Subprime and Hedge Funds: Hard Lessons to Learn Here?

By Emma Trincal, Senior Financial Correspondent

The subprime crisis has sent a jolt this summer through the global financial markets and across stocks, bond markets and even money market funds. But what exactly is the role played by hedge funds in this global shakeout? And what can the marketplace learn from it?

"If CDO and structured products are affected by further downgrades, many of such investors will be forced to sell the paper. This will cause a float of paper that will depress this market," says CMRA's Ms. Rahl. And as a result, hedge funds holding CDOs or MBS will be hit with further losses.

But managing liquidity risk won't be easy.

"We can't really measure liquidity," says Ms. Rahl. "Liquidity can change over time. Something can be very liquid today; then something happens and it becomes illiquid." In an illiquid market, managers will have to decide how much yield they need on any given instrument to compensate for the lack of liquidity. A firm with a lot of cash reserves can afford a margin of error in those risk assessments. A smaller fund with less liquidity can't.

Another way to control liquidity for a hedge fund is to impose longer lock-ups on investors. Opinions vary on this measure. "I don't know if hedge funds will resist the temptation to impose lock-ups, yet they should," says Mr. Easterling. "Longer lock-ups would only apply to new investors and would not impact existing investors. The only way to reduce the liquidity risk of existing investors is to lock-down the fund … and that is a death knell for a fund," he says.

"The trend of longer lock-ups already exists, but it will continue," says Ms. Rahl. "But you won't see extended lock-ups all across the board. There will be maturity ladders." Such a formula allows a manager to offer a fee schedule based on the length of the lock-up with the fees decreasing when investors agree to stay longer.

"People are focused on leverage, but what we're really seeing is embedded leverage," says Leslie Rahl, founder and president of Capital Market Risk Advisors Inc., a New York-based financial advisory firm specializing in risk management. "Some hedge funds have indirect leverage because they are holding structured products that are less liquid and which they can't sell. It's not clear whether leverage ratios are going to decrease as a result of this crisis. Actually, leverage levels are much lower than they were during the 1998 crisis."

Whether the critics are unfair or not, one sure way to protect a portfolio was to be skeptical about everything, including the ratings.

September 13, 2007