Credit risk managers are scrambling to keep track of multifaceted exposures to hedge funds. The industry's torrid growth has propelled assets past an estimated $1 trillion, but that's just equity capital. Most funds leverage their portfolios either directly or through derivatives.
Although banks typically don't provide revolving credit facilities to hedge funds, they do finance fund operations through derivatives and foreign-exchange trading. Banks also lend to prime brokers, who provide margin loans to their hedge fund clients.
"Counterparty trading exposure is the biggest," explains John Hogan, managing director of risk management at JPMorgan Chase, "Then there's clearing risk and foreign-exchange settlement risk." Even though JPMorgan has highly collateralized exposures that are short term in nature and incorporate conservative covenants, the bank watches them like a hawk. "We track the daily mark-to-market variance of the exposures and make sure we're comfortable relative to the fund's overall creditworthiness," he says. "It's a much more dynamic, proactive type of credit management than you would have in a corporate environment."
Prime brokers who lend to hedge funds have an advantage because they hold custody of the assets. Knowing what securities a fund holds, they can test the portfolio and set credit limits based on a worst-case simulation. Banks don't have that luxury. "Hedge funds don't want to divulge trading strategies and portfolio holdings," says Curtis Knight, director of securities lending at the Risk Management Association.
Credit managers can rely on collateral instead-as long as it's marked to market. "The frequency with which you do that is shorter than the life of the instrument," says Christopher Finger, head of credit products at RiskMetrics Group. If a bank revalues a three-month forward foreign- exchange contract and adjusts the collateral every two days, it curbs the potential loss. "In practice, it's exposed to more than two days' market move," he says. "If the fund got into trouble things would take a little longer to play out and they'd stop paying."
He advocates a higher-level approach to identify the sources of a fund's risk and returns. If its strategy depends on selling volatility, the long-term risk relates to short volatility, not the options the manager has sold at a specific time. RiskMetrics' research found quantitative factors can explain up to 80 percent of past performance for some hedge-fund strategies. Over time, statistical analysis can reveal both style drift at individual funds and correlation among apparently unrelated funds.
Credit managers feel far more comfortable lending to prime brokers than to hedge funds. "[Prime brokers] are highly regulated entities with a significant amount of capital and, in theory, a large control structure around the business including appropriate limits," Hogan says. He relies on prime brokers' regulatory and internal controls to "make sure they don't get over their skis" in extending credit to hedge funds or other counterparties.
Secondary credit exposure through prime brokers has received little attention to date, according to Finger. That may be because banks find it hard enough to track their direct risk. It's a game best left to the big boys. "You've seen a couple of hedge funds recently that have gone under," says Knight. "You do begin to wonder if this is a business that people should be in, outside of the JPMorgans and Citibanks."
