Friday, December 21, 2007

Hedge funds assess their risk to banks

(FT Alphaville) Hedge funds are scrutinising their levels of exposure to bank defaults, in a telling reversal of conventional risk management concerns, reports the FT on Friday.

While bank exposure to the hedge funds they trade with has been in sharp focus since the 1998 collapse of Long Term Capital Management, a run of record-breaking losses and bailouts in banking has hedge funds re-examining how much they can be hurt by a bank collapse.

Bear Stearns on Thursday reported losses that were four times analysts’ expectations and a $1.9bn writedown on subprime losses, and on Wed­nesday, Morgan Stanley became the third big investment bank in a month to raise capital from a sovereign wealth fund after it announced $9.4bn writedowns, also from subprime. And on Friday, the Wall Street Journal reported that Merrill Lynch may receive a $5bn capital infusion from Temasek, one of the Singapore government’s investment arms.

In this environment, some hedge funds have found they are more exposed to the risk of bank failure because they agreed to trading terms that did not require banks to post collateral against certain derivatives trades, Lauren Tiegland-Hunt, managing partner at law firm Tiegland-Hunt, told the FT.

“When the credit crunch took hold, many firms were surprised to discover they had entered ‘one-way’ collateral agreements that not only left money on the table, but also left them exposed to increased counter-party credit risk,” she said.

Many industry-standard collateral agreements are intended to be bilateral, meaning either party can call for collateral when market prices move in their favour, notes the FT.

However, some banks revised the documents so that only they could call for collateral. In other cases, bilateral agreements were amended to prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as “infinity”, said Ms Tiegland-Hunt.

Hedge funds subject to such terms were unable to call on banks for margin, depriving them of the opportunity to reinvest the cash, or more importantly, to use it to cover margin calls on related off-setting trades.

Hedge funds and derivatives lawyers say this is not the norm – many hedge funds had successfully called on banks for collateral against trades in the current crisis.

However, some start-up hedge funds had fallen foul of the practice, and were now forced to try to renegotiate their trading agreements, said Ms Tiegland-Hunt.

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