Tougher Lending Terms for Hedge Funds? Free Market Regulation in Action

The Financial Times had a front page story today titled Tougher terms for hedge funds, discussing the impact of credit market uncertainty on the willingness of investment banks to provide leverage:

Investment banks are responding to rising credit concerns by imposing tougher lending terms on hedge funds, in a move that threatens to exacerbate investor unease in the financial markets.

Prime brokerage departments at several investment banks have raised their margin requirements for certain hedge fund clients as they seek to insure themselves against the possibility of new hedge fund collapses as a result of the recent market turmoil.

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The move could raise pressure on parts of the hedge fund sector, since it comes at a time when performance at some groups has slumped as a result of market swings. The average hedge fund, across all strategies, returned 0.8 per cent in June, down from 2.3 per cent in May, according to Credit Suisse Tremont.

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The stricter approach to lending to hedge funds by investment banks comes as markets continue to suffer as a result of concerns about the state of the US credit markets.

There are several messages one can extract from this story:

1. The Bear Stearns debacle has put prime brokers behind the 8-ball;
2. Credit-driven strategies are hurting, and are dragging down the returns of composite indexes;
3. Hedge fund leverage will be harder to come by for the foreseeable future;
4. Prime brokers are able to manage their policies, practices and exposures based upon market conditions; and
5. Regulation via the free market is effective.

I'd say 2-5 are right and 1 is wrong. Prime brokers aren't behind the 8-ball, they're on the ball. Most of the people I know at the leading prime brokers have lived through ugliness before, and are pretty experienced as it relates to non-normal market risks. And while competitive market forces may drive down pricing and hurt the risk/reward balance for prime brokers in hot markets, my sense is that sufficiently conservative controls exist around the risk side of the equation such that they will do just fine in most market dislocations. They've taken their lumps in the past and have learned from their mistakes. In fact, almost all leading investment bank risk management infrastructures, policies and controls have been strengthened dramatically over the past decade. So I am pretty sure that 1 is untrue.

2-5 are factually correct. Credit-driven strategies (at least most long strategies) are hurting, and it appears that their is more blood to be shed on the Street. Prime brokers are reining in lending practices, so portfolios for both credit and non-credit strategies alike may well be more difficult to finance. Clearly prime brokers have the flexibility to deliver bad news to their clients and make lending more restrictive, as this is happening all across the globe. And this is the very essence of market regulation, provided courtesy of the free markets, no government involvement required.

Prime brokers are in business to make money, not make friends, and if this means pissing off some friends by tightening lending standards to protect current and prospective P&L, so be it. And this is highly rational. And it's not as if they needed the SEC, Congress, the OCC or anyone else to tell them how to do it. They know just what to do as rational market actors. I hope Commissioner Cox and those in Congress are tracking this story. Because this is the way it should work. Mr. Market driving decision-making. And, as is almost always the case, leading to the right answer.

Comments

[cfageek]

good post, actually i just finished reading R. Bookstaber's "A Demon Of Our Own Design".
Quoting from his book:
"....Innovation increases complexity. Many innovative instruments are in the form of derivatives with conditional and non-linear payoffs"
i believe keyword here is non-linear payoffs+leverage , and he continues:
"...What is all the troubling is that attempts to add layers of safeguards or regulation to prevent these disasters may actually do the opposite by increasing complexity"
But he doesn't define how HFs should be regulated. In your previous posts you nicely did, IMO neither SEC nor FED have guts to put the hammer down. Anyway, he finishes the book as:
"..Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our own markets. These modifications will lead to financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But like the coarse response mechanism of the cockroach, when faced with the inevitable march of events that we cannot contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable"
Now, you basically say that the market will regulate itself smoothly. But many of the HFs finance their positions from multiple prime brokers, which are competing with each other on financing basis (maybe at this point your "light touch regulation" should step in if I understand it correct). Plus the market keeps offering more and more complex instruments everyday. No one can dictate a limit on innovation, so this proposition is meaningless I think.