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Financial Crisis Watch October 22, 2008, 3:07PM EST

The Hedge Fund Contagion

(page 2 of 2)

Citadel's Griffin apologized to investors for a near-30% drop in two funds Phil McCarten/Reuters/Corbis

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Hedge funds aren't just dumping stocks. In early September, Ospraie Management, one of the largest players in the commodities market, had to shutter its flagship fund after it lost nearly 27% from wayward bets on oil, natural gas, and the like. Winding down the fund and selling off the assets—at one time worth $3.8 billion—have contributed to the precipitous decline in commodity prices since the summer. On Oct. 20 an executive at mining conglomerate Rio Tinto (RTP) blamed hedge fund liquidations for unduly punishing uranium prices.

No corner of the market has been spared. After Lehman filed for bankruptcy on Sept. 15, the investment bank's traders dumped tens of billions of dollars of convertible bonds—hybrid securities that have both equity and debt features. Flooded with investments, the market for convertible bonds tanked.

Leveraged Loans

The weak prices prompted lenders to ask managers who owned such securities to pony up more cash in margin calls. Unable to do so, some funds trashed holdings. One convertible bond fund caught in the crossfire: the once $6 billion Platinum Grove Asset Management, founded by Nobel prizewinning economist Myron S. Scholes. Sources familiar with Platinum Grove say its portfolio has suffered deep losses this year.

Perhaps nowhere has rapid-fire selling been more pronounced than in the $500 billion market for so-called leveraged loans. In recent years companies sold these securities to finance private equity buyouts, acquisitions, and other corporate deals. But hedge funds, which lined up to buy the loans during the boom, have been off-loading them in recent weeks to meet redemptions and margin calls.

Highland Capital Management, a $38 billion money-management shop that invested heavily in this arena, has been among the most aggressive sellers of leveraged loans. Highland declined to comment.

The sell-off by hedge funds and other investors is depressing loan prices. In recent weeks the value of the typical loan, according to research firm Standard & Poor's LCD, quickly dropped from 85¢ on the dollar to just 66¢, a deeply distressed price usually reserved for companies that are in bankruptcy. (Historically, investors have recovered 70¢ on the dollar when a company defaults.)

Yet few of the companies whose loans are trading near those prices, including utility TXU Energy and credit-card processor First Data, are in such dire straits. "The loan market is a very funny place right now," says David Ford, a founding member of Latigo Partners, a hedge fund that buys distressed investments. "It's not being driven by fundamental forces."

In essence, the market is suggesting that owners of such securities won't get their money back. That unlikely scenario has some market observers scratching their heads. In the event of bankruptcy, investors in leveraged loans are the first to be repaid, outranking other holders of corporate debt and stock. And many companies today have more than enough assets on hand to make their loan investors whole. For example, Tennessee-based Community Health Systems (CYH), whose loans are selling for roughly 75¢ on the dollar, has $9 billion in assets, far more than its $6 billion in loans.

Although fear still dominates the loan market, there are small signs of hope. Prices are so cheap that investors potentially can make nice returns even without borrowing to do so. Rizwan Hussain, a credit strategist at Morgan Stanley (MS), pointed to the bargains in a report to clients on Oct. 17. Since then, Hussain has been fielding calls from institutional investors about opportunities. And, he says, some of those money managers don't have to worry about meeting redemptions and can put their money to work right away—assuming they're willing to risk the market dropping further. "In the short run, it's easy to get run over," says Latigo Partners' Ford.

Those corporate credit markets are a crucial signal. They must bounce back before the stock market has a chance to fully recover. After all, until investors are confident that companies can cover their debts, it's hard to have faith that their stocks will stabilize, much less appreciate.

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Shakeout Ahead

Nouriel Roubini, whose gloomy predictions about the financial crisis have proved all too accurate, thinks there will be a run on thousands of highly leveraged hedge funds: "After a brief lockup period, investors…can redeem their investments on a quarterly basis, [making] a bank-like run on hedge funds highly possible," the New York University economist writes on his Web site. He says the "bloated" industry will suffer failures over the next two years as investors pull their money and banks pull credit lines.

To read Roubini's article, go to http://bx.businessweek.com/hedge-funds/reference.

Goldstein is a senior writer at BusinessWeek. Henry is a senior writer at BusinessWeek.

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