Why You'll Feel Hedge Funds' Pain

One of the big trades that hedge fund managers working on behalf of your pension put on in recent years has been to buy the "mezzanine," or medium-risk bond tranche of CDOs, and short the equivalent amount of money in the equity tranche or equity of the company. The amount of money involved in these trades is quite enormous; because the trading environment was so tame up until quite recently, the equity tranches were leveraged by as much as 17 to 1, according to Peter Petas, research director at the corporate capital-structure research firm CreditSights in New York.

Automakers are among the biggest sellers of bonds in the U.S., so they are overrepresented in even the most diverse CDOs. And now we get to the heart of the matter.

Enter Kirk Kerkorian

What happened last week that imperiled a number of hedge funds' carefully constructed credit-spread compression strategies was the very unusual span of two days in which Los Angeles financier Kirk Kerkorian first announced a significant bid for General Motors stock at a premium, and then debt-rating agency Standard & Poor's downgraded GM bonds to junk status. As you might recall, GM shares went straight up and then its bonds went straight down -- blowing up a trade that was leveraged to the hilt. In the space of a few hours, an unknown amount of highly leveraged hedge-fund money that probably totaled well into billions of dollars went poof!

No hedge fund has admitted yet that it was on the wrong side of this trade, but it will eventually come out. And the reason that it can have a "contagion" effect is that the funds at risk will undoubtedly face a large number of redemption requests from their members -- and failure of a fund could have a combustible impact on its counterparties and prime brokers, which are big investment banks.

Fallout -- and Bankruptcy?

Funds are required by contract to provide "liquidity" -- that is, cash -- to members either at the end of a month or a quarter. So, many in the investment community are holding their breath now, waiting to see how many funds need to liquidate stock and bond portfolios in order to meet a flood of redemptions.

One serious issue is that CDOs may be widely sold, but they are not terribly liquid. There is no easy market for these things, and they can typically only be sold back to the organization from which they were purchased. Plus, since they are just sitting on the funds' books for long periods of time, they are usually not marked to market, or priced, until the time of sale. And that is why no one really knows how much money is at stake.

"We have seen that these sorts of trades only work until they stop working," said Peter Petas, of the capital structure research firm CreditSights. "It is not the most tested market, but guys are taking these trades anyway to get yield in a low-volatility environment."

If we see big up days in the market followed by big down days, you can be sure that funds are using every uptick to unload inventory to meet their obligation and avoid bankruptcy. At times like this, the Federal Reserve and other central banks have learned to flood the system with money to avoid big disruptions. So from now until the end of the month, or quarter, there may be an interesting battle between the private forces of fear and the public forces of balance. Stay tuned: It could be your money.