The unraveling of the Shadow Banking System moves to hedge funds as Schmalpha replaces Alpha

[MikeWB]

http://www.newmogul.com/item?id=229

The unraveling of the Shadow Banking System moves to hedge funds as Schmalpha replaces Alpha

Nouriel Roubini | Sep 23, 2008

In my column in the FT yesterday I described the unraveling and demise of the shadow banking system that started with non-bank mortgage lenders, SIVs and conduits, major independent monoline broker dealers and money market funds.

I then argued that the next leg of this unraveling would be hedge funds and private equity firms and their reckless LBOs:

"The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years."

And indeed, faster than I can type it, this run on part of the hedge fund industry has already started. As reported by the Independent under the headline "Hedge Funds Suffer Mass Redemptions":

Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week's shock regulation of short selling. It has been a tough year for the industry with high-profile funds blowing up, clients increasing redemptions, as well as public fury over short selling and increased threats of regulation.

One hedge fund expert pointed to The Hedge Fund Implode-O-Meter (HFI) as how he judges the state of the industry. The HFI was set up online in the wake of the credit crunch "to track as hedge funds learn the double-edged-sword nature of the often extreme leverage they use".
The group's "imploded funds" list has hit 51 companies since the sub-prime mortgage crisis in the United States kicked off a widespread downturn. That compares with its historical list, stretching back more than a decade to the end of 2006, of just 14, including the collapse of Long-Term Capital Management and Amaranth.

This year, big names including Peloton Capital Partners, Carlyle Capital Corporation and Dillon Read Capital Management are just some of the half century to collapse. "We think hedge funds have largely lost their way," HFI said. "Notably, most have abandoned capital-preservation for the goal of aggressive accumulation of capital gains, with the benefit of lax regulation and extreme leverage available to exploit."

It has 34 stocks on its "ailing/watch list" of those that have suffered significant value declines or temporarily halted redemptions. According to EuroHedge, a hedge fund data provider, 272 individual funds strategies were launched during the first six months of 2008, the lowest for nine years. In the same time, 243 funds have been liquidated, the highest in a six-month period.

Nouriel Roubini, the New York University economics professor, says worse is to come. He believes there will be an increase in client withdrawals and a shake-up of how funds are regulated.

The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: "I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous."
Performance numbers are also under pressure. Some have done well out of the market disturbance, but on average the performance numbers are at a low ebb. Andrew Baker, the deputy head of Aima, the hedge fund trade body, said: "The performance is undoubtedly soggy. There are not many strategies that stand out."

EuroHedge revealed that strategies that have done particularly badly this year include several run by Naissance Capital, once bankrolled by the Habsburg families, which are down a fifth and Pico Fund, which is down 32 per cent. At Endeavour Fund, set up by former Salomon Smith Barney traders, the second fund has fallen by 40 per cent, while its third fund is down 38.79 per cent in 2008. In the emerging markets, PharmaInvest Fund's investments in emerging markets are 38.16 per cent down.
Other funds have sought to lock in investors by halting redemptions. The latest example was RAB, with its flagship Special Situations Fund, as it was so desperate to prevent exits after a 22 per cent drop in performance that it offered vastly reduced fees in return for a lock-in period of three years.

One of the main problems experienced by hedge funds is the extent of leverage in the industry. The funds were able to take on huge amounts of debt, with little capital needed as security, to boost returns. One observer said some of the leveraged strategies were like "picking up pennies in front of a steamroller, and that only takes a turn in the market to cause severe problems".

Andrew Lodge, the managing director of fund of hedge funds Nedbank Investments, said: "Some funds have gone in for huge leverage-driven strategies, which can be a problem. The appetite for leverage is less." He added that some could be affected by increased margin calls, and could face issues over their covenants.

At the same time, hedge funds, like the banks, have had to write down exposures to investments in risky instruments including collateralised debt obligations and asset backed securities, and also been exposed to the huge swings in the market.

Another issue is the regulators sniffing around. There have been wider calls for transparency and official controls of the industry, which has already been stung by the shock short-selling rules.

Mr Lodge said: "It's a myth to say hedge funds aren't regulated. There is a perception that they are running wild with no oversight, which isn't true. We would welcome some regulation, just as long as it doesn't strangle the industry."

On Friday, the FSA banned short selling in financial stocks, and forced hedge funds to disclose their positions. As the underlying shares rose as a result, the industry was looking at well over £1bn in paper losses on the day.

Stuart McLaren, financial services partner at Deloitte, said: "When the dust has settled, I expect the regulators to look at the role that hedge funds have played in the current issues. I expect there will be increased calls for regulation, but I doubt much will come from it."

Mr Baker said: "Some hedge funds are doing well. However, the number of professionals feeling good about life will be dwindling. The health indicators are generally negative, while costs are up and performance is down. Many are feeling battered and bruised and feeling worried about the future."

Let me now discuss in more detail this unraveling of parts of the hedge fund industry...

First, note that too much of the shadow banking system was about "Schmalpha" rather than "Alpha" i.e. the returns that fund managers and asset managers were getting – by imposing ridiculously high management fees of 2% or more – by parting investors with a good chunk of their assets rather than superior absolute returns. 2/20 most of the time was 2% for the fund managers and no 20% (some time single digit returns and this year actual negative ones) for investors. This scam is now unraveling. Also many funds were following high risk strategy (high leverage and extremely risky bets) that, for a while, were providing superior returns but were bound – with probability one – to lead to the collapse of the such funds. And given lack of transparency in the industry it was very difficult to distinguish between managers getting high return because of reckless gambles compared to those who were superior managers.

