could become morewary about lending to each other. It was to avert this that centralbanks flooded the market with liquidity last week.

Did the central banks' action do the trick?

Well,it certainly managed to drive overnight interest rates down to theofficial levels. But the fact that the central banks felt they had toinject liquidity three days in a row suggests that the interbank markethasn't yet returned to normality.

What would that take?

Banksaren't going to start lending to one another again with confidenceuntil they know who is sitting on risky exposures and losses. Rumorsare still swirling around markets about how one or more banks could bein trouble. If everybody knew who held the risky positions, therewouldn't be a problem. Some institutions would report a loss but itwould be manageable within their existing capital; others would need acapital injection; yet others would close shop. Everybody else wouldthen go back to business. But until the victims are named, everybody isa suspect.

When will we know who is at risk?

Thisis the biggest unknown. Banks and other financial institutions don'tdisclose detailed risk positions to the market because other marketplayers can then use that information to trade against them. Generalcomments about how their losses are containable, how their capitalpositions are strong and how they have no liquidity problems may notreassure skeptics. IKB said it was fine and dandy just weeks before ithad to be rescued; BNP Paribas's chief executive said its exposure tosubprime was "absolutely negligible" only days before it suspendedliquidity in its funds.

So what will the central banks do if confidence doesn't return?

They can just keep injecting liquidity into the system -- day after day.

And banks can borrow as much money as they want, just like that?

It'snot quite so simple. A bank that wants cash has to put up collateral.Central banks obviously don't want to lose money by lending to a bankthat then goes bust. Otherwise, they will have to ask for cash fromtaxpayers. So normally, they insist on rock-solid paper like governmentbonds as collateral.

Is that what's happening?

Notquite. On Friday, the Fed accepted mortgage-backed securities ascollateral for the first time. That may have been necessary to avert aliquidity crunch. But Uncle Sam has started to assume some of thebanking system's credit risk.

What will happen next?

Thecentral banks will hope that, after a few more days, confidence returnsand they can step out of the picture. Many central bankers think that ashort sharp shock is just what's needed after the loose lendingattitudes of recent years. And they're not too worried because theeconomic fundamentals are strong. Such a correction is probably themost likely scenario. But there's a risk that, if more cockroachescrawl out of the innards of the financial system, panic will set offagain.