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Wednesday, July 18, 2007

Derivatives Banks Concerned by Hedge Fund Leverage

" Hedge fund borrowing to invest in credit derivatives may magnify volatility in a market slump, according to a Fitch Ratings survey of 65 banks and insurers.

A "dramatic'' increase in hedge funds' use of credit derivatives has pushed their share of trading to 60 percent of credit-default swaps, and about 33 percent of collateralized debt obligations, Fitch said in the report today, citing data from Greenwich Associates. "

The failure of both Bear Stearns funds illustrate just how quickly things can go badly with that kind of leverage. Smaller, less know funds have been succumbing to their wounds almost unnoticed at a pretty decent clip. Things can go from calm to wild eyed panic in a hurry...

" U.S. corporate bond risk premiums reached the highest in almost two years last week as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns Cos. was forced to provide $1.6 billion for one of two funds that made wrong-way bets on subprime debt. The New York-based firm didn't bail out lenders to the other fund, which borrowed against its investors' capital to take bigger risks. "

Keep watching corporate bond spreads. We still have not even come close to historic and 'normal' levels.

We've gone though the 'accumulate' phase. We've had the 'rally' phase and we're probably quietly into the 'distribution phase' already. That would suggest the 'correction' phase of this market cycle is fast approaching...

" In a market slump, large deals financed with borrowed money, or leverage, may "result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,'' analysts led by Ian Linnell in London wrote in the report for the 2006 survey. "

The first step of the 'distribution' phase is deleverage...

" "Until all of this recent volatility, investors had been forced down the credit quality ladder, and up in leverage to meet investment targets,'' said Matt King, head of credit products strategy at Citigroup Inc. in London. "Now it appears hedge funds are deleveraging'' to meet demands from their lenders. "

Source: Derivatives Banks Concerned by Hedge Fund Leverage (Update3) (