Risk Rap

Rapping About a World at Risk

Hedge Funds Flight to Quality

Volatility in the equity markets, credit market dislocations and continued concerns about market liquidity are prompting hedge funds to seek out prime brokerage and custodial relationships with investment banks that boast healthy balance sheets.

JP Morgan’s acquisition of Bear Stearns has given hedge fund mangers pause to think about the financial health and balance sheet condition of their principal counterparties. The potential insolvency of first tier investment banks was once unimaginable. But the near bankruptcy of Bear Stearns due to losses in mortgage derivative and financing businesses, the persistent rumors concerning Lehman Brothers financial condition and the continued quest of Merrill Lynch, Citibank, UBS, AIG and Morgan Stanley to seek funding from Sovereign Wealth Funds to bolster capital adequacy is driving hedge funds to secure relationships with bank’s that have healthy balance sheets.

Risk aversion is a strong theme for all providers of credit. Hedge funds have a voracious appetite for credit. Many hedge funds require generous lines of credit to support highly leveraged and short selling trading strategies. If their prime broker becomes capital constrained these funds will not be able to execute their strategies. So the need to maintain relationships with healthy banks that provide consistent access to large lines of credit is critical.

The potential effect of market contagion in the event of Bear Stearns’ insolvency was the primary issue of concern that prompted the Federal Reserve to take its unprecedented action. Had Bear Stearns become insolvent the levered positions of its substantial hedge fund and correspondent broker clientele would create a wave of defaults that would cascade throughout the global capital market industry. Extreme market volatility and the negative effect on market liquidity in equity, futures, debt and foreign exchange markets could have been dramatic.

Hedge fund managers also require that banks have a product set, support infrastructure and market presence they require as trading strategies become more sophisticated to include numerous asset classes trading on multiple global exchanges. Cross-netting of product set positions and margin account requirements are important for hedge funds as well as the bank. Cross-netting of all positions helps fund mangers to gain preferential finance rates and transaction fees. Cross-netting for bank’s is a critical risk management tool to determine its aggregated exposure to the numerous investment positions of large sophisticated hedge fund complexes.

As the large money center banks struggle to integrate their global capital markets and investment banking businesses, capital adequacy in line with the requirements of the Basel II initiative heighten the need to measure and fund sufficient regulatory capital levels. The temptation of banks to arbitrage their regulatory and economic capital balances will certainly be put to the test as they seek to woo lucrative hedge fund business. The continually expanding global hedge fund industry may pose a competitive threat to the commercial credit side of these banking institutions as liquidity in the credit markets continue to be a pressing concern. It bears watching and it will be interesting to monitor developments to see if community banks can take advantage of its larger competitors capital constraints posed by its focus on capital markets business.

I can hear the frenzied flying now.

You Tube Video: Flight of the Bumblebee

Risk: capital markets, hedge funds, credit, commercial banking, regulatory, Basel II

Advertisements

June 5, 2008 - Posted by | banking, Basel II, Bear Stearns, hedge funds, investments, regulatory | , , , , , , , , , ,

No comments yet.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: