Fed Says Dealers Made it Tough for Hedge Funds to Finance Trading

A Federal Reserve survey showed that “Wall Street dealers made it tougher for hedge funds to finance trading of securities and derivatives in the three months through November,” reports Bloomberg.

“Responses indicated a broad but moderate tightening of credit terms applicable to important classes of counterparties,especially hedge-fund clients… according to the quarterly survey of senior credit officers at 20 dealers covering the period of September to November.”

Respondents who reported tighter borrowing terms for hedge funds “most frequently pointed to a worsening in general market liquidity and functioning and to reduced willingness to take on risk and, to a lesser extent, adoption of more-stringent market conventions and deterioration in the strength of counterparties as the reasons.”

The Federal Reserve report also showed that “hedge funds’ use of financial leverage, considering the entire range of transactions with such clients, had decreased somewhat over the past three months.” Obviously, tighter borrowing terms will tend to lead to a decrease in the frequency that hedge funds use leverage, but there is a greater issue – without leverage, hedge funds can’t make the massive returns they have a history of making. By borrowing money, a hedge fund can take a larger position in a stock than would otherwise be possible. This way, a fund can make big profits on a small gain.

Given that there is already an issue with many hedge fund filings (not all), tougher credit terms may make the issue worse. A 2011 study by Cici, Kempf and Puetz found that hedge fund “valuations were marked below quarter-end closing prices and in bad times they were marked up. Investors gravitate toward funds whose performance is less volatile, and lower measured volatility also gives funds the green light to use more leverage.”