Prime Brokers Selling Hedge Fund Exposure

The Financial Times
By Gillian Tett
June 22, 2006

If a high-rolling hedge fund was to implode in London or New York tomorrow – say, as a result of a bad bet on copper prices or Turkish bonds – who would be left on the hook?

Right now, that question seems easy to answer. Hedge fund investors would obviously suffer. So would the managers of the fund (though probably only after several years of collecting fat fees) and possibly counterparties to the hedge fund’s trades.

However, one of the biggest casualties would be the investment bank that had been prime broker to this mythical fund and supplied it with credit. Ergo the panic felt by prime brokers such as UBS when Long-Term Capital Management, the US hedge fund, imploded eight years ago.

But now this question about hedge fund casualties could be about to become more complex, and for reasons that have absolutely nothing to do with gyrations in the markets.

In recent weeks, an investment bank has reportedly been trying to sell several billion dollars worth of the loans it has extended to hedge funds. The idea behind this putative sale, which seems to be the first of its kind, is that the risk in this lending would move from the prime broker to a wider investor pool. And the members of that pool would include more, er, hedge funds.

I do not know the name of this pioneering prime broker. Hints on a postcard would be most welcome. But if the story is true, and I strongly suspect it is, this marks a startling watershed for the financial system.

After all, the interface between hedge funds and their prime brokers is currently one of the most incestuous parts of the financial world. It is also potentially one of the more dangerous, given the scale of lending in sometimes murky circumstances. (One dirty little secret of the leveraged finance world, for example, is that when a bank distributes bonds or loans it often also provides the funds with the leverage to buy these products).

However, if prime brokers start to sell some of their hedge fund exposure, this adds a whole new dimension to the dispersion of risk. More specifically, if another LTCM were to implode, it would no longer be just banks left on the hook but a much wider group of investors.

Is this a good idea? For prime brokers, the answer is “yes”. In recent years the banks have offloaded plenty of other credit risks, such as mortgage loans, in an attempt to improve their balance sheets. Selling hedge fund risk is a natural extension of this process, particularly given the size of this risk.

Moreover, what is good for the prime brokers might also be good for the broader financial system too. If risk is shared between lots of investors, rather than concentrated on one spot, it is less likely that corporate collapse – or a LTCM-style shock – will wipe out a large financial group.

But there is, alas, one crucial catch. As credit risks have become dispersed across the system, the process of credit oversight has also been spread round, sometimes to the point where it has almost disappeared.

If a single bank is lending heavily to a company or hedge fund, it has a burning incentive to watch that client.

But when risk is sold to wider investors, the process of seasoned credit analysis tends to be replaced by a short-term trading mentality instead, particularly at times of excess liquidity like now.

This is dangerous enough when you are dealing with mortgage loans. But hedge fund credit lines create a whole new problem of oversight. How on earth, for example, could an outside investor judge the risks attached to opaque funds? And how can they separate out the credit risk from other operational risks?

If the deal goes ahead, then financiers will undoubtedly find creative ways of solving these problems (one obvious one would be to use a basket approach). And as long as the only investors involved are other hedge funds or sophisticated investors, regulators are unlikely to worry too much.

If this experimental loan deal does ever blow up, and knocks out other hedge funds, there would be a certain poetic justice.

If there is a moral to be drawn from this story it is just how ultracreative bankers are becoming in their efforts to slice, dice and redistribute risk, at this time of easy liquidity.

It would be nice to think that this is making the world a safer place. That is certainly what the bankers like to believe. I will not bet on that happy outcome until we have lived through another credit cycle. Or seen what happens if, or when, the next LTCM-style disaster strikes.

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