The Lie That Will Kill Hedge Funds

By Jim Cramer Columnist

It's all in the marks.

Unless you have run a hedge fund, you have no idea what that means.

So I will explain it to the uninitiated. When you run a hedge fund, you are always seeking capital. You can seek money directly from institutions or individuals, or you can do the easiest thing and seek money from those who are offering it: "fund of funds" managers who, specifically, look for managers to place other people's monies. This cohort of investors had just gotten started in about my seventh year as a hedge fund manager, and they were always plying me with capital. I tried it for a while, but the ones I had, and they were substantial, demanded too much of my time and, I thought, forced me to make shorter-term decisions than I liked. I valued my independence too much.

So I sent their money back. Lots of people thought that was foolish. Lots wanted to grow their funds gigantically because they figured that was the way to get rich, quick. I was an idealist, and I wanted it to be a like a club where someone had to nominate you to get in. I wanted it that way because I didn't want any heat from them, and as long as I didn't seek them out, I didn't have to worry about pleasing them beyond the numbers. Anyway, few people run money as I did. Maybe none. Most take the fund of funds' money.

Fund of funds managers interview and bracket managers into different groups: high-growth stocks, even-oriented managers, arbitrage, market-neutral, short, long, etc. They put them in buckets and measure them against others and then they go back to their real clients and say "here is the menu," or "here is what we recommend." When I was in the game, by far the most popular were the "market-neutral" and "arbitrage" funds because they could absorb any amount of money and play all around the world without being hostage to "the market." They make money no matter what, which is the definition of what you are supposed to want if you are a client. These managers can take advantage of the vast discrepancies that exist in the markets worldwide and borrow a lot of money to exploit them.

That's hard if you are a pure stock guy. It is true that Pepsi (PEP) is cheaper than Coke (KO) on a price-to-growth metric. (Coke grows slower than Pepsi but has a higher multiple.) But does that mean you can go long Pepsi and short Coke and the twain meets? I wouldn't bet that way. But how about this? American Home Mortgage (AHM) issues $1 billion in mortgages that Citigroup (C) packages. American Home isn't a "deposit" institution with a broad range of businesses to fall back on. It just issues mortgages, 2 and 28, teaser, little documentation, etc., etc.

Citigroup pools all of those mortgages and offers them into a bond that yields 7%, say, as a blend of the payments. A market-neutral and an arbitrage fund manager might say, "OK, I have $1 billion under management. I will go to Citigroup and borrow 10 billion and invest in these kinds of bonds." They yield 7%, I am borrowing at 5%, I get 2% on all I lever up, which can produce, risk-free, a lot of return. It sure seems risk-free; the bonds are "highly rated" by S&P and Moody's, which gives me ample protection. I am not doing anything reckless. I am doing what every other manager in my class, the biggest and most profitable class, is doing. But the strategy isn't risk-free.

Only Treasuries are risk-free. Now I am showing a really consistent rate of return because of that trade and dozens like them -- regardless of the stock market. So funds of funds drool and throw money at me and I keep buying more mortgage-backed securities and borrowing Treasuries. I can handle trillions! Houses go up in value, mortgages get paid, employment's strong; that's all that matters. The bonds pay. But housing stops going up in 2006. I keep buying the bonds, but I keep reading there are defaults. I don't see it. My traders don't see it. Everything's seems very ethereal.

And then in June, Bear Stearns (BSC) , doing this strategy at its funds, gets told the bonds are moving down in value and it must put up more collateral. But it doesn't have much cash and all of it is deployed. So it sells some bonds to meet the call. But nobody wants the bonds; everyone reads the papers and knows that defaults are mounting. So by the time it finishes selling the bonds, which now have no natural buyers, the collateral is gone. The funds close. That happens in June. In July, the funds of funds get their reports and they see that, let's say, one of the funds is down 10%. They immediately put two and two together and they figure, "Wow, we could have a Bear on our hands."

They go to the manager with redemptions. But things are much worse than they seem. The "marks" -- meaning what the bonds in their portfolio are marked or priced at -- is some last sale price, presumably around par because they don't trade. A redemption notice forces the trade. There are no buyers. That's how a Sowood could be down 10% at the end of June and 50% a few weeks later. The marks are all lies.Nobody is getting anywhere near the price of the bonds, which has become subjective anyway because of the number of defaults within the bonds. All over the Street, these redemptions are happening. All over the Street, those doing these strategies are being wiped up.

There are not enough people who were short this stuff to buy it at what might turn out to be pretty good prices unless all the mortgages within the security are going to be wiped out. I would bet that half of these funds are gone this year. They represent trillions of dollars. You will hear a lot of chatter about "the resetting of risk premium" right now. And it is true. But what's really going on is lying prices. These strategies didn't take into account the risk of default. The agencies didn't take it into account. The packagers didn't. The homebuilders that relied on it didn't.

Because these same hedge funds were also the buyers of high-yield bonds for private equity -- same trade: borrow money against Treasuries to capture the differential -- they don't have the capital to buy the corporates. Again, discussed as "repricing of risk," when what it really is is defrocking of marks. But that would reveal the whole industry as glib and unthought-out and complacent, which is what it really was. This process is playing out everywhere, and the government isn't going to bail out these hedge funds. The good news is that it will happen fast.

The money will come out, the losses will be big, but these hedge funds will all be closed by year-end. Trillions will vanish. But then we will start all over again. Once this whole process is understood, the casualties, including some banks and some homebuilders and almost all mortgage companies except Countrywide (CFC) because it has a bank and lots of other businesses and is not a pure broker, will be taken. By November, this will be over. The stock market will rally before it is finished and the Fed will act to save a Washington Mutual (WM) and we will rally huge.

Let it play out. It's happening with Mach 5 velocity, so you won't have to wait too long. Some days stocks will rally because the pressure will look like it's over. Other days it will return. No one who did this strategy will survive. But then we will thrive.

Sooner rather than later.


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