Another Accelerant Fanning the Meltdown Flames

Throughout history, excessive use of leverage has been a cornerstone of financial crises and economic collapse. The reasons are fairly obvious: when there is a lot of borrowed money involved, there is less of a cushion available to absorb losses when conditions turn sour. Moreover, those with little skin in the game have greater incentive to cut-and-run than to hang in there and work things out. Finally, credit and confidence are intimately linked: when one suffers, the other does, too, which can easily cascade into contagion and panic.

What is especially toxic about the current environment, though, is the degree to which greed, financial innovation, and a lack of transparency have enabled leverage to be multiplied to such an extraordinary degree over the course of several years at so many different levels, with few people even being aware of the scale of exposure -- until now, that is. In "Crisis for New Class of Funds," the New York Post details yet one more accelerant fanning the flames of the still unfolding credit-bubble meltdown.

Hedge-fund executives say the next blow to hammer their industry will likely come from a wave of hedge-fund redemptions driven by highly-levered funds that invest in other hedge funds.

One bellwether of how this may play out in coming months can be seen in the performance of two key European-hedge funds that have sustained sharp losses because of their exposure to some of the most problematic investment strategies in this summer's hedge-fund sell-off.

Fix Asset Management's Canary Fund Ltd. and Fairfax Fund Ltd. - each of which have $3.5 billion under management - have suffered a brutal three months.

Their fund-of-fund portfolios have dropped between 16 percent and 18 percent between June and August.

A fund-of-fund invests capital across a series of hedge funds on behalf of pension funds and endowments.

Fund-of-funds are traditionally conservatively managed and use the diversification of their hedge-fund investments as their primary risk management tool.

Even though the losses are painful for Canary's and Fairfax's investors, Fix Asset Management told The Post that they have not had any margin calls, despite the sharp losses and the use of leverage.

As a result, "there has been no need to redeem from underlying funds," Fix executive Panos Katsambas told The Post.

While it could not be determined which hedge funds had investments from Canary and Fairfax, given the size and timing of their monthly losses, it appears likely that the two funds had significant exposure to funds employing statistical arbitrage, credit arbitrage and merger arbitrage strategies.

Once these strategies started to hit trouble, the funds' outsized exposure - via leverage - to losing bets locked in losses.

In August, the bottom fell out for the two funds.

The Canary Fund Class A Euro portfolio dropped 10.11 percent; The Fairfax Fund Class A portfolio dropped 9.89 percent in the month.

The problem for the hedge-fund industry, according to a veteran hedge-fund capital provider, is that Fix's Canary and Fairfax funds are likely not the only fund-of-funds that used borrowings to enhance their performance.

Several hedge-fund executives told The Post that a next wave of hedge-fund redemptions would likely be fueled by highly-levered fund-of-funds needing to redeem their investments to meet margin calls.

(Hat tip to FiNTAG)