Hedge Funds Hit the Wall

Investors fear more blowups as levered-up funds book a bad month.
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July couldn't end soon enough for most investors, but hedge fund watchers say the worst could be yet to come.

Hedge funds have bet heavily on the junk bond market, which just completed its worst month in five years. As some heavily leveraged funds count up their month-end profits and losses, some observers fear they know all too well what will follow.

"Having amplified returns on the way up, leverage now amplifies the declines," writes Jeffrey Rosenberg, head of credit strategy research at Bank of America. He adds that "month-end marks and tightening of leverage terms now challenge hedge fund liquidity -- potentially leading to an existential crisis for many."

July ended with a thud for stocks. The

Dow Jones Industrial Average

dropped 146 points Tuesday after earlier being up as many as 138 points. Much of the swing took place after the market learned of the latest casualty tied to the collapse of the subprime mortgage business,

American Home Mortgage

(AHM)

.

American Home shares plunged 89% after the lender told investors it was seeking an orderly liquidation of its assets, following a series of margin calls that essentially put it out of business.

American Home's plunge came a day after the implosion of a much bigger player, Sowood Capital Management. The hedge fund collapsed under the weight of different issues -- specifically a widening of credit spreads, or the difference between the yields on safe government debt and risky corporate securities.

But even if this week's blowups aren't explicitly linked, market observers say they point to a coming reckoning for credit-oriented hedge funds. Rumors are already flying about more hedge funds meeting with huge declines for July, and bid lists circulating through the bond markets.

"This stuff is more widely held than just a handful of firms have reported," Peter Goldman, managing director at the money management firm Chicago Asset Management, says of distressed debt. "I would be surprised if there weren't more skeletons in the closet."

While credit markets have rebounded this week after Citadel Investment Group swooped in Monday to buy the credit assets of Boston-based Sowood, the Sowood story is not so different from the story of the two

Bear Stearns

(BSC)

hedge funds that collapsed in June.

Sowood's demise may provide credit investors with more information about how risk is being repriced in the market, and it may also be a harbinger of more collapses yet to come as month-end margin calls from prime brokers are likely to roll in.

"We're definitely worried about month-end performance issues for hedge funds," says Paul Ocenasek, high-yield bond portfolio manager at Thrivent Financial for Lutherans.

The end of the month is when hedge fund managers mark to market their investment to holdings -- meaning they value them on the basis of the prices of comparable transactions. They report their performance to their counterparty lenders, or prime brokers. If they've lost enough money, the prime brokers can demand more collateral. This is what led to blowups of Bear Stearns hedge funds and to Sowood's declines.

With July having turned into an even worse month for the credit markets than June, investment managers may soon have to face the music. Money manager Jeremy Grantham told

Bloomberg

that credit-market declines may force as many as half of all hedge funds to close in the next five years.

The Merrill Lynch High Yield Master II Index had dropped 3.86% in July through Monday's close. That made July its worst month of the year, bringing the asset class into negative return territory for the year. July 2002 was the last time the high-yield market saw as big a loss.

Ocenasek notes that the last time the market sold off on hedge fund trades gone bad was after the junk-ratings cuts of

General Motors

(GM) - Get Report

and

Ford

(F) - Get Report

in 2005.

"But there is a lot more leverage in the system now than even two years ago," Oceanasek warns.

Ocenasek remains cautious on the credit markets, citing what he says seems like forced-selling pressure. He believes the sellers in the market are unloading some of the higher quality securities in order to meet margin calls, rather than really adjusting for risk by selling the weak credits and loading up on quality.

"The recent declines have been steep, kind of breathtaking," he says.