Leverage: Going South Fast

One key reason why hedge funds suffered such steep losses is due to leverage, the degree to which a fund uses borrowed money. "Any fund that uses margin leverage is going to be more volatile. As the price of investment goes up and down, it's going to be amplified by the utilization of leverage," says Anthony Clemente, CEO of Canaras Capital, an alternative asset manager specializing in collateralized loan obligations (CLOs) in New York. "When you use leverage to buy portfolios, it cuts like a knife." If a fund is seven times levered on an investment, for example, and the market declines 5 percent, the fund is down 35 percent, the debt expert explains.

"We don't think that the cause of [the credit crisis] is the wholesale deterioration of credit in the sub-prime markets," says Mark Sunshine, president and COO of First Capital, a West Palm Beach, Fla.-based commercial lending company. "The reason that a lot of lenders, [hedge] funds, and mortgage companies and commercial financial companies are going out of business really relates to an over-leveraging of the unregulated financial services sector," he contends.

BSAM's Enhanced Leverage Fund was leveraged more than 10 to 1, according to a source in the credit markets who requested anonymity. Since investors put up around $600 million, the fund had exposure to $6 billion. "If you are leveraged 10 to 1, it doesn't take a big correction to wipe out your equity," the source says.

Some hedge funds borrowed money to purchase CDOs through repurchase agreements (repos). A repo is a form of short-term financing in which the seller (i.e., the hedge fund) posts collateral as margin deposit and agrees to buy back the securities from the dealer at a later date for a greater amount of cash. The hedge fund posts securities as collateral for the loan, protecting the dealer against default. If the value of the asset posted as collateral declines, however, the hedge fund may have to post additional collateral. The hedge fund either has to come up with more collateral or liquidate the positions against which it borrowed. In this case, when the value of CDOs dropped, hedge funds faced margin calls to post more collateral with the dealers that provided the repo financing.

But as hedge funds tried to sell their assets to post collateral as margin deposit for the loans, there were no bids from the dealers. In the absence of trades, fund managers were not sure of the fair market value of the CDOs.