Thousands of hedge funds are expected to go bust in the next few months, amid fears that the secretive sector of the financial industry will be the next to buckle under the pressure of global market turmoil. Tumbling stock markets and a reluctance among banks to do business with hedge funds has further worked against an industry known as much in recent years for multimillion-pound bonuses and jet-set lifestyles as the increasing reliance of pension funds and other investors on its investment returns. Yesterday two major funds in the US revealed they were under pressure. It is estimated that 20-50% of the 10,000 hedge funds worldwide are vulnerable to a squeeze on their funds. Highland Capital Management, a US fund that has seen its assets fall in value by almost a quarter, to $33bn, since March, was yesterday expected to close its flagship Highland Crusader Fund and one smaller fund after suffering losses on high-risk loans. It was the world's largest non-bank buyer of leveraged loans last year, according to Bloomberg. Citadel Investment Group, one of the world's largest hedge funds, has warned investors that returns for one its major funds would swing wildly as it was battered by the markets. Its $18bn worth of funds have fallen by 30% in value this year, despite putting a third of the funds into cash. Recent figures from Hedge Fund Research revealed a 15% rise in the number of hedge fund liquidations. The prospect of a sharp downturn in the industry's fortunes follows 10 years of rapid growth, as wealthy investors and then institutions such as pension funds reaped supercharged returns. In 1990 there were 610 hedge funds worldwide; this year there were 10,233. Average gains in the late 1990s topped 20% a year. Short selling became a particular favourite as traders saw an opportunity to borrow shares in a firm and sell them in the expectation that the price would fall. Philip Falcone, who earned £1.7bn last year from his Mayfair-based firm Harbinger Capital, is believed to have made £280m from shorting HBOS before its rescue by Lloyds TSB. To cope with the crisis, several hedge funds are expected to follow the example of RAB Capital, the beleaguered fund that lost millions of pounds in Northern Rock. Last month it persuaded investors in its troubled Special Situations Fund to maintain their investments for three years, by threatening to liquidate the fund. Many of the industry's leading players have expanded rapidly in recent years, based on borrowed funds which they have used to multiply their gains. However, banks have become increasingly reluctant to lend for hedge funds to make bets, except at prohibitive interest rates. The collapse of Lehman Brothers has also hit hedge funds, many of which relied on the investment bank as a counter-party in complex trades with clients. Several funds are believed to be in financial trouble after being told they must wait to access funds locked up in the US bank. PricewaterhouseCoopers, the administrators for Lehman Brothers, who are demanding that £8bn of funds be repatriated from New York as part of a rescue plan for the bank's London operations, have denied the hedge funds access to accounts holding hundreds of millions of pounds Ominous talk of big names and big sums continues to haunt global markets, thwarting efforts by the US and European authorities to unlock inter-bank lending. Traders have noted with acute interest that insurer AIG - now nationalised - says it will need another $38bn from the US government, on top of the $85bn bail-out it has already received. AIG is the world's biggest underwriter of credit protection. Those on the wrong side of these Lehman debt contracts - known as credit default swaps (CDS) - must come up with the money by Tuesday, the next D-Day in the ever-fraught calendar of the credit markets. There has been a deafening silence so far. There is no easy way of finding out who they are, so every bank and insurer is suspect. The $55,000bn CDS market is "completely lacking in transparency and completely unregulated" in the words of Chris Cox, the chairman of the US Securities and Exchange Commission. The settlement auction on Lehman CDS contracts last week was in itself a bombshell. Creditors retrieved just nine cents on the dollar from the Lehman wreckage. As Naked Capitalism put it, the bank had "vaporised". The biggest players at the auction were Goldman Sachs and Deutsche Bank but they were almost certainly transacting for clients. The insurers of the debt -- a third are hedge funds -- will have to pay 91pc of the $400bn in contracts. The Depository Trust and Clearing Corporation says the risks have been exaggerated in headline scare stories, insisting that the total sum to be paid will be closer to $6bn. It says most positions are "netted out". "That's not credible," says Andrea Cicione, credit chief at BNP Paribas. "They keep coming up with these number by 'netting' but we think the amount is going to anywhere from $220bn to $270bn. The chain broke in the CDS market when Lehman Brothers went down. We may now see other counter-parties defaulting," he said. With hindsight, it is now clear the decision to let Lehman Brothers go bankrupt set off a melt-down of the world financial system, forcing North America, Britain, Europe, Australia, and now parts of Asia to rescue their banks. "A dramatic error," said Christine Lagarde, France's finance minister. US Federal Reserve chair Ben Bernanke said this week that Washington lacked the legal power to take on the vast liabilties stemming from a Lehman rescue. "A public-sector solution for Lehman proved infeasible, as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done," he said. The new legislation passed by Congress "will give us better choices." In truth, both Congress and the US public wanted a scalp. Treasury Secretary Hank Paulson had to bide his time until it was clear to almost everybody that a domino collapse of the US banking system would lead to catastrophe. The Lehman collapse did the trick. The list of companies admitting to losses on Lehman investments reveals the global extent of the damage. Dexia held €500m of bonds, which may have caused its own need for a Franco-Belgian rescue days later. Among the others with declared exposure: Swedbank $1.2bn; Freddie Mac $1.2bn; State Street $1bn; Allianz €400m; BNP Paribas €400m; AXA €300m; Intesa Sanpaolo €260m; Raffeissen Bank €252m; Unicredit €120m; ING €100m; Danske Bank $100m; Aviva £270m; Australia and New Zealand Bank $120m; Mistubishi $235m; China Citic Bank $76m; China Construction Bank $191m, Industrial Commercial Bank of China $152m and Bank of China $76m. Ultimately, some money may be recovered. These losses are out in the open, but the CDS shoe has yet to drop. Perversely the insured volume is greater than the $150bn total of Lehman debt. Some $400bn of CDS contracts were sold. Many were used by hedge funds to take "short" bets on the fate of the bank. The contracts nevertheless have to be honoured. Chris Whalen, head of Institutional