The absence of liquidity in the market is leading to some steep losses for highly leveraged hedge funds, according to The New York Times.

“For hedge funds, illiquidity is their Achilles’ heel,” said one fund investor.

Banks are putting on the pressure to raise margin levels and investors are scrambling to get out of funds, and the stresses couldn’t have come at a worse time for hedge funds. The prices on the debt instruments they hold continue to fall, if they are trading at all.

Stocks, such as small-cap value stocks that are potential targets for leveraged buyouts, have taken a beating. The volatility in the market is causing hedge funds and banks to reduce risk and sell off securities that can be easily disposed of.

“It’s not that suddenly everyone is out of cash. They just don’t want to lend it or invest it,” said Frederick Joseph, head of investment banking at boutique Morgan Joseph & Co.

A liquidity vacuum can be dangerous to hedge funds as they try to make money by spotting variances in the market. When liquidity dries up, people get scared and prices start to act abnormally and funds bets go haywire.

“Hedge funds can withdraw liquidity rapidly, particularly when facing mounting losses, and this can cause severe market dislocation on the rare occasions when they all head for the exit door at the same time,” said Andrew Lo, a professor at M.I.T. Sloan School of Management.

Due to the subprime mortgage problems, large multistrategy funds have faced increased margin calls on their mortgage- or credit-related portfolios. Banks started to demand more collateral, and the funds sold stocks. However, many funds held the same stocks, including shares of companies known to be headed for a leveraged buyout.

Funds started to dump stocks they owned and buy back stocks they had borrowed because they had no ability to sell risky loans.

Subsequently, value stocks fell while popular shorts rose. The occurrence was counter to quantitative models, including some owned by Goldman Sachs, AQR Capital, and D.E. Shaw.  

At United Capital Asset Management, John Devaney, said in early July that the fund had received an “unusually high number of redemption requests,” including one from its largest investor that accounted for nearly a quarter of the firm’s assets under management. Due to that, the firm suspended redemptions in several funds “in order to protect the interest of our investors,” Devaney said.

SAC Capital’s multistrategy fund is down 6% for August, one of its worst months ever, one investor related.

Toward the end of the week, Tudor Investment’s Raptor Fund was down 7% for the year and Highbridge Capital Management, owned by JPMorgan, was down 4% for the month last week and up 2.5% for the year.

Regulators have expressed to banks and hedge funds the importance of managing liquidity risk. However, the warnings often fall on deaf ears. Unpredictable events seem to crop up every few years and when they do they cause damage, even for firms with long track records.

The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries.

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