Hedge Funds Also Caught in Tempest
Pension Funds, Endowments and Loans Count On the Huge Investment Pools

By David Cho and Heather Landy
Washington Post Staff Writers
Tuesday, September 23, 2008

The federal government's dramatic reshaping of Wall Street has thrown the hedge-fund world into turmoil, threatening the viability of some of these massive investment pools that have become increasingly critical for pension funds and endowments and a source of financing for a wide range of consumer loans.

This year has already been the worst in at least a decade for the $2.5 trillion hedge-fund industry, associations say. But last week's collapse of Lehman Brothers and an unexpected, temporary ban by the Securities and Exchange Commission on the short selling of financial stocks -- a widespread hedge-fund practice that bets a share price will fall -- sent shockwaves through the industry. Several funds are now teetering.

Unregulated and secretive about their trading strategies, hedge funds have enormous sway over the markets. Industry groups say they are responsible for more than a third of stock trades. Some market analysts worry that a collapse of a major fund could shake confidence in an already fragile financial system.

Losses from hedge funds may also quickly spread to other segments of the investment world. In 2007, pension funds had about $76.3 billion in hedge funds, up from about $50.5 billion the previous year. Endowments have invested about $75 billion, according to a recent study.

Some pension funds and endowments that have relied on hedge funds for a stable, higher-than-average source of investment returns have been watching the unfolding trouble with alarm.

As last week's events progressed, Jim Hille, the chief investment officer at Texas Christian University, recalibrated his expectations for returns on the school's hedge-fund investments, which total 22 percent of the university's $1.2 billion endowment.

"The ability for hedge funds to maneuver around changing environments is part of the reason we invest in them," Hille said. "Their benchmark is a double-digit rate of return at a low level of risk, and how they get there is up to them. But there's no question it's going to be very challenging to achieve that now."

Of all of the tumultuous events of the past week on Wall Street -- which included the bailout of the nation's largest insurer, conversion of investment giants Morgan Stanley and Goldman Sachs into bank holding companies, and the promise of a $700 billion rescue package from the government -- the biggest source of problems for hedge funds was the temporary SEC ban on shorting financial stocks.

Industry groups say the ban, if made permanent, could make it difficult for some funds to survive because their entire trading strategy was based on the practice. Hedge-fund managers said shorting plays an important role in the markets because it helps them properly price securities.

Critics of hedge funds say the ban was necessary, accusing short-selling hedge funds of creating a false crisis of confidence at investment banks and profiting from their fall.

Richard H. Baker, president of the Managed Funds Association, the largest U.S. hedge-fund association, said he is pushing for a meeting with the Treasury and the Securities and Exchange Commission to lobby them to overturn the ban, which blindsided many hedge-fund managers.

"I think there's been an emotional response to blame the hedge-fund sector because it's a hard sector to understand," Baker said. "Most people don't understand the relationship our industry has to the working family on the street and the relationship to pensions and endowments."

Some financial analysts blame the recent swings in the stock markets on hedge funds covering their short selling. This occurs when a hedge fund borrows shares and then incorrectly bets that the price of the shares will fall. The funds' losses are magnified because they often use borrowed money to make such investments and must pay back both the lender of the stock and the lender of the money.

To mitigate those losses, hedge funds often try cover their shorts by scrambling to buy more of the stock as it rises in price. This frantic buying can make it look like markets are rallying, when in fact they are simply being driven by hedge-fund activity.

Baker said that the bankruptcy of Lehman Brothers also staggered several funds that had relied on that investment bank as a business partner or owned Lehman's bonds or stock.

The restructuring of Goldman Sach and Morgan Stanley are likely to have less of a major impact because their investment banking divisions will not change fundamentally, other hedge-fund managers said.

Even before the events of last week, the credit crisis had claimed some funds, including two run by Peloton, a firm that specialized in mortgage-backed securities, as well as Turnberry Capital Management, which focused on distressed debt. The Ospraie Fund began winding down after losing bets on commodities stocks, while Windmill Management put two of its SageCrest funds in Chapter 11 bankruptcy protection to head off a forced asset sale.

Jaeson Dubrovay, who advises institutional investors on hedge-fund investments for the consulting firm NEPC in Cambridge, Mass., said more failures are ahead for the industry, especially the 2,900 small to medium-size hedge funds.

"I would venture to say that a lot of these in this environment are not going to survive," Dubrovay said.

In the late 1990s, massive losses at a hedge fund called Long Term Capital Management threatened the financial markets and ultimately required the Federal Reserve to offer a bailout of $3.6 billion to stop a broader crisis from developing.

Since then, hedge funds have become critical cogs in the credit markets. Many of them buy corporate loans, mortgages and other kinds of debt that have been turned into securities and can be traded like shares on the stock market. With hedge funds as financiers for this debt, investment banks and lenders were able to make massive loans to freewheeling borrowers and feel less impact from the risk during the boom of the past few years.

As a result, the banks were able to offer mortgages to people with questionable credit. The business of borrowing billions of dollars to buy troubled companies boomed. Backed by hedge funds, insurance companies offered coverage to homeowners in New Orleans after Hurricane Katrina.

These kinds of transactions have now all but shut down. And if more hedge funds end up closing, the markets could lose some of their liquidity, a term that refers to the free flow of money through the financial system.

"Right now I think it's a pig in a poke, and I think people are paralyzed and probably rightfully so," said Peter Kaufman, president and head of restructuring and distressed mergers and acquisitions at Gordian Group, a New York-based investment bank. "This is a brave, new, ugly world."