Sorcerer's Apprentice time

Section:

Hedge fund rumors knock markets;
Widespread jitters focus on GM, convertible bonds

By Alistair Barr and Kathie O'Donnell
CBSMarketWatch.com
Tuesday, May 10, 2005

http://www.marketwatch.com/news/yhoo/story.asp?
source=blq/yhoo&siteid=yhoo&dist=yhoo&guid=%7BF6DCAC87%2DFC3E%2D4907%
2DBFFC%2D0C73ACA0CC98%7D

SAN FRANCISCO -- Rumors of trouble in hedge fund land gained enough
momentum Tuesday to sway broader markets and pressure shares of some
of the world's largest banks.

Speculation swirled that a couple of hedge funds were facing trouble
as a result of their exposure to General Motors Corp. bonds. Last
week, Standard & Poor's cut its credit rating on the world's largest
automaker to "junk" status.

The implications of the downgrade on hedge fund positions in credit
derivatives also weighed on the minds of investors and traders.

Equities and the U.S. dollar fell while Treasury bonds and gold
climbed as investors looked for relatively safe places for their
money.

A Wall Street Journal report Tuesday highlighting recent troubles in
the hedge fund industry also fueled concerns.

Deutsche Bank slid 3.3% amid talk that the bank is the prime broker
for QVT Financial L.P., one of the hedge funds rumored to be in
distress. A London-based spokeswoman wouldn't comment.

Other investment banks with sizeable hedge fund brokerage businesses
also dipped: Bear Stearns slid 3.4%; Goldman Sachs shed 3.2%, and
Morgan Stanley declined 2.6%.

QVT Financial, investment manager of the QVT Funds, said speculation
that a QVT hedge fund was one of those in trouble is "categorically
untrue."

"We were up 2.6% year-to-date through April, and we are up even
slightly more in May at present," said Dan Gold, chief executive of
QVT. "We welcome further difficult market conditions because we
think they will present buying opportunities to strong funds such as
ourselves."

Gold added, however, that QVT believes "the current conditions in
convertible and structured credit markets will pose difficulties for
many of our competitors."

Other hedge funds mentioned by market professionals were GLG
Partners, a London-based hedge fund, and Highbridge Capital, a $7
billion New York firm majority owned by J.P. Morgan.

Spokesmen for Highbridge and J.P. Morgan declined to comment.

GLG, which has reportedly been in talks with Lehman Bros. about
being acquired, also wouldn't comment.

Tim Ghriskey, chief investment officer at Solaris Asset Management,
a New York-based investment firm that offers hedge funds, said he
heard speculation Tuesday morning that a large hedge fund was
unwinding positions in GM bonds and may have taken losses in those
positions.

Still, Ghriskey said rumors of hedge fund blowups are "very common."

So-called arbitrage hedge funds may have been hurt the most by
General Motors' recent troubles.

Arbitrage involves ironing out price anomalies between related
securities.

One common type of trade is to short the equity and buy the bonds of
a company that's been downgraded to junk status.

In theory, if the company files for bankruptcy, its stock would be
worth nothing, while its bond holders may be entitled to a portion
of the firm's assets.

Last week, this type of trade involving GM stocks and bonds would
have suffered a double hit.

When S&P cut its rating on the carmaker's debt, GM bonds fell. But
the company's shares also rose when Kirk Kerkorian announced he
would bid for a stake in the firm.

As the largest issuer of convertible bonds, GM's troubles
highlighted the recent struggles of hedge funds operating in that
market.

Convertibles pay a coupon like traditional corporate debt notes, but
also give investors the chance to convert their holdings into stock
of the company at a set price in the future.

Hedge funds are big players in this market and many follow
strategies known as convertible arbitrage, which involves ironing
out differences between the value of convertible bonds and the
stocks to which the debt is linked.

Hedge funds that trade convertible bonds lost 3.5% in April on
average, leaving them down 6.3% so far this year, according to
Hennessee Group, an industry consultant which tracks performance.

Overall, hedge funds lost 1.8% in the first four months of 2005,
according to Hennessee's Hedge Fund Index, which tracks the
performance of about 900 managers overseeing at least half of the
capital in the industry.

Several convertible arbitrage managers took a beating in April as a
result of widening credit spreads, problems at General Motors and
redemptions from hedge fund investors, Hennessee said.

That's created "the worst convertible arbitrage environment since
1994," the consultant added.

GM's credit downgrade may have triggered problems in structured
credit markets too.

Structured credit products use derivatives to shift credit risk from
a person or entity looking to buy protection onto sellers of
protection.

The products include collateralized debt obligations and credit
default swaps that can cover a basket of different companies,
according to Randall Dodd, director of the Financial Policy Forum, a
non-profit research institute set up to study the regulation of
financial markets.

Credit default swaps are a form of insurance against corporate debt
default.

Providers of this credit insurance have to pay in the event of a
default or bankruptcy. However, depending on how products are
structured, they may also have to pay if there's a credit downgrade
or credit spreads widen beyond a certain point, Dodd said.

Because GM has sold so many bonds, it's usually a part of these
baskets of credit risks, he added.

"People that have sold protection now are taking a beating because
they have GM all over the place," Dodd said.

Standard & Poor's cut its ratings Tuesday on six synthetic
collateralized debt obligations arranged by Deutsche Bank
after "negative credit rating migration within the underlying
reference portfolios of each transaction."

S&P didn't say what credit rating changes triggered the move,
however Dodd said it was likely related to GM and Ford debt being
cut last week to "junk" status.

Hedge funds are private investment partnerships that can bet on
falling as well as rising prices. Sporting track records of steady
annual returns in both up and down markets, the funds have attracted
billions of dollars in new money in recent years and now oversee
about $1 trillion.

Surging assets and the proliferation of new managers have sparked
concerns that returns may fall as more traders chase a finite number
of investment vehicles.

In recent years, hedge funds have faced further challenges as
interest rates languished near record lows, credit spreads narrowed
and market volatility declined.

With fewer opportunities, some managers have taken on more risk in
search of higher yields, said Kevin Mirable, a partner at S3 Asset
Management, which provides prime brokerage services to the industry.

Now that interest rates are rising, credit spreads have widened and
volatility has picked up, some hedge funds may not be able to handle
the change, he added.

"These things are historically handled very well by hedge funds,"
said Mirable, former head of Barclays Capital's hedge fund services
group. "But there are a lot more hedge funds doing this now and
there'll be some that may have come into business in the past five
years that will really be challenged."

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