Hedge Funds and Margin Calls

Many hedge funds use margins (borrowing money usually from banks) to amplify their returns. Now banks are asking hedge funds to return some of the money.


This could be another vicsious cycle. Banks ask for money back. Hedge funds have to liquidate some of the positions. Which brings down the price of their holdings. Which leads to more margin calls.

So far, the turbulence touched off last summer hasn't resulted in many big
hedge-fund blowups. If that changes, banks and other financial firms could end up holding even more hard-to-sell securities. Already, their troubled investments, especially in securities tied to mortgages, have cost them some $140 billion in write-downs.

Let's just hope any big hedge funds don't have to unwind. Otherwise it's going to get UGLY!

"The appetite for risk is dropping sharply," said Steven Abrahams, chief interest-rate strategist at Bear Stearns Cos. in New York.

This is the great unwind. Until now, everyone invested/lent and asked questions later. Now, it is exactly opposite.

The issue came to the forefront yesterday as Carlyle Capital Corp. said it failed to meet margin calls on loans backing part of its $21.7 billion portfolio of highly rated securities issued by Fannie and Freddie. Carlyle Capital, whose shares are listed in Europe, is managed by a unit of Washington, D.C., private-equity firm Carlyle Group.

Fannie and Freddie are perceived as having the backing of the U.S. government, so they're usually seen as a safe haven.

"The fact that this is happening in top-quality agency paper is really worrying," said Tim Bond, a strategist at Barclays Capital in London. "It's marking an extension of this stress into the group of players who only invest in the safest mortgage-backed stuff."

Losing confidence in US or the mortgage markets? Either way, the mortgage rates are probably going to be significantly higher in coming months.

First Peloton, then Thornburg, and now Carlyle have had margin calls in last week. As they unload some of the holdings, many financial firms are going to be left with their holding.

Amid waves of selling, bonds backed by home loans that are guaranteed by Fannie Mae and Freddie Mac were yielding 3.51 percentage points more than ultrasafe five-year Treasury securities. That spread is a record. A year ago it was 1.23 percentage points, and a month ago it was 2.48 percentage points.