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Teetering hedge funds fuel swings

Leverage high, regulation low

By Patrice Hill (Contact) | Monday, October 20, 2008

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The recent wild swings in stocks and other markets, including some of the biggest point losses and gains ever seen in the Dow Jones Industrial Average, are widely attributed on Wall Street to shadowy hedge funds experiencing big losses and forced sales that have the power to move entire markets.

Thousands of hedge funds, which serve mostly wealthy clients and have only recently been required to report their secretive trading activities to federal authorities, are in the midst of a monumental rout spawned by the global financial crisis. Many investors are pulling out their money after suffering record losses of 10 percent on average so far this year and, for some funds, as high as 30 percent. Some analysts predict that as many as half of hedge funds with nearly $2 trillion under management will fail or be closed in coming months.

But they're not going down without a fight, and leaders from Washington to New York are worried that some gigantic funds could flame out in spectacular fashion and dangerously roil already racked markets.

"People are nervous," said Robert Elliott, senior managing director at Bessemer Trust. "If we have roughly 8,000 hedge funds now, we might see 4,000 by the end of next year. ... Hedge funds could be the next hiccup, and people could say this is another example of poor regulation."

David Dietze, president of Point View Financial Services, said the market made whipsaw moves in the past month as highly leveraged hedge funds and mutual funds were forced to sell positions to meet margin calls from their lenders and demands from shareholders for the return of their money.

Hedge funds get their loans from Wall Street firms and are the most highly leveraged market players, with leverage ratios as high as 60 for every dollar of cash invested. But the credit crisis has made it harder for the hedge funds to get loans, and they're being forced to sell even winning positions in some investments to reduce their debts and holdings.

"These hedge funds are getting hit by redemptions, their credit lines are being pulled and they are having to sell furiously," Mr. Dietze said. "Selling begets selling, which begets selling, which begets more selling."

One result is an index that measures volatility in the stock market has reached a record seemingly each day in the past month. On some days, the Dow fell several hundred points in the morning and then staged a near-1,000-point reversal midday that left it up by several hundred points at the end of trading, or vice versa.

Huge gains or losses typically are registered in the final hour of trading, when many computerized buy and sell orders from hedge funds and other large institutional investors are triggered.

"It is hard to pinpoint the dynamics driving the volatility ever higher, but we believe the selling at low levels is mainly led by funds either shorting the market or being forced to liquidate long positions to meet margin calls," said Paul Lennox, corporate treasurer at the Canadian investment firm Custom House, referring to the practice of short-selling stocks through complicated trades that profit when the stocks decline.