Subprime's Next Victims: Hedge Funds

Like mortgage originators such as Novastar(NFI) and New Century(NEW), 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.

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