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Subprime's Next Victims: Hedge Funds

Doug Kass

This column was originally published on Street Insight on March 5 at 9:28 a.m. EST. It's being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

The fallout in the subprime market won't be limited to the originators of these risky mortgages -- the next area to keep an eye on is hedge funds.

First, it's clear we haven't seen the worst of the subprime wreakage and that we'll soon see the hurt spread to the prime-mortgage arena, as I've argued recently.

Indeed, delinquency data are deteriorating -- and at a rapid clip. The largest originator of home loans in the U.S., Countrywide Financial (CFC Quote), reported sharp rises in delinquencies in its prime mortgage loans. Surprisingly, at year-end 2006, Countrywide's subprime delinquencies were approaching 20%. That's nearly twice the rate reported by the subprime industry in November.

The low volatility, liquidity-driven, see-no-evil, hear-no-evil investor mentality of the last several years has introduced a degree of investor complacency rarely seen. It also has led to a far more leveraged hedge fund community -- not necessarily by the hedge funds themselves, but by a core base of hedge fund sponsors and investors, the fund of funds industry.

It is my view that the next shoe to drop could be the disintermediation of funds out of the dominant investor class of our time, the hedge fund industry. The source of that disintermediation could be, like portfolio insurance in October 1987, something that few have addressed: the forced hedge fund liquidations emanating from the increasingly dangerous leveraged role of the fund of funds industry.

The fund of funds industry has ridden the wave of hedge fund asset growth. Funds of funds provide high net-worth individual investors and institutional investors with access to a diversified portfolio of hedge funds. The funds of funds charge a fee, on top of the traditional hedge fund fee, which is defended as ameliorating risk and generating excess returns by selecting the "best of class" hedge fund investors in each asset class -- long/short, arbitrage, distressed, market neutral, emerging market, event-driven, macro and even short-selling.

The fund of funds industry has played a huge role in providing capital into hedge funds. Based on the availabIe data, I estimate that funds of funds provide approximately one-third of all assets to hedge funds.

Like mortgage originators such as Novastar(NFI Quote) and New Century(NEW Quote), which offered mortgages with little money down and even less documentation, many funds of funds have utilized a similarly aggressive technique to differentiate themselves and try to deliver superior returns. Encouraged by low volatility and a healthy stock market -- characterized by a relatively orderly advance -- many have goosed their clients' investments in hedge funds by the use of debt.

In North America, banks like RBC Capital Markets have been prominent leveragers of investors' capital into hedge funds. But the real devotees of leverage lie abroad, particularly in the fund of fund departments of the private banks of Switzerland, which routinely leverage the capital of their investors (and for themselves) between 1.5 times to three times. Every significant hedge fund has an offshore fund to complement a domestic fund, which attracts non-U.S. investors from the fund of funds industry.

The risks are clear.

Should the markets' recent swoon develop into something more severe, funds of funds that use leverage (especially of a Swiss-kind) will quickly liquidate. The reason I believe liquidations might occur more quickly than generally anticipated is that European banks and fund of funds investors are not sticky -- their investment attention disorder kicks in more quickly than others.

Isn't it funny (and ironic) how the aforementioned fund of funds situation is eerily reminiscent of the egregious use of debt in the mortgage market over the last decade?

Well, maybe it won't prove that funny.