Wow, it's just starting and it's not going to stop. Basis
Capital is an Australian hedge fund. They run about a
billion dollars under management. What you have to keep in
mind however is that hedge funds use LEVERAGE, big
leverage. The average hedge fund manager in the United
States is using 6 times the capital base of the money he is
managing, as leverage. In the race for performance or the
elusive alpha, some hedge fund managers are pushing the
envelope and using as much as 10 times leverage. This can
cause serious problems because when leverage goes against
you, it's DEADLY.
An example is now the latest announcements coming out of
Basis Capital. Apparently this hedge fund was invested in
the US home loans to investors are less than creditworthy.
The hedge fund claims that the collateral in their
portfolio is sound, but sound is a matter of judgment.
Unfortunately for Basis Capital, the prime broker clearing
for the hedge fund doesn't agree with them. The prime
broker has re-priced this so-called sound collateral.
What does it mean?
The hedge fund now has to go into a crisis mode to survive.
Immediately many investors will ask for their money back.
This is the step that kills off the hedge fund. In order to
prevent a run on the bank, as they like to say, the hedge
fund has announced that they may restrict redemptions,
which is the right of the investor to withdraw their money
at, will. If investors are allowed to withdraw their funds,
the collateral securing the underlying investments usually
collapses because other smart money knows that that
collateral has to be sold in order to fund the redemptions.
Prior to originating a hedge fund, most hedge funds will
install restrictive covenants in their investor agreement
that build in what are called gates. These gates limit by
quarter what can be withdrawn from the fund. It's about
self-preservation. In this case Basis Capital and its two
hedge funds require 90 days notice before capital can be
withdrawn. Once again this policy attempts to prevent a
forced liquidation of the underlying collateral securing
the hedge funds' investments.
Basis Capital has warned that the true extent of their
problems might not become evident until September. What
does that mean? These people mark to market every day.
They have the finest computer pricing systems in the world.
PhD's in mathematical modeling are a dime a dozen in the
hedge fund industry, and yet this hedge fund doesn't know
where it stands financially. This is a breakdown in the
system, and it has great meaning to the rest of the hedge
fund industry.
What happened to Basis Capital is very simple. In the range
of assumptions they used to make their bets they determined
normal risk parameters. They did not give any consideration
to the possibility that the investments they were making
might, just might move outside their normal variability
ranges. In other words they excluded worst-case
possibilities from their consideration. The melt down of
the sub prime lending market is such a possibility and it
has HAPPENED. For an elaboration of this article, please
see our website.
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Richard Stoyeck's background includes being a limited
partner at Bear Stearns, Senior VP at Lehman Brothers, Kuhn
Loeb, Arthur Andersen, and KPMG. Educated at NYU, and
Harvard University, today he runs Rockefeller Capital
Partners and StocksAtBottom.com
http://www.stocksatbottom.com/
For an elaboration of this article, please see our website
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