Hedge funds are growing increasingly prevalent across various market sectors, as the overall size and scope of the alternative investment vehicles require more capital to grow. But the tightened correlation hedge funds are causing among various sectors, including CDOs and derivatives, could cause an unpleasant domino effect across credit markets should a substantial credit event occur, Fitch Ratings warned last week.

"This was something that we started looking at in the beginning of the year. It was not spurred by auto activity - there was a realization on our part that everywhere we looked, hedge funds seemed to be becoming more and more significant participants in all of the sectors that we cover, whether it is the cash market or the credit derivatives market," said Fitch analyst Roger Merritt.

Some analysts call the corporate credit downgrades of General Motors and Ford Motor Co. the first real test of the credit derivatives market, which is largely influenced by hedge funds. The downgrades resulted in losses and spread widening, and some funds were required to unwind their positions, but the market overall proved resilient according to most reports. But, as Fitch pointed out in research last week, "Even having weathered these events, market participants are still wary of the circumstances that may result in hedge funds acting more synchronously in response to some market dislocation."

Alternative investment vehicles control as much as 30% of the trading volume in the $8 trillion global credit derivatives market, according to Fitch estimates. Fixed-income strategies have grown to about $60 billion last year - triple the $20 billion seen in 1997. The rating agency points out that, assuming an average five times leveraging, actual fixed-income assets under control by hedge funds may be closer to $360 billion.

The highly leveraged positions estimated to be held by hedge funds amplify the potential effect of a credit event spurring forced selling of multiple positions. For example, on average hedge funds leverage the credit default swap carry trade 20 times, and the long/short credit derivatives 10-to-15 times, according to prime brokers surveyed by Fitch. A four-times leveraged hedge fund may be forced to sell 25% of its assets in the event of a 5% price correction, according to Fitch, and further price erosion would increase the fund's margin requirements. Assuming the same price decline, a leverage-maxed fund absent a debt cushion, needing to increase its dealer margin to 25% from 20% would require a fund to de-lever as much as 40% to meet its margin calls, Fitch writes.

Similarly, the high leverage employed in synthetic CDO squared structures results in a heightened sensitivity to spread or correlation changes. Fitch estimates that a CDO squared structure could withstand price declines as much as three times greater than a CDO backed by other assets. Hedge funds are estimated to be large buyers of CDO equity, CDO squared structures and various synthetic structures, and are largely credited for the rapid growth in the credit default swap market. Some, more sophisticated, hedge funds are turning to CDO structures for alternative financing mechanisms.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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