Risk Analytics, says this creates a huge moral dilemna. Why should taxpayers now responsible for AIG foot the bill for huge windfall transfers to hedge funds? "We need to shut this whole thing down. The people who don't own the underlying collateral and were just betting should be flushed away. It would be grotesque if the US authorities were now to subsidize speculators. The US political class is waking up to this," he said. If so, the winners may have more trouble than they realize collecting their prize. We are moving from the mysteries of Libor (the London interbank offered rate) and credit default swaps to more tangible concerns - our jobs, our spending power, our well-being. The financial markets may like to think themselves a world apart from the real economy in which the rest of us live and work - but we are bound together by multiple cords. The fear now is that confidence-shattering financial turmoil is going to provoke a big jump in unemployment. The auguries are poor. Figures out next week will show that the third quarter of this year was the first to show lower growth since 1992. As a forerunner, last week's unemployment statistics indicated that job losses are now running at more than 50,000 a month - the highest for 17 years. In particular the young have been hard hit - 56,000 of the 164,000 who lost their jobs in the three months between June and August of this year were under 25. And that was before the meltdown, when people wondered for the first time in their lives if the money in their bank was safe. In 1974, it took mere rumours that NatWest would need bailing out to help provoke a stock market slump and two years of recession. Now the real thing has happened to some of the great names of British banking. There is now near universal consensus that the economy in 2009 will contract, and there is a growing risk that it could shrink still further in 2010. The combination of early government action and collapsing oil prices, opening the prospect of falling interest rates and inflation, could limit the unemployment damage to some three quarters of a million over the next 18 months. But the recessionary forces and shredding of confidence are profound. In a worst case unemployment could rise by up to a million and half. Nor is there much prospect of a rapid recovery in the years afterward, as Japan and Sweden, both countries that went through credit crunches of similar magnitude, portend. Over the good years unemployment came to be characterised as a matter of choice; there was work out there if you wanted it or could be bothered to get out of bed. It has been a controversial argument; worklessness has always been part of a vicious circle of self-reinforcing lack of self-worth and poverty of opportunity, tending to be clustered in areas of deprivation. It is rarely if ever a matter of choice. People want to work. Human beings want to realise our potential and dreams. Work provides sustenance, meaning and structure to our lives. It is where we meet the bulk of our friends and partners. In a recession the argument that the unemployed are unemployed by choice will not wash. To stand idly by is to condemn our fellow citizens to poverty, futility and meaninglessness. As the figures already show, it is the innocent who feel the pain first. The first reaction of firms is to freeze hiring school and college leavers and to make redundant new recruits who have yet to show their usefulness and to acquire specific skills - in other words, the young. And unlike other recessions, where resentment has been targeted at the government for mismanagement, this time round it will be bonus-addicted bankers and the City of London who will be the focus of collective anger . A Newsnight poll showed that nearly 60 per cent of respondents thought the City was to blame for the crisis. This is going to change the politics of the next few years. In recessions there is always a renewed impulse for fairness. In good times when everybody is doing well, the super-rich can be indulged. In bad times the shared view quickly becomes that the pain should be fairly distributed; those who are wealthy should help to alleviate the distress of those suffering the bad luck of unemployment through no fault of their own. The question is how to go about it. Long years of boom have rusted the ideas of how the public budget can best be deployed to alleviate unemployment and inject crucial compensatory spending power into the economy during a recession. The best I have seen is a 2008 paper by the Washington-based Brookings Institution, 'If, When, How: A Primer on Fiscal Stimulus'. Authors Douglas Elmendorf and Jason Furman show that by far the quickest and most effective means is to put cash into the hands of the unemployed by raising unemployment benefit, increasing temporary cash payments to them for specific items such as food and clothing, and making benefit unconditional for longer. It is not just they need the cash; they spend it fastest. The next most effective measure is to increase spending on the national infrastructure - housing, roads, ports, hospitals, schools. The trouble is that there tends to be such a long time between the decision to spend and execution, so that too frequently spending kicks in not during the recession but the upturn. Tax cuts are the least effective. None act quickly, although reducing the tax on employment - payroll and employer national insurance contributions - does moderately well. The message is unambiguous. Here, as in most areas of economic policy, conservative prejudices are wrong. Chancellor Alistair Darling is working on plans to bring forward infrastructure spending planned for 2010 and 2011; he is correct, especially as already earmarked plans are more likely to be executed when they are needed than those dreamed up from scratch. He should set a target of £5bn. But the government should also make our very mean unemployment benefit much more generous. I would follow Barack Obama and introduce higher income tax on those earning more than £250,000; indeed, go further with a wealth tax on fortunes greater than a £1m. Holding our angry society together over the next few years will demand an ever stronger commitment to fairness. This, I think, must become the new watchword. It is not capitalism that is now being judged: rather it is unfair capitalism organised only to benefit the City that is in the dock. We need to recast our capitalism so that it is fairer, more balanced and more sustainable. And we should start by the way we respond to recession.Secretive sector next to face the squeeze
Fears of Lehman's CDS derivatives haunt markets
It is a full week after bankers gathered in New York to start sorting out the derivatives mess left by the bankruptcy of Lehman Brothers. We still do not know who is on the hook for some $360bn of default insurance, or how much they will have to pay.
Smoke clears to reveal the monster of rising unemployment
Sunday, 19 October 2008
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