Legions of hedge-fund managers in open-necked shirts are poised to jump from the ledges outside their Greenwich and Mayfair offices, if the scuttlebutt about losses in the derivatives market is to be believed.

Standard & Poor's cut Ford Motor Co and General Motors Corp to junk this month, which prompted unexpected shifts in the value of credit derivatives and a lot of smoke about hedge funds those potential weapons of financial mass destruction.

It is impossible to tell whether their investment strategies are on fire, or whether analysts are just extrapolating from a few faltering funds and fearing the worst.

Some flames are visible at individual funds.

The Strategic Allocation Fund, run by Boca Raton, Florida-based John W. Henry & Co, lost almost 27 per cent of its value in the year's first four months, indicates its website.

London-based GLG Partners LP's Market Neutral Fund, a convertible arbitrage fund, lost more than 10 per cent from mid-March to the end of April, indicates Bloomberg data.

It delivered more than 5 per cent last year, and almost 33 per cent in 2003.

The smoke may clear somewhat in the first part of June, when many hedge funds will reveal how well or badly their investments performed in May.

They lost about 1.2 per cent in March and April, indicates an index of returns compiled by Credit Suisse Group and Tremont Capital Management Inc.

Counting the cost

Still, it may take longer to assess the full damage wrought by the turbulent markets of the past few weeks.

"If we go back to the Russian crisis in 1998, the default occurred in August, but the credit market did not feel the full effects until October," says Jim Reid, a credit strategist with Deutsche Bank AG in London.

"The true consequences of mark-to-market losses from General Motors and Ford may take a few months to become apparent," he says.

The credit derivatives market risks spiralling into a tailspin.

Investors facing losses on their corporate-bond and credit-default-swap investments may shun new collateralized-debt sales.

That, in turn, may sap demand for the corporate bonds and default swaps used to create collateralized debt, which would drive their values down even further.

Hedge funds may be forced to sell money-losing securities to repay fleeing investors. And so on.

Money managers are definitely taking some risk off the table.

Investors have pulled money out of high-yield bond funds in the United States for 14 consecutive weeks, which has resulted in the withdrawal of almost US$6.6 billion from funds that invest in the riskiest fixed-income securities, says Sarah Franks, a New York-based strategist at Merrill Lynch & Co.

Sales of new European high-yield bonds are at their lowest since September 2003.

Not a single borrower has braved the market since S&P dropped the two biggest US automakers to junk.

The total value of new corporate-bond sales in Europe is more than one-third lower compared with this time last year, says Suki Mann, head of credit strategy at Societe Generale SA in London.

Government bonds, meanwhile, are being boosted by that newfound risk aversion, as fund managers move cash into the least-vulnerable fixed-income securities.

The 10-year US Treasury yield is just a handful of basis points away from its three-month low. Yields in Germany dropped to a record low earlier this month.

Risk management

Mounting concerns about hedge-fund performance has prompted protestations of innocence from the two biggest derivatives houses: Deutsche Bank and JPMorgan Chase & Co.

"Our hedge-fund exposure is, we think, extremely well managed," said JPMorgan's chief executive officer, William Harrison, during the bank's annual meeting in Chicago on May 17.

At Deutsche Bank, trading positions with hedge funds are "fully collateralized," chief financial officer Clemens Boersig said on May 11.

That has not stopped the investment banks from lowering each other's earnings estimates.

Merrill Lynch said last week the "recent turbulence" in credit derivatives will cut Deutsche Bank's 2005 earnings per share by 4 per cent, to 6.40 euros (US$8.06).

JPMorgan, meanwhile, cut its second-quarter estimates for Goldman Sachs Group Inc and Morgan Stanley on May 9. JPMorgan said "fixed-income trading results will likely be weaker."

We are also hearing mutterings from market regulators, although they have resisted the urge to demand greater oversight, talking education rather than investigation.

"We need to be aware of where the concentrations of risk are," said Randy Quarles, the US Treasury's acting undersecretary for international affairs, on May 19.

Bloomberg News

(China Daily 05/30/2005 page11)