Distress in Hedge Funds Continues in the Background

We have long since detached from fundamentals, but what makes "this time different" from other bear markets is the influence of hedge funds. We talked about it constantly during the past 15 months; how HAL9000 (computerized algorithms) were creating very weird action that made little sense, and how while controlling only 3% of the assets, estimates are hedge funds do anywhere from 30-60% of the trading. So despite their relatively small size, their impact is completely out of whack with their size. I wrote sometime in the fall/early winter that these unregulated pools of money would at some point reach a size that they would cause some major dislocations in the markets - but I was thinking years from now. I did not realize the leverage they were employing so their impact has been much larger than their size would imply.... so this day has come far earlier than I imagined. Every day we are reading some fascinating factoids from the industry.

News from the past 24 hours - Citadel which if not the "best of the best" of hedge funds is "top 5" had its worst month ever in September and reports are it's main funds, Kensington and Wellington are down approximately 25-30% year to date. Simply unheard of for these guys - Kensington for example only had 1 losing year in history (1994 at 4%). Keep in mind, October has been worse than September!

• Citadel Investment Group LLC, one of the world's largest hedge funds with about $18 billion of assets, said September was the single worst month in the history of the company.
• At last count, Citadel’s two largest investment funds were down a little over 26% for the year. Just a month ago, the two funds were down 20%. Sources say Griffin’s two flagship funds may have tumbled even more with Oct. 15’s big market plunge.
• In a letter to investors obtained by Reuters on Wednesday, Citadel chief executive Ken Griffin said: "September was a devastating month for financial institutions and investors around the world -- September was also the single worst month, by far, in the history of Citadel." Griffin said Citadel's performance reflected extraordinary market conditions he did not fully anticipate, combined with regulatory changes "driven more by populism than policy."
• About a quarter of Citadel's losses in September came from stocks, as industrial, technology, communications, media and entertainment shares all tumbled, according to the letter. Citadel may have difficulty selling convertible bonds, which accounted for about a quarter of the loss, because there is little demand. Citadel's wagers on corporate debt and structured credit also lost money as did trades on energy, reinsurance and mortgages, it said. (this is the problem with this market right now - there is NO PLACE to make money - it is asset deflation in every asset class)
• Citadel executives have been outspoken about their expectations for traders to make big returns even in difficult markets. ``When the markets change, we don't accept lower returns,'' said Mike Pyles, Citadel's head of human resources in a 2005 interview. ``We aren't that kind of firm. We expect the manager to go figure out how to make money in the new markets. We make no apology for it.'' (I wonder what they are saying today?)
  
• Griffin told investors that in mid-summer, he decided to reduce risk in Citadel's poorly performing strategies while at the same time increase risk allocation to its "core relative value investment strategies" including convertible bond arbitrage. "Regretfully, I did not foresee the financial disaster that was to unfold in September," wrote Griffin. "The financial crisis dramatically raised the cost of borrowing and reduced the availability of credit to market participants, materially reducing the value of cash assets as compared to the value of derivative instruments," added Griffin.
• The Citadel chief executive said the decision by regulators around the world to ban the short selling of equities "created material dislocations across many of our portfolios and disrupted our ability to assume and manage risk."

Just the rumors of Citadel's struggles are causing selloffs in this market - that's how influential some of these funds are. I am posting this just to show you how much the game has changed and how players behind the scenes dominate the markets - it's not your father's stock market anymore.

• But rumors that its performance was far worse were so rife that they helped drag down the stock market on Wednesday, and prompted Citadel to take steps to set the record straight. The rumors swirled for days and gained momentum on Tuesday morning when they were published on a financial Web site. After a complaint from Citadel, the site pulled down the item within an hour. Still, by Wednesday afternoon, the rumors were buzzing all over Wall Street -- and around the globe.
• Citadel has told clients that, contrary to the rumors, it has not seen its borrowing lines cut or the terms of its borrowings altered. Standard & Poor's last week affirmed its long- and short-term counterparty credit ratings at BBB+/A-2, a reasonably strong rating. The firm also has assured clients that it is on solid footing. It has $6 billion in cash.
• The fact that some large hedge funds are under stress could provide a window for governments to step up their regulation of hedge funds, as many have long wanted to do, Mr. Alikhani said. Since Mr. Griffin, 40 years old, founded Citadel about 20 years ago, it has been one of the world's most lucrative places to invest. Its returns, on an annualized basis, have been 18% to 20%. The firm manages about $17 billion now -- down from about $20 billion at the beginning of the year.

Here you see the leverage of hedge funds - Citadel is down to 4:1 leverage from 7:1. So think of a typical margin call for a retail account which 1.5:1. i.e. you can borrow 50% against your holdings. You know how quickly that can turn on you when your holdings fall - you need to sell to make margin. Now imagine you borrowed $7 for every $1 you have and when the bank comes calling how much you need to sell. Now multiply this among thousands of hedge funds.

• One of the rumors had to do with the amount of money the firm borrows. Citadel, in reality, borrows about $4 for each dollar it has of equity, which is heavy leverage for a hedge fund. But the figure is down from $7 of leverage earlier this year.

Another hedge fund in Texas (it's not been a good time for hedge funds in Texas - see Maverick Capital) is closing its flagship fund

• Highland Capital Management LP will close its flagship Highland Crusader Fund and another hedge fund after losses on high-yield, high-risk loans and other types of debt, according to a person with knowledge of the decision.
• Highland, whose total assets under management has shrunk to about $33 billion from $40 billion in March, will wind down the Crusader fund and the Highland Credit Strategies Fund over the next three years, said the person, who declined to be named because the decision isn't public. The hedge funds had combined assets of more than $1.5 billion. The firm plans to sell 20 percent of the Highland Credit Strategies Fund's assets in the next six months and a further 20 percent in the following six months, the letter said. (again these are huge institutions, $40 Billion - throw some amount of leverage on it and you begin to move markets in huge ways)
• The Crusader fund is down more than 30 percent this year, the person said. The fund slumped 14 percent in January after reporting 40 percent gains in 2006 and a 4.5 percent loss in 2007.
• The Highland Credit Strategies fund suffered from ``unprecedented market volatility and disruption'' in financial markets, according to a letter to investors that was obtained by Bloomberg News. (Black Swan! Black Swan! Our computer models never accounted for this!)
• Dallas-based Highland, the world's largest non-bank buyer of high-risk, high-yield loans last year, also manages collateralized loan obligations and in March raised $1 billion to buy distressed loans. (excellent, they are closing 2 funds worth $1.5 billion but already have institutions lined out the door to give them another $1 billion to try again! Ah you gotta love institutional investors)
  

Again, as I keep saying, these are simply historic and unprecedented times; some of the industry giants with some of the best long term records - and with the most sophisticated trading strategies - cannot find ways to make money. We've been saying for months on end, there has been no attachment to fundamentals, and only daytraders seem to have a chance to make money on the equity side. It appears even in non equity areas of investment, the struggles are the same.

I'd expect another wave of withdrawals from hedge funds in December.