< meta name="DC.Date.Valid.End" content="20050825"> Amendment Nine: Enough With the Hedge Fund BS

Thursday, May 12, 2005

Enough With the Hedge Fund BS

Bugging me today is the reporting on the hedge fund "crisis" or "problem" or "bad news" or whatever they've dumbed it down to now. It is seriously off point. The rumors out there, at least the ones I've heard, have nothing to do with hedge fund greed and overreaching or over-leveraging. The rumors are all about the credit default swap market and possible exposure to under-collateralized protection. Yeah, PRO-TECT-TION. Here is a down and dirty synopsis.

GM and F are now junk. Fixed income arbitrage managers had owned a lot of those bonds. The tanking isn't bad for them per se, so long as GM and F make their payments (in some instances, FI arb mgrs might actually be doing better now because of the junk rating). Of course, arb managers are afraid of risk to the point that they shit themselves when they hear the word. So, they have purchased a LOT of protection on all their bonds. One example of this is the CDS market. Buyers are hedgies looking to protect against possible default. Sellers are ins. cos and institutions looking to make some cash. Sellers offer protection, buyers give cash. The protection is the problem. What if one of these sellers goes bust? What if they renege? ("efficient breach" as some lawyers I know like to say). The hedgies are out and caught on the long side of a sell off. Further, what happens when that hedge fund is in trouble? He can't make payments on his other contracts, which then causes the other sellers to renege on other contracts, and so on and so on. That is the doomsday scenario, and its a result of an unregulated SELLER in the derivatives market, not hedge funds taking on too much risk (quite the opposite actually).

I accept that hedge funds will eventually be regulated out of existence, but lets at least understand the real reason why.