Another Hedge Fund Warns- Basis Capital

Stock Research – Another Hedge Fund Warns- Basis Capital – This is just the Beginning!!!!

Richard C. Stoyeck
StocksAtBottom.com
July 12, 2007

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 that 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 These gates limit by quarter what can be withdrawn from the fund.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 In this case Basis Capital and its two hedge funds require 90 days notice before capital can be withdrawn.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.

Rich investors are not stupid investors by definition. Merrill Lynch puts together what is called a World Wealth Report. In the last issue, which came out recently, Merrill stated that investors might be bailing out of hedge fund investments. A year ago in 2005, rich investors had 20% plus of their investments in what are called alternative investments. Such investments include venture capital, currencies, hedge funds, private equity, and structured products.

Last year in 2006, the 20% capital commitment decreased to 10%. Keep in mind that Merrill Lynch is such a big part of the financial landscape, that when they come up with a survey, that survey is pretty accurate. Merrill doesn’t have to go much further than their internal customer base to know what is happening in the financial world.

It seems that investors are already coming to the conclusion future hedge fund performance in the future will not be the same as in the past. This is reasonable because as more and more money has come into the hedge fund industry, the law of large numbers must take over. The ability to chase the elusive alpha of high returns just doesn’t hold together as asset classes expand.

Hedge Fund & Private Equity managers come under fire

The director of the Congressional Budget Office fired a salvo at the managers of this industry when he testified before Congress that income received by these managers should be taxed at ordinary rates, not capital gains rates. The difference is 35% versus 15%.

The testimony given by Peter Orszag was compelling. In part he stated that the manager of these types of investment plays a different economic role than the passive investors who write a check. He believes that the income the managers receive is really performance based compensation, and not capital gains which is the way it is taxed today. It will be interesting to see how the Congress votes on this topic.

Goodbye and Good Luck

Richard Stoyeck
StocksAtBottom.com

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Stock Research – Another Hedge Fund Warns- Basis Capital – This is just the Beginning!!!!