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Lend me a bomb

29 February 2008 By Richard Beales

Structured finance is hardly flavour of the month with investors. It s also barge-pole material for those who lend against such investments. That s one reason why London-based Peloton Partners has crashed out of the hedge fund tour. When asset-backed securities trades started going wrong, its bankers tightened up, setting off a spiral of sales and losses.

Long-Term Capital Management had a similar experience back in 1998, at least the way those involved tell it. Risk management, they say, was highly sophisticated but unfortunately didn t allow for counterparties all getting irrationally cold feet about its creditworthiness at the same time. At a time when banks are short of capital and fearful of new losses, hedge funds need to stay a step in front to avoid a similar fate.

LTCM s level of leverage is legendary. Peloton s apparently amounted to a relatively modest 4-5 dollars of debt for each dollar of equity. That s probably less than it had been, but still appears to have been too much for safety. One US-based fund active in structured credit had 6-7 times leverage back in the heady days before the credit crunch. In an effort to stay ahead of the conservatism of its counterparties, it has reduced that to nearer 2 times.

Funds in less unfashionable segments of the market may not have to do quite that much. But they still need to scale back borrowing enough to ensure they aren t at the immediate mercy of a few nervous prime brokerage bankers. A few big fund groups – Chicago-based Citadel, for example – have put in place more permanent sources of debt to offset this risk. But for most, lower leverage is the new reality. Of course, this makes it that bit harder to turn in big returns for fund investors. The need to make clever trades, rather than leveraged market bets, may soon start to sort the hedge fund world’s sheep from its goats.


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