Teetering hedge funds fuel swings

Hedge fund short-sellers in recent weeks have targeted financial stocks such as the now-defunct Lehman Brothers and Washington Mutual as well as troubled firms such as Morgan Stanley to try to restore the double-digit returns that endeared them to wealthy investors. But now that the federal government is standing behind all the major banks with $1 trillion of capital infusions and other subsidies, they are looking for other targets.

Ironically, among the stocks in the sights of short-sellers now are the handful of hedge funds that are publicly traded, including the giant Citadel group, which has had a 30 percent loss so far this year. Forced sales by Citadel as bets went awry and investors pulled out of the fund were rumored to have helped fuel Wednesday’s 733-point drop in the Dow, the index’s second-biggest point drop.

Citadel founder Ken Griffin, who earned $2.8 billion in fees and commissions last year, complained in a letter to investors that “September was a devastating month” for institutional funds everywhere and that bans on short-selling by U.S. and European authorities during the month made it “the single worst month, by far, in the history of Citadel.”

Hedge funds strenuously opposed the U.S. ban and persuaded the Securities and Exchange Commission to make it temporary, successfully arguing that market volatility during the three weeks it lasted was just as bad as it was when short-selling was allowed. But now that the ban is lifted, hedge funds themselves have become enticing targets because, like the Wall Streets investment banks that were targeted earlier, they have highly leveraged investments in toxic mortgages and they are not protected by the federal bank rescue program.

In an interview with Bloomberg Television last week, Treasury Secretary Henry M. Paulson Jr. ruled out any assistance to hedge funds. He said the Treasury plans to aid only “regulated” institutions like banks and thrifts. Hedge funds through the years lobbied hard to escape regulation - to their detriment, as it turns out.

“Big banks around the world are now mostly backstopped by governments, so the rumor mill has found new grist: hedge funds,” said Robert Cyran, an analyst at Breakingviews.com. He said a well-established fund like Citadel should survive the onslaught because it has a leverage ratio of only 4-1 - not as “deadly” as other firms.

“Most of the biggest, conservatively managed funds should pull through. But losses, deleveraging and redemptions could claim a few big scalps,” Mr. Cyran said. “Such failures are unlikely to pose the same kind of systemic risk as the collapse of a dealer like Bear Stearns. But even if they did, a hedge-fund rescue would be a tough political sell. Any managers on the brink shouldn’t bank on help from Washington.”

Far from helping hedge funds, legislators and regulators in Europe and the United States are considering much stricter regulations. Italian Finance Minister Giulio Tremonti recently proposed abolishing hedge funds entirely. But the huge sums that hedge funds contribute to political candidates and lobbying in Washington make it unlikely that would happen in the United States.

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