Of course there are thousands of high quality managers in the hedge funds industry and some provide superior returns and diversification; but there was also plenty of mediocre talent going into this industry as in the go-go years of the hedge funds bubble any trader with an ok return could raise money and create its own fund. And a bank run on the hedge funds is exacerbated by the fact that, on top of redemptions of the investors, shares many funds are highly leveraged and rely – like broker dealers – on overnight repos for their funding. And with prime brokers now defunct (Bear, Lehman) or squeezed and losing billions there is a significant risk that credit to hedge funds will be significantly curtailed.

Could one or more systemically important fund go belly up and lead to a systemic shocks. While no major player today is as leveraged as LTCM in 1998 many of these funds are much larger than LTCM was. So while until now the financial crisis has been concentrated among traditional banks, broker dealers and their off balance sheet scams (SIVs/conduits) one cannot rule out that some systemically important hedge fund may get into trouble with systemic consequences. In 1998 the NY Fed orchestrated a private sector bailout of LTCM. What would happen today if a large and systemically important hedge fund were to collapse? Will the Fed then extend to deposit insurance to hedge funds too as it did for money market funds? Will the Fed extend its lender of last resort support to hedge funds as it did for major broker dealers? Of course not even if the events of the last few months show the desperation of the policy makers leading them to desperate – and at times reckless – actions.

Given the systemic importance of larger hedge funds the time when the hedge fund industry will start to be directly regulated are also coming closer. Indirect regulation – the approach favored by the industry and the G7 so far – has not worked. We will soon move towards more direct regulation.

Already the SEC is literally forcing all hedge funds to reveal their short positions as part of its investigation of alleged manipulation by hedge funds of financial firms' stock. While months ago hedge funds were fighting a battle to avoid even minimal reporting of their positions to authorities they are now slapped with across the board restrictions on short sales and being forced to report their short sales to the SEC. So the process of directly regulating hedge funds has already effectively begun even before formal executive and legislative action is taken to formalize this regulation.

http://www.newmogul.com/item?id=229

[Ognir]

Thanks Mike for all your recent articles

I've had a song in my head all week (http://www.youtube.com/watch?v=zeo0_3gN190)

The End of the World as We Know it - REM

The banking system and capital system as we know it is fucked. America is fucked and a lost cause imho

"Jews worried that the looting of the public till will generate "Anti-Semitism""
http://www.wakeupfromyourslumber.com/node/8286

[MikeWB]

Don't mention it my friend. I'm immersed in this news so posting it here is a pleasure. That's a good song, actually!

I too think that US is a lost cause. I doubt anything can be done this late in the game. People are too brainwashed and they won't believe any truth they receive. The media brainwashing and consumerism is just way too powerful. Until you have lines of people in front of soup kitchens, they won't listen. And then it's too late.

So our task is an ungrateful one. But at least we're collecting all the info that those that eventually wake up will be able to use to educate small groups of people. And it will be there as a testament that we knew what we were talking about.

[joeblow]

Be careful everyone, remember that it's ANTI-SEMITIC to say that the Federal Reserve isn't Federal and has no Reserves. If you do, then SHAME ON YOU BECAUSE YOU'RE JUST ANOTHER HITLER!

[CrackSmokeRepublican]

Strangely enough, you may witness the economic crisis in the USA inducing radicalism among the staid "mid-westerners" - mostly settled by Central Europeans and mostly tied to economic security via the US Military right now.  

The mid-west actually is an informed but somewhat politically naive group.  Paul Findley is a prime example of this type of Mid-westerner - nice, patient but telling it like it is and then he lets the chips fall where they may as he belts what he thinks.  

[googlevid-:1cxbecei]http://video.google.com/videoplay?docid=-3252642434022358005[/googlevid-:1cxbecei]

These regions have witnessed a massive dislocation of economic stability since the 1970s and are better informed about how the rip-off game happens on Wall Street than many of the "speculators" on the East and West coasts that benefited from it, and who are more entrained in "Bubbly Americana" talk pushed out by the US Press system. They do drink the poison of small talk radio at times but have pretty clear insight into cause and effect.  They are also less "ethnic" like the Coasts and the South, where the Jew Media has people divided and diversified.  These people have a stronger sense of right and wrong too.  They will judge the Jewish mismanagement of the USA and will likely deal the justice.  Like soldiers returning from a Crusade, they will attack their apparent masters who sent them to kill in the name of God for Israel.

Don't be surprised if they tell the Democrats and Republicans and the entire Jewish corrupt media to go wreck themselves at 99 mph on Wallstreet.  They can rebuild the USA without the Jewish Federal Reserve. In fact, without it, this region  would be vibrant particularly when the USA becomes a manufacturing center again. They have the smartest people in the USA if you just go by test scores and such.  And most importantly, if the Jews try to enforce a Homeland Security crackdown, these folks will be the first to fight back. And they won't go easy or quietly.

The most dangerous people are those that live by principal and have nothing left to lose. A lot of younger American Mid-Westerners are in this boat and they are often written off as Beer drinking Nascar types by the Jewish media. This is a massive miss by the Jew media and it will come back to haunt them as the goy kids get active. A lot of these kids had parents in Unions. They also were not let in on the Financial and Real Estate binges on the Coasts. They also have made the most sacrifices in Afghanistan and Iraq in terms of numbers on the front-- and they know the game is crooked as the Jew propaganda machine is exposed globally.