Subprime's Next Victims: Hedge Funds

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), 